Passive Clearly Beating Active

These past few years have not been good to actively managed funds, or their managers. As this Morningstar article shows, funds are continuing to lose investor money and as a result, they have to lay off their fund directors. Shed no tears for them though, as they’ve had several years of high six figure+ income without providing a corresponding return to their investors.

Let Uncle Warren and Jack Bogle light the way. It’s no secret why the biggest indexer, Vanguard, is growing more than everyone else combined!

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The Few Proud Stock Winners

Remember my exhortation against stock picking, due to the few winners driving gains and the majority of stocks being meh or losers? This Morningstar article posted an insightful finding based on a recent study:

Half of U.S. stock-market wealth creation has come from 0.33% of listed companies.

Please note, that figure is not 33%. It is one third of 1%—one security out of 300.
Of the 26,000 stocks that appear in CRSP’s database, 86 provided half the aggregate wealth creation, 282 are required to reach the 75% figure, and 983 account for the full 100%. That is, after the 983 highest wealth creators, the remaining 25,000-plus securities are net neutral. Some made money for their investors, and some lost, but overall they were a wash.
Let’s re-emphasize. 86 stocks drove half of the gains of the market as a whole. If you were to randomly pick a stock to place your bets on, you would only have a 0.33% chance of picking a major winner. What’s the lesson, Morningstar?
In other words, do as your columnist prescribes, not as he does: Diversify. Widely and broadly.
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How the Wealthy Became Rich

The answer? It’s mostly through slow and steady investment.

The article defined wealthy as those with at least $3 million in investable assets, which is easily within reach.

According to the survey, more than three-quarters of the wealthy investors surveyed came from middle-class or lower backgrounds, and earned their wealth mostly through income from work and investing.

They took one of three basic paths to wealth: earning it; investing to get it, or becoming an entrepreneur. Only 10% attributed their wealth mostly to an inheritance. In short, the wealthy have worked their way to their enviable portfolios, and took a long time getting there.

Regardless of the asset (preferably stocks or real estate), diligent saving and investing over time will let anyone achieve great wealth.

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There’s a Reason They Promote Active Management

Just saw this ad on Morningstar:

marketwatch ad

Investors have started to wake up to the high fees and poor performance seen with active management, and as a result, big financial service firms are trying to stem the flow of money away from active funds to passive funds. As a result, they’ve ramped up advertising trying to sell potential customers with fear. “Now is a turbulent time,” they say. “In an uncertain world, it’s not good to be passive.” “Have an expert guide you.”

But really, if they have to work that hard to sell you on something, it’s probably a bad investment. Just remember: they’re worried about profit, not about working in your best interest. They (apart from Vanguard) have little incentive to sell you on low-margin passive products.

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Why Boring is Best in Investing

Are you a solo investor trying to imitate the big boys? It may not be such a good idea. You may have seen hedge funds, institutional investors, and big university endowments delve into “alternative” investments, meaning esoteric low-liquidity products that ordinary people wouldn’t have access to. Financial service providers, hoping to capitalize on a trend, created mutual funds and ETFs allowing ordinary people to buy into these supposed hot new strategies. Warning: they just want to charge high fees.

The performance has been dismal. As the chart on the link shows, a boring tried and true approach with stocks and bonds has outperformed all of these newfangled products.

The article goes on to explain the reason for the discrepancy:

Ben Johnson, Morningstar’s director of global ETF research, says many alternative ETFs have serious flaws. “Those guru-type portfolios are just equity strategies taking the long side of some well-known hedge-fund managers’ positions and following them on a lagged basis,” he told me.

“Oftentimes what you see in these ‘mimicking’ strategies is the derivative of the underlying asset that is many times watered down or is otherwise not directly connected to the…real asset.”

In other words, the ETFs are very poor substitutes for the real thing. Institutions like Yale get to pick the best private equity and hedge funds, and can buy, say, actual timberland rather than the WOOD ETF.

So yeah, if you can buy and operate an acre of farmland and know how to run it profitably, you may do ok. But for the rest of us, just stick with a diversified collection of stocks and bonds.

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Are ETFs Too Risky?

There’s a lot of news out there about ETFs lately, focusing on their negatives. They’re an untested instrument. The bid-ask spreads are too wide. They tempt people into trading when they should be holding on to their investments.

My book on wealth recommends using ETFs as the instrument with which to build a diversified mix of stocks and bonds, a time tested approach to accumulating wealth over the long haul. Just in time to discredit the rash of negative reports is a great Schwab article on the facts of ETFs.

Like anything, ETFs are an instrument, and can be used for good or evil. Like any instrument, the ETF in question can be sharp or blunt. Here’s the lowdown on why they’re still useful and things to look out for:

  • You don’t have to worry about the wide bid-ask spread at times. If you’re using ETFs as a mutual fund substitute, you shouldn’t be looking at daily prices and being tempted to trade in and out. Broad market stock or bond ETFs are meant as vehicles for investing. Even though they offer you the ability to trade in or out at any time as easily as individual stocks doesn’t mean we should. Moving too much incurs frictional trading expenses and incurs taxes.
  • For the same reason, you shouldn’t worry about temporary fluctuations in value versus the underlying asset. 99.9% of the time the two will be correlated. When things are derailed, it will be temporary (usually minutes at most), so hold on to your investment through the panic. Chances are you won’t even notice that anything happened unless you obsessively follow the market every day, which you shouldn’t be doing.
  • Stick to the tried and true (broad market funds). Don’t get suckered in by fancy ETFs such as triple inverse or super sector specific funds. Those exotic instruments usually have much higher expenses (you can see how much on Morningstar) and offer no benefit for long-term investors.

