Active
investors, like casino gamblers, often do not account for their total return
properly. Common mistakes include the exclusion of loads, commissions,
taxes, and cash flows in and out of their portfolios. Another common error
is quoting the returns of only the portion of their portfolios that performed
well. Then there is the problem of hearing only from the winners and not
hearing from the losers who seem to disappear into thin air. Since 1961,
twenty-eight percent of mutual funds have vanished from the record. There
is no accounting for their returns.
The stock market
moves with new information. News is unpredictable and random; therefore,
the stock market moves in an unpredictable and random way. The Random Walk
Theory describes the way stock prices change unpredictably as a result
of unexpected information appearing in the market. This "random walk" of
changing prices has created a misconception among investors that stock
prices change randomly for no rational reason. The news is random and unpredictable
by nature. Investors react to the news, thereby effecting stock prices.
The year 2000 marked the centennial of the Random Walk Theory of stock market
prices. Many scholars have confirmed and refined the research of Louis Bachelier,
the hapless unsung hero of financial economics. On March 29, 1900, Bachelier
presented "The Theory Of Speculation" as a thesis before the faculty
of sciences at the Academy of Paris. He anticipated what was to become standard
fare in financial theory: the random walk of financial market prices. One
hundred years since the theory's conception, the vast majority of investors
are still not convinced that the markets are random.
In 1964, MIT professor Paul Cootner published a 500-page book of reprints
of all research on the randomness of the market. The book was titled,
"The Random Character of Stock Market Prices." It contained the
first full text English translation of Bachelier's 1900 thesis.
The Efficient
Market Hypothesis explains the process of free and efficient financial
markets. First, information about stocks is widely and inexpensively available
to all investors. Second, all known and available information is already
reflected in current stock prices. Third, the price of a stock agreed on
by a buyer and a seller is the best estimate of the true value of that
stock. Finally, stock prices change almost instantaneously as new unpredictable
information appears in the market. All of these factors make it nearly
impossible to capture returns in excess of a market return without taking
greater than market levels of risk. As discussed in Step Eight: Riskese™,
the only issue of concern is the relationship between risk, return, time,
and correlation.
Risk is
the source of investment returns, yet investors want to avoid it. It serves
investors well to learn about and embrace risk in accordance to their capacity
level. Risk Capacity™ defines the risk level that is appropriate
for a particular investor. Many investors invest in portfolios that are
mismatched to their Risk Capacity™. A thorough analysis, such as
the one in Step 10: Risk Capacity™, looks at an investor’s investment
time horizon, net worth, income, investment knowledge, and attitude towards
risk. With this analysis, an investor can then review investment choices
and make a selection that matches personal Risk Capacity™.
An investment policy or portfolio is a statement of the Risk Capacity™
assessment and the resulting risk exposure, in the form of an asset allocation
of indexes.
Most investors
do not get around to fully assessing their Risk Capacity™
and find themselves without an investment policy for their short-term and
long-term investing. Without this policy, they are easily persuaded to change
their course. They lose out on the long-term returns that would result from
subjecting their capital to risk.
High
turnover creates short-term capital gains in a mutual fund or a portfolio
of individual stocks. In taxable accounts this can create an insurmountable
barrier to beating an index. The average mutual fund turns over ninety
percent of its stock each year. This high percentage forces the distribution
of capital gains by the fund, which become tax liabilities for the fund’s
shareholders. Active investors incur far greater federal and state taxes,
since almost all of the capital gains are short-term and are taxed up to
forty-six percent. On the other hand, index fund investors buy and hold,
so they rarely incur capital gains. When they do, they are long-term gains
that are taxed at twenty percent. New tax managed funds harvest losses
to offset gains. By their passive nature, they have lower turnover rates.
These tax-managed funds nearly eliminate federal and state taxes.
Investment returns are far
more dependent on investor behavior than the performance of the investment.
Investors generally make bad decisions under the pressure and stress of trying
to outperform a market. These shortfalls are directly attributed to investors
overreacting to constantly changing conditions in financial markets, resulting
in brief holding periods for mutual funds. The tendency of investors to bail
out of stock funds during market downturns and buy back in too late when the
markets recover obviously harms performance.
