| This
website lays out a thorough and elaborate analysis of how capital markets
work. However, to give you a preview, here is the short version. Please
read it once without clicking the links, then go back and review the links.
Otherwise, you will be so distracted that it will take several weeks to
get to the tenth point.
1. Market
Randomness and Active Management: Markets are moved by news.
News is unpredictable and random by definition. Therefore, the markets
movements are unpredictable and random. However, this market randomness
does have a positive average of about 10%/year because capitalism works.
Active managers who have claimed to outperform a market average or index
have also implied that they have the power to predict
tomorrow’s news. But since it is impossible to consistently predict
the future, the results of active managers are unpredictable and random.
This concept is known as the Random
Walk Theory and it was first discussed in The
Theory of Speculation,
a paper written in 1900 by Louis Bachelier. In 1964, MIT Professor Paul
Cootner published a 500 page collection of research papers on the randomness
of the market titled, The
Random Character of Stock Market Prices. In 1965, Nobel Laureate in
Economics and MIT Professor Paul Samuelson wrote his now famous paper,
Proof
That Properly Anticipated Prices Move Randomly. Also in 1965, University
of Chicago Professor, Eugene Fama wrote his highly regarded papers, Random
Walks in Stock Market Prices, and The
Behavior of Stock Market Prices. After carefully reading this extensive
collection of peer-reviewed research, you will be convinced of the randomness
of stock market prices.
2. Skill or
Luck: The average actively managed investment must underperform
the indexed investment, when all costs are deducted. [source]
Those actively managed investments that beat the indexed investments fail
to consistently beat the index in the future. The reason for market beating
performance in a random market is simply due to luck
and not due to a skill that is repeatable.
Research
shows that only about 3% of active managers beat an appropriate index
over a 10 year or longer period. Needless to say, it is nearly impossible
to predict those winners in advance. Lucky investors are well advised
not to expect a continuation of their good fortune. [see 1,
2,
3,
4,
5,
6,
7]
3. Index Portfolios
Best Capture Risk and Return: Actively managing your money will
create higher risk and lower returns than a globally diversified, tax-managed,
and small value tilted portfolio of index funds. Due to commissions, management
fees, margin costs, taxes, stock randomness, and market efficiencies,
you will slowly transfer your money into the pockets of stock brokers,
mutual
fund managers, hedge
fund managers,
and the many other individuals profiting from your numerous transactions
and your lack of understanding of free market principles. Active management
is hazardous
to your wealth. A recent study
by Brad Barber of the University of California, Davis, showed that 82%
of the 925,000 active traders on one stock exchange lost $8.2 Billion/year
from 1995 to 1999. Dalbar Research stated in their 2004 report on Investor
Behavior that the average equity investor earned a paltry 3.51% annually
for the last 20 years, compared to 3.05% inflation and 12.98% for the
S&P 500 over that same period. The gap between the average active
investor and the market is 9.47%/yr. The global equity total market value
is $25
Trillion as of 12/31/04, so 9.47% of that is $2.4 Trillion!
4. Returns
from the Risk of Capitalism Rank Highest: Capitalism is a great
idea that has worked for centuries. It has provided an annualized return
of about 10%/year since 1926 and has the highest rate of return of all
investments tracked over periods of 50 years or more. That rate of return
is explained by the difference between the low risk of capital and the
high risk of capitalism. It is not the result of speculating in short
term price changes. There is no additional expected return from speculation
above the average return. The gains from speculation are offset by the
losses in any random situation, leaving the average, or the index, as
the most likely return. This concept is known as a zero sum game. Investors
earn returns from consistant exposure to the right
risk factors, not from gambling
on tomorrow’s news.
5. Market
Efficiency Is Why Capitalism Works Better: The world’s
stock exchanges facilitate a free market system that is the cornerstone
of capitalism. These capital markets simultaneously price the cost of
capital and the expected return from the risk of capitalism. Free markets
perform this highly important task in the most effective and efficient
manner because the knowledge of all investors exceeds the knowledge of
any individual. Due to the millions of intelligent and highly competitive
investors, it is unlikely that any individual investor will consistently
profit at the expense of all other investors. From this we can conclude
that free markets work and that current prices reflect the knowledge and
expectations of all investors at all times. [more]
This concept is known as the Efficient
Market Theory. If free markets were not more efficient than controlled
markets, like those in communist countries such as North Korea or Cuba,
then the communists would be more prosperous than the capitalists. [more]
6. Cost of
Capital and Expected Return for Capitalists: The expected return
for a capitalist, equity buyer, or investor is equal to the cost of capital
of the equity seller. An intelligent capitalist will estimate the expected
return based on the risk of the equity, which is tied to the risk of the
company. The higher the risk of the company, the higher their cost of
capital, and the higher the expected return for the capitalist. The lower
the risk of the company, the lower their cost of capital, and the lower
the expected return for the capitalist. Those investors who carefully
match their risk capacity with their risk exposure have the best chance
of obtaining the long-term historical returns of the global markets. A
buy, hold, and rebalanced
risk exposure strategy is the best method to capture those returns.
7. Small Value
versus Large Growth Companies: Public companies that are unglamorous,
small, and relatively cheap (small value) are riskier and have higher
costs of capital than those that are glamorous, large and relatively expensive
(large growth.) As a result, a dollar invested in a Fama/French Index
of small value companies in 1927 grew to $40,095 by the end of 2004 (14.6% annualized return),
and a dollar invested in a Fama/French Index of large growth companies
grew to only $1,154 over the same period (9.6% annualized return.) [more]
8. Diversify,
Diversify, Diversify: Diversification is the investor’s
best friend because it reduces the uncertainty of expected returns, otherwise
known as risk, without changing the expected return. Concentrating investments
only adds risk, and does not increase expected return. For example, any
one stock in the S&P 500 has an expected return of about 10% per year,
plus or minus about 50% two thirds of the years. However, the S&P
500 Index has the same 10% expected return, but it only has a risk of
plus or minus 20% two thirds of the years. So 10% plus or minus 20% is
far superior to 10% plus or minus 50%. Highly efficient portfolios of
index funds have had returns of 14.3%/year with risks of 15.6% over the
last 34 years, after fees (see Index Portfolio
100, which includes about 15,000 companies from 35 countries.) This
is why buying the whole haystack (index) is better than looking for the
needle (a stock) in the haystack. What is the risk and expected return
of your portfolio, based on the same investment strategy over the last
34 years? [compare]
9. Selecting
Index Funds: Dimensional Fund Advisors is the premier
commercial provider of capital markets research, historical risk, return
and correlation data, investment advisor education, and mutual fund products
that reflect the leading academic research. Their complete product line
of index mutual funds are based on the efficiency of capital markets.
They have constructed unique rules of ownership for their funds that allow
investors to better capture the right risk factors and engineer portfolios
with greater precision and efficiency. At the heart of their fund eligibility
rules is the Fama and French three-factor model, which has become the
gold standard among academic researchers for risk-adjusted returns. The
three-factor model on average explains more than ninety percent of the
performance of diversified portfolios of stocks.
10. Peace
of Mind: Don’t let your retirement years be tainted by
the discomfort of poverty. Reliance on family members or government programs
for your financial well-being will be a source of unhappiness, insecurity,
and low self-esteem. The sooner you start saving and planning for your
retirement, the better. A prudent
and intelligently managed investment portfolio of index funds has the
highest probability of providing security and peace of mind in the years
when it will be needed the most.
To further understand
the above 10 points, we have created Index Funds: The 12-Step Program.
You can begin your climb with the overview.
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