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Jul 31 2010

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Pride and Prejudice


When investing, most people think they can find a genius to navigate the shark-infested waters of the stock market. 

Pride

Close your eyes and throw a blanket over the stocks on the New York stock exchange. Pretend that you have bought all of them for your investment account.

Sound reckless?  It isn’t.

A selection like this (buying all of the stocks in a market) will beat nearly all of the professionals who are paid very large salaries they don’t deserve, to nimbly buy and sell stocks for mutual funds and hedge funds.

Excessive pride and ignorance leads us to look, mostly in vain, for these crafty captains.

But if we swallow our pride and buy a total stock market index such as Vanguard’s Total World Stock Index Fund   or Vanguard’s Total U.S. Stock Market Index , that’s it. 

Going with one or the other will give you all the stock market exposure you need.

Forget the dancing mutual fund experts.  You’ll pay them hidden fees to do worse—and in some cases, a lot worse than the stellar indexed examples above.

Prejudice

Those in the financial service industry will say, “Wait, buying an index fund is too risky.  It’s better to buy great mutual funds, run by brilliant managers who can navigate the market’s waters. “

It makes sense, doesn’t it?  But the paradoxical reality suggests otherwise. 

Do nothing.  Buy everything.  Beat the pros with indexes.

But what about a falling market?

Finance professionals will suggest that trained fund managers can protect your money during falling markets: that their pulse on the economy will save you; that they can jump out of stocks in the nick of time; that their research and cat-like reflexes can save your money.

 An index fund has all of its money in the market, all the time.  So it makes sense that having a fund with a manual transmission (and a wily driver) will beat the car on auto-pilot.

If you were investing in mutual funds in 2001, 2002, 2008/2009, your fund values probably dropped heavily.  Let out a big roar now.  Come on.  Let the laughter erupt from your belly.  It’s therapeutic.   Mutual fund managers can perform no such magic.  When stock markets fall, fund investors get hurt.

Proof adding to proof

Since mid April, 2010, the U.S. total stock market index has fallen 8.85%.  An investment of $500,000 in a broad U.S. stock market index would be worth $455,741.74.  Bummer.

But if you’re a regular reader of this blog, you’ll note that in mid April of this year, I asked readers to give me the names of the best actively managed funds they knew:  funds that could leap tall buildings in a single bound, funds that could make you loads of money over the long term, funds with managers smart enough to dodge Wall Street’s bullets so you can dance off into the sunset of your eventual retirement tax haven (Blue Lagoon style) with bucket loads of cash.

I tracked those funds using the portfolio tracker at www.smartmoney.com

The celebrated funds were as follows:

  • American Funds Mut;A
  • Amer Cent:Hertge;A
  • Dodge & Cox Stock
  • FMI:Large Cap
  • Fidelity Puritan
  • Fidelity Sel Energy
  • LM CM Value Trust;A
  • American Funds NWld;A
  • T Rowe Price Eq Inc
  • Sound Shore

So, if you bought all ten of them—if you split your $500,000 evenly between these super funds, and held them during a market decline (such as the 8.85% decline of the market index), how much better off would you be?

Answer:

Investing in the total U.S. stock market index would have been better.

Pardon me? 

Investing in the total U.S. stock market index would have been better.

Your $500,000 would be worth $454,695.33 with the super funds.  With the blanket over the stock market page strategy (the index fund) you would be more than $1,200 better off.  Your $500,000 would be worth $455,741.74.  And that difference occurred in just 4 short months. 

The crazy reality

Professional fund managers, who tap dance in and out of stocks, and in and out of the markets, aren’t able to save your money during market declines.  When markets fall, so do their funds.  And as a group, they lose to the market indexes during declines (thanks to fees and dancing) and they fall much further behind the indexes during market rises (because they often try jumping their cash reserves into the market after the market has already surged a great deal).  Of course, fees and taxes ensure an even larger disparity between actively managed funds and market indexes.

So what do you do?

Swallow your pride.  Ignore the prejudice of those whose livelihoods depend on you not knowing the truth.  Buy just two indexes:

1.  A total bond market fund roughly equalling your age:  if you’re 40 years old, have 30% to 40% in this Vanguard bond index,  and if you’re 60 years old, have 50% to 60% of your money in this government bond index with Vanguard.

2.  And with the remainder, put your money in a U.S. stock market index,or world stock market index.   

Buy these through Vanguard.

Take note of these very specific names and symbols.  Ignore Vanguard’s other products.  Combinations of their other funds at Vanguard can also be good but the endless list of Vanguard’s indexes can be confusing.

Keep it simple.  You’ll probably do a heck of a lot better that way.