In fact,
trading patterns analyzed by a Dalbar study showed that most investors
invariably buy high and sell low. The more an investor buys and sells mutual
funds, the lower the expected return. All these findings were also true
of bond fund investors. According to the study, a buy-and-hold strategy
outperformed the average investor by more than three to one after ten years.
When the
stock market performs well, as it did for most of the 1980's and '90's,
investors are more prone to believing they can beat a market. When they
get lucky and make a profitable investment call more than once, they are
lured into thinking they are successful market forecasters. Unfortunately,
this false sense of confidence leads them to the poorhouse.
The media continues to foster and encourage the high emotions of active investing.
Many ads lead investors to believe they can beat a market through stock picking
and time picking. In a September 1999 advertisement from Ameritrade (Online
Broker), an image of a scowling young woman was displayed. Her quote read
as follows: "I don't want to just beat the market. I want to wrestle
its scrawny little body to the ground and make it beg for mercy." It
goes on to say, "Ready to take on the market? The sooner you do, the
sooner you can show that lily-livered stock market who's boss." Finally,
it ends with, "Believe in yourself."
Watch this short interview, where James Altucher, managing director of Forumula Capital,
says that day trading is a mistake.
The lack
of investor education has generated a lot of recent interest. Most school
systems have not incorporated an educational program for investing. The
average investor is unprepared to make decisions about investing hard-earned
money. Investors usually receive their education in bits and pieces from
advertisements, television, magazines, newspapers, or books. These sources
are created by an industry that generates huge margin interest, fees, and
commissions from the trading of active investors. Most of the promotion
and education provided by the investment industry encourages investors
to gamble in the stock market.
Money Magazine and the Vanguard Group conducted a study in 1997, which randomly
selected 1,555 investors from across the United States, and asked them twenty
basic questions on investing. The investors received a sixty-seven percent,
or an "F" grade! In a 2000 update of the survey, the average score
dropped to only thirty-seven percent correct answers.
Why do investors continue to invest in something they do not understand?
A 1998 PriceWaterhouseCoopers study on the first 25 Years of Indexing,
concludes, "even as better information on indexing becomes available,
emotional factors may continue to constrain the growth of indexing. Many
institutional fund managers feel driven to beat the market, even while
recognizing the arguments in favor of indexing."
I am Mark Hebner, president
of Index Funds Advisors (IFA), a registered investment advisory firm. Years
ago I learned some painful lessons when I sold my previous business and
turned the profits over to active managers. I woke up one morning crestfallen,
realizing that my decision to do so had cost me $30 million in lost opportunity.
After thoroughly researching the science of passive investing and index
funds, I came to the conclusion that I needed to withdraw all of my investments
from several stockbrokers and place them in index funds. I concluded that
a 12-Step recovery program for active investors was critically needed.
Today, I am passionate about educating investors about the benefits of
index funds
Homer’s legendary story about Ulysses (Greek name Odysseus) tying himself to the mast to avoid destruction can be aptly applied to investing. Ulysses was able to hear the beautiful siren songs without being led to his destruction, because he made an agreement with his seafaring crew as they approached the sirens. He ordered them to plug their ears with wax and keep him tied to the mast despite his protests and cries. Under no circumstance were they to untie him. Ulysses desperately tried to break free upon hearing the sirens, but the men kept their promise, and the entire crew sailed safely through danger. They all worked together to strategically prevent their own demise.
The lure and noise of financial media often drive the behaviors and decisions of investors. A Ulysses Pact is like an investment policy statement, a proactive and strategic agreement that is made between a client and advisor in advance of any market turmoil or uncertainty. An advisor can guide clients through the murky or turbulent waters and ensure they don’t jump ship in response to the noise by signing a Ulysses Pact. This pact allows an investor to agree up front that under no circumstance will he act on emotions that can lead to irrational and wealth destroying decisions. It can serve as a promise to one’s self to follow a passive advisor’s counsel to hold on and not buy or sell as a reflexive reaction to the short-term movements of the market. This encourages a client to hold on and understand that the free market will set prices for a positive expected return, so that the storm will pass.
