Monthly Archives: May 2011

Finances, Investing

Investment Advice: Bow to the Wisdom of the Market

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Finally we arrive at the hallmark of Malliel’s investment strategy: invest in low cost index funds in the broad market rather than relying on professionally managed funds who can point back at their superior results. Why: the index does better than 85% of such funds and you cannot know who will beat the market in advance. Much more often than not, yesterday’s hot funds, underperform versus the market today. Read on. 

Malkiel’s Rule 8: Bow to the Wisdom of the Market

In this chapter is the second foundation for his core investment strategy recommended in the book. The first foundation from Rule 7 is that “costs matter”. In Rule 8 he works to persuade us that market is smarter than not only non-professional investors (not difficult for me to accept) but also the “experts”. He says that 90% of the money in the market is invested through such advisers despite the fact that those investment underperform versus the market as a whole.

Again, he quotes Vanguard founder Jack Bogle: It’s time to face reality: There is no evidence that research – even the research of the Institutional Investor all-stars—adds value. Academic studies only confirm what we all believe: The stock market is highly efficient, and that stock princes incorporate virtually all information. As I’ve often said, “Never think you know more than the market. Nobody does.”

Malkiel goes on to explain why. When news arises about a company, an army of profit-seeking Wall Street professional on it rapidly, driving stock prices up or down depending on the news. He says when we read it or hear it, it is likely already reflected in the market.

Further he says this news is random and unpredictable. “And so market prices (except for the long-term up trend reflecting growth in the economy) move like a drunkard meandering down the stream. This is what financial economist mean when they say the stock-market prices in an efficient market behave like a random walk.”  [Thus the name of the book.’

If you recall his first basic point, fire your investment adviser, it is based on this efficient market theory. As the experts can’t predict things any better than the market, it is best to just invest in a low-cost index fund (see next chapter for specifics).

Does this mean the market never make mistakes? No, the internet bubble of the year 2000 is an example of mass insanity of the market. But such incidents are rare and cannot be predicted either.

Having read and embraced this idea, I still wondered if there might be a way to see the big patterns of bull and bear markets and know when to get out of the market for each least some of the bad periods (bear markets). His section “Timing Isn’t Everything” addresses this. He says no one can time the market.  He quotes Bernard Baruch, famed investor, who says, “Only liars manage always to be out during bad times and in during good times.”  He backs this up with some statistics that a significant amount of the growth in the market occurs in small windows of time, some of which is in the “bad times.”  He quotes Charles Ellis, “Investors would do well to learn from deer hunter and fishermen who know the important of being there and using patient persistence – so they there when opportunity knocks.”

Ok, I guess I am convinced (I think; I still might change the stock/bond ratio if I am convinced we are heading for a rough time).

Here are the summary statistics that say the index fund win over the professionals:

  • over 10 years, 84% of professional managed funds are beat by the index (e.g. S&P 500); over 20 years, it is 88%.
  • Over 10 years, the S&P 500 gained 9.27%/year, the average professional managed fund gained 7.18%. Over 20 years, the spread is even greater.

Why? Expenses drag down the performance of professional managed funds.

Next he addresses the question as to whether there are managers that beat the market consistently. He says that some managers do for a time but they do not do it consistently. He says there is no way to know the best manager in advance; it is only looking back that we can find them. [He addresses the lone exceptions or two in the last part of the chapter.]

He demonstrates that chasing hot performance (using managers who have done best in the most recent two-year period, 5-year period, 10-year period or those listed on Forbes Honor Roll or Morningstar’s 5-star funds) does not beat the market. He quotes Jonathan Clements on this point: “When an investor says ‘I own last year’s best performing fund’, he usually forget to add, ‘unfortunately, I bought it this year.’”

Finally, he spends the last part of the chapter on the Warren Buffet exception. In the end, he says you will never know in advance who the winners will be.

I find this pretty compelling logic and research here. My remaining question: are there not broad segments of the market I can buy into and stay in that beat the market as a whole? Perhaps the answer will be in the next chapter.

Next time:  Rule Nine: Back Proven Winners Model Portfolios of Index funds.

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see my summary.

Finances, Investing

Investment Advice: Costs matter

I started this investing study seeking to find out why my professionally managed investments are outperformed by unmanaged indices of the stock market (e.g. the DOW). In this chapter, I believe we uncover the dominant reason and the most important single paragraph of his book. With the foundation complete, in the three chapters that follow, we will see Malkiel’s strategy for beating managed funds.

Malkiel’s Rule 7: Pay Yourself Not the Piper

This chapter focuses on the costs of financial services. In his opening paragraph, he makes the point that over the long haul “the sales charges and ongoing expense you pay will hake a dramatic difference in the cumulative value of your portfolio.”  He says that these costs can be about 2% a year.

An illustration of why this matters: If over the long haul your investments make 8% a year (as stocks have done over the long haul), these costs will effectively reduce your net rate of return from 8% to 6%. Now remember the rule of 72. Instead of your money doubling over 9 years, it will take 12 years.  Suppose you invest $1,000 over 40 years. At 8%, this amount will grow to $21,725; at 6%, it comes to $10,286 instead. His conclusion: costs matter.

He warns that many financial services companies obscure their costs. He quotes the former chairman of the Vanguard Companies, “A low-expense ratio is the major reason why a [mutual] fund does well…the surest way to top-quartile returns is bottom-quartile expenses.” He says that most mutual funds turn over their entire portfolio in a year, adding transaction costs to the management expenses they charge.

So you need to look for funds with low expense ratios.  He advises against mutual funds with a load charge. He says the situation it the same with bonds and money-market funds, costs matter.

“Every extra dollar of expense you pay is skimming form your investment capital. Those funds are lost forever.”

So here is the most important paragraph of the book (so far at least) in my opinion:

In rules 8 & 9, I will recommend broad-based stock and bond index funds as the preferred investment vehicles of choice. Of all the funds offered in the market, index funds have the lowest expense ratios. Moreover, index funds mangers are fundamentally “buy and hold” investors. Thus, they avoid the transaction costs that are associated with funds that trade from security to security and regularly turn over the holdings in their portfolios. But even with index funds, expense ratios vary among mutual fund companies. You can be an educated consumer by learning about expense ratios from the Morningstar Mutual Fund Service (www.morningstar.com) and the Securities and Exchange Commission (http://www.sec.gov/investor/tools/mfcc/mfcc-int.htm). Don’t let high fund expenses eat up your retirement funds.

 Finally he says that cost matter in all financial products.

  • He cautions against buying insurance via variable annuities and whole life policies as they are in essence mutual funds with a costly insurance wrapper.
  • He suggests if one wants to buy stocks directly, to look for a discount broker (but make sure you know what you are doing and you get an honest broker belonging to the Security Investor Protection Program).
  • He also has a strong caution against something called a “wrap account” as they cost can be very high.

Next time: Rule Eight: Bow to the Wisdom of the Market

The above is from my on-going study on investing, from Malkiel’s The Random Walk Guide on Investing. For more, see my summary.