As you can see, ETFs are not to be feared, but rather something that the wise ones can control. Use ETFs like this and stay on the slow but steady well-trod path to wealth. Tune out the noise and you will prosper.

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Declining Worth of Hedge Funds

Maybe it’s because of the high fees, persistent underperformance, or the recent spate of movies about the greed of Wall Street. Whatever the reason, investors are withdrawing money from hedge funds. Maybe some of them see the light at the opposite end of the spectrum, with low cost index tracking funds. Aside from Vanguard, the 800 lb gorilla, other brokerages are getting into the act as well, including my own Fidelity. Undoubtedly, they are responding to consumer demand. Those who have read my book on wealth know how much I emphasize the importance of tax-optimization and low fees are to returns. Maybe more people are naturally starting to realize this.

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Should You Dollar Cost Average?

It’s an interesting question. Let’s say you are an investor looking to start investing for the first time. Should you invested a large sum in bulk or purposefully trickle in a little bit every month?

First, we should recognize that not everyone has the luxury of doing this. Most of us in the accumulation phase of life have to invest alongside our biweekly paychecks. There’s no choice except to trickle in our money.

But what if you’re blessed with a sudden large windfall, say from an inheritance, a house sale, or lottery? Is there really an advantage to investing piecemeal or all at once?

Vanguard ran a study back in 2012 about this. By doing historical simulations on different strategies dating back to 1926, they found that lump sum investing outperformed dollar cost averaging in every country they studied over all time horizons, for all mixes of stocks and bonds.

The reason is that on average, the market goes up more than it goes down. Therefore, by maximizing time in the market by investing in a lump sum, we are able to enjoy the market’s rewards earlier. Delaying also means missing out on dividends as they are distributed. The only time that dollar cost averaging makes sense is if we time our investments to match a downturn, but if we knew there would be a downturn, why not delay 3-6 months when the market is lower and then invest lump sum? Dollar cost averaging makes no logical sense.

Vanguard though does note that even though it produces poorer returns, dollar cost averaging can be helpful in calming the nerves of some jittery investors because it reduces short-term volatility. That’s literally the only benefit it provides.

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Illustrating Why Not to Pick Stocks

If you’ve read my book on wealth, you know that I highly discourage trying to time the stock market or to cherrypick which stock to buy. In today’s stock market, we have another great example of why. The market overall has been wobbly, with a few stocks (Facebook, Google, Amazon) shooting into the stratosphere and the rest of the market essentially in recession-level pricing (especially the energy and industrial sectors). This is great if you have concentrated your wealth correctly in those few stocks that are doing well, but most people didn’t guess right and are instead dealing with huge portfolio losses.

Let’s illustrate this point with a simple example. Assume a stock market with four different stocks.

  • A has dropped by 20% in the past year
  • B has dropped by 25% in the past year
  • C has gained by 150% in the past year
  • D has dropped by 10% in the past year

Assuming that each stock is weighted equally in the market, this means that the entire stock market as a whole has increased by 23.75%, all on the back of stock C.

Now we have fifteen different people each with a different approach to the stock market, scattered on the spectrum between concentration and diversification. We also list their gains. For math/stats geeks, we are essentially enumerating all the possible combinations of choosing among four options.

  • Person 1 concentrates all wealth in stock A (-20%)
  • Person 2 concentrates all wealth in stock B (-25%)
  • Person 3 concentrates all wealth in stock C (+150%)
  • Person 4 concentrates all wealth in stock D (-10%)
  • Person 5 buys two stocks (A and B) (-22.5%)
  • Person 6 buys two stocks (A and C) (+65%)
  • Person 7 buys two stocks (A and D) (-15%)
  • Person 8 buys two stocks (B and C) (+62.5%)
  • Person 9 buys two stocks (B and D) (-17.5%)
  • Person 10 buys two stocks (C and D)  (+70%)
  • Person 11 buys three stocks (A, B, and C) (+35%)
  • Person 12 buys three stocks (A, B, and D) (-18.33%)
  • Person 13 buys three stocks (A, C, and D) (+40%)
  • Person 14 buys three stocks (B, C, and D) (+38.34%)
  • Person 15 is the closet indexer and buys all four stocks equally (+23.75%)

In short, the more stocks you buy, the closer you get to the index average and thus are more likely to get a positive return. The fewer stocks you buy, the greater the chances of scoring a home run hit, but with a greater chance of losing money as well. The effect is magnified even more when only 3/500 stocks in the S&P index are outperforming the index. This example illustrates the value of diversification. In a world where most of the gains come from a few stocks, and where most of the gains come on a few days, missing out on those days or those stocks can be catastrophic for the overall portfolio. This should serve as yet another point in why low-cost index funds, with their instant diversification, are the only correct way to invest in the market.

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