The
concept of a 12-Step Recovery Program originated in 1935 and today is used
to treat more than thirty addictions, including gambling, alcohol, overeating,
drugs, and sex. Millions of people rely on such programs.
In the early 1930’s
an American alcoholic named Rowland H. (only the last initial is used to
keep him anonymous) traveled to Switzerland to undergo treatment from the
world renowned Dr. Carl Jung. After a couple unsuccessful trips, Dr. Jung
told Rowland that he needed a "profound spiritual experience"
to enable him to stop his drinking. In other words, he needed to find a higher
power. Other patients with these experiences had overcome their addictions
and changed their behaviors.
The 12-Step Program is
partially based on the replacement of an addiction with a higher power,
whatever that may be for a person. As investors become more familiar with
the Nobel Prize winning stock market research outlined in this book, many
may experience investing epiphanies and transform their thinking and investment
behaviors. Many “Stockaholics™” are already beginning to
see the light.
Rex
Sinquefield, a director at DFA, attended the University of Chicago in the
1970s. He said, "Every time one of my professors talked about efficient
markets, I thought I was looking at Moses coming down from the mountain,
and I took that seriously." DFA is now known as the “mecca” of
indexing. Maybe Sinquefield had his profound spiritual experience there
in the classroom.
I had my epiphany when I heard Professor Eugene Fama of the University of
Chicago, and a Director of Research at DFA discuss the Three Factor Model
at a financial conference. After reviewing Step 2, which describes the research
of Fama, French, and many others, readers will know why.
When the founder of Alcoholics
Anonymous, Bill W., needed a vehicle to carry his message to millions of
alcoholics, a book was the only affordable method. So, he wrote Alcoholics
Anonymous in 1938. That book has become affectionately known as “The
Big Book.” Coincidentally, 1938 was the same year that Alfred Cowles
created what was later to become the Standard
& Poor’s 500. (Cowles did not know that his creation would go on
to become the first index used to establish an index fund by Rex Sinquefield.)
This book is a modified
12-step Program designed to educate investors on how to overcome the emotional
desires to actively invest. Some refer to it as the “Big Book on
Investing.” In 1938, Bill W. was limited to books as an affordable
method of communication. But, today we have the Internet. It’s a
medium I take full advantage of in my mission to lead investors to a highly
efficient, tax-managed, low-cost and risk appropriate portfolio.
Warren Buffet
stated in a February 1996 investment letter to his Berkshire Hathaway shareholders:
“…the best way to own common stocks is through index funds….”
In his 1997 letter he writes: “Let me add a few thoughts about
your own investments. Most investors, both institutional and individual,
will find that the best way to own common stocks is through an index
fund that charges minimal fees. Those following this path are sure to
beat the net results (after fees and expenses) delivered by the great
majority of investment professionals.” In February 2003 he gave
this advice to investors in his shareholder letter: “…those
index funds that are very low cost (such as Vanguard’s) are investor
friendly by definition and are the best selection for most of those who
wish to own equities. And, his February 2004 letter states: “Over
the [past] 35 years, American business has delivered terrific results.
It should therefore have been easy for investors to earn juicy returns:
All they had to do was piggyback corporate America in a diversified,
low-expense way. An index fund that they never touched would have done
the job. Instead many investors have had experiences ranging from mediocre
to disastrous.”
Benjamin
Graham
Even
though some professionals outperform a market, it is a different group
of professionals that do so each year. A consistent methodology to identify
them in advance has yet to be discovered.
Benjamin
Graham, the father of fundamental stock analysis, and a man revered by
Warren Buffet, also relinquished the idea that investors can expect to
beat a market. Shortly
before his death in 1976, he was interviewed by Charles Ellis and said: “I
am no longer an advocate of elaborate techniques of security analysis in
order to find superior value opportunities. This was a rewarding activity,
say, 40 years ago when [the Security Analysis by] Graham and Dodd was first
published; but the situation has changed.... [Today] I doubt whether such
extensive efforts will generate sufficiently superior selections to justify
their cost.... I’m on the side of the ‘efficient’ market
school of thought.”
Several
other questions and answers from this interview are shown below:
"In the light of your 60-odd years of experience in Wall Street what
is your overall view of common stocks?
Common stocks have one important characteristics and one important speculative
characteristic. Their investment value and average market price tend to increase
irregularly but persistently over the decades, as their net worth builds
up through the reinvestment of undistributed earnings--incidentally, with
no clear-cut plus or minus response to inflation. However, most of the time
common stocks are subject to irrational and excessive price fluctuations
in both directions, as the consequence of the ingrained tendency of most
people to speculate or gamble--i.e., to give way to hope, fear and greed."
Can the average manager of institutional funds obtain
better results than the Dow Jones Industrial Average or the Standard & Poor's
Index over the years?
No. In effect, that would mean that the stock market experts as a whole could
beat themselves--a logical contradiction.
Do you think, therefore, that the average institutional client should be
content with the DJIA results or the equivalent?
Yes. Not only that, but I think they should require approximately such results
over, say, a moving five-year average period as a condition for paying standard
management fees to advisors and the like.
What about the objection made against so-called index funds that different
investors have different requirements?
At bottom that is only a convenient cliche or alibi to justify the mediocre
record of the past. All investors want good results from their investments,
and are entitled to them to the extent that they are actually obtainable.
I see no reason why they should be content with results inferior to those
of an indexed fund or pay standard fees for such inferior results.
Graham: ... "The main point is to have the right general principles and the character to stick to them.
...The thing that I have been emphasizing in my own work for the last few years has been the group approach. To try to buy groups of stocks [this is what an index does] that meet some simple criterion for being undervalued [Fama/French would call this riskier, not undervalued] - regardless of the industry and with very little attention to the individual company [Don't try to pick winning stocks]. My recent article on three simple methods applied to common stocks was published in one of your Seminar Proceedings.
I am just finishing a 50-year study-the application of these simple methods to groups of stocks, actually, to all the stocks in the Moody's Industrial Stock Group. I found the results were very good for 50 years. They certainly did twice as well as the Dow Jones.
And so my enthusiasm has been transferred from the selective to the group approach.
What I want is an earnings ratio twice as good as the bond interest ratio typically for most years. One can also apply a dividend criterion or an asset value criterion and get good results. My research indicates the best results come from simple earnings criterions.
Hartman Butler: I have always thought it was too bad that we use the price/earnings ratio rather than the earnings yield measurement. It would be so much easier to realize that a stock is selling at a 2.5 percent earnings yield rather than 40 times earnings.
... Hartman Butler: I understand that you have about completed this research.
Graham: Imagine - there seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience, it seems to stand up under any of the tests that I would make up."
Investors in index funds
usually win over active investors over long periods of time. The path to
recovery for active investors begins with understanding the following steps
outlined in this book.
About 85% of investors
engage in active investing. This 12-Step Program comprehensively addresses
the emotional hurdles an active investor needs to clear. The first step
of every 12-Step recovery program is admitting to the existence of a problem.
My hope is that this first step has helped you recognize active investing
behavior, and realize that harmful behaviors can be changed.
In Step 2, Nobel
Prize winners and other academics are discussed. These legendary individuals
have committed most of their lives to researching the stock market in order
to develop the ideas that today determine how trillions of dollars are invested.
Once these capital market ideas are understood, the investor can start ignoring
stock pickers, market timers, last year’s winners, Wall Street strategists,
technical analysts, and investment media gurus who attempt to make stock
market predictions. I trust that you will be inspired to see the stock market
in a whole new light.
The
concept of a 12-Step Recovery Program originated in 1935 and today is used
to treat more than thirty addictions, including gambling, alcohol, overeating,
drugs, and sex. Millions of people rely on such programs. 
Rex
Sinquefield, a director at DFA, attended the University of Chicago in the
1970s. He said, "Every time one of my professors talked about efficient
markets, I thought I was looking at Moses coming down from the mountain,
and I took that seriously." DFA is now known as the “mecca” of
indexing. Maybe Sinquefield had his profound spiritual experience there
in the classroom.