Live long and prosper with index funds! 



About the author

andrew hallam

I'm a freelance finance writer, lucky enough to have been nominated as a finalist for two Canadian National Publishing Awards. I'm also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School, a book explaining how I became a millionaire on a teacher's salary, while still in my 30s. Working to empower people financially, I'm available to motivate and inspire people on basic retirement planning and index investing. I'm happy to comment on your questions, first, please read the Terms of Use.

Permanent link to this article: http://andrewhallam.com/2010/07/pride-and-prejudice/

13 comments

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  1. avatar
    Kevin@InvestItWisely

    Great recommendations, Andrew. I am a little more aggressive than you and I would just dump everything in stocks, but I'm younger, and I see these as long-term investments.

    It really doesn't have to be complicated, and anybody can learn to make these simple investments. Now if only Vanguard's products were available in Canada…

  2. avatar
    Andrew Hallam

    Hey Kevin,

    In time, I think Vanguard's non ETF indexes will be available in Canada. They're already in the UK and Australia.

    As for a 100% stock portfolio outperforming a portfolio of bonds and stocks over time, it might not always been the case. For fun, I'm going to play devil's advocate and suggest that I'm more aggressive than you are.

    If you check out the couch potato portfolio's historical track record since 1976 (it has 33% bonds) it has beaten the Canadian and U.S. stock market indexes thanks to mechanically "being greedy when others are fearful and fearful when others are greedy" —through annual rebalancing. http://www.canadianbusiness.com/my_money/investin

    I've also found that, despite the success of my investment club (annual compounding returns of roughly 7.5% per year from 1999 to 2010 with 100% equities) I've done much better with my personal account. By taking a more "active" approach with my own money, even with my indexes, I've rebalanced with bonds when asset allocations have gone askew–rather than just mechanically doing it at a given date.

    Selling bonds from January to April 2009 allowed me to put money into the stock market (a 6 figure deposit) that a fully invested equity investor couldn't have done. And then, during the recovery, I was able to make great gains with the equities I bought "on the cheap".

    Likewise, the recent bond sales I made last month ensured a lot of equity money into the markets that I couldn't have made (if I had a 100% stock portfolio).

    http://andrewhallam.com/investmentreport-18-jun-1

    So, one could argue that my strategy has been more aggressive than having 100% equities. Of course, you wouldn't expect that—because conventional wisdom suggests otherwise. But conventional wisdom is worth challenging from time to time.

    I enjoy reading David Swensen's book, "Unconventional Succcess". With roughly a 40% bond allocation, he has easily beaten the S&P 500 index over decades, with Yale's endowment fund money, thanks to very regular rebalancing in a tax free account.

    Most of the time, I just purchase my laggards with my monthly purchases: bonds lagged in 2007, so that was all I bought. Stocks lagged in 2008/2009, so that was all I bought. Of course, 2008/2009 involved some more aggressive rebalancing that paid off nicely. It didn't involve "timing" or forecasting. I just rebalanced.

    If the markets go on a tear, Kevin, perhaps you might want to think about loading up on some XSB. It's contrarian, but contrarian thinking, I think, is the key to investing well.

    I'm curious to hear your thoughts on this.

    Cheers,

    Andrew

  3. avatar
    Kevin@InvestItWisely

    Hi Andrew,

    You are quite right in that holding bonds in the portfolio over stocks alone would have boosted your returns over the dog years that we've had recently. I completely agree with you on asset rebancing as a better way of buying lows and selling highs than attempting to time the market.

    On the other hand, had you been holding 100% stocks during the bull years, it's possible that you would have gained enough so that you would have a higher total portfolio value than you would have by going with stocks and bonds. This is something I'm interested in actually comparing to see if this is really the case.

    If you look at the "total portfolio value" charts at http://spwfe.fpanet.org:10005/public/Unclassified… you can see the values going higher and higher as the stock % increases. These are retirement portfolios with a 4% withdrawal per year, and analyzed from different periods (well, you should recognize it as you were kind enough to send me this PDF yourself ;)) At 75% stocks and 25% bonds, it's higher than the other portfolio values. Unfortunately, there's no graph for 100% stocks.

    There's three ways we can approach this:

    1) Stick to a bond allocation as per your age or just leave it fixed. i.e. a 40-year old person will stick to 40% bonds/60% stocks, and someone like me would stick to around 25% bonds/75% stocks. Rebalance whenever you feel things go out of whack.

    2) Use a variable bond/stock allocation, depending on which is doing better. If the stock markets are doing really well, then start increasing your bond portfolio from 0% to a max. of 30% or so by diverting your cash flow into bonds and perhaps selling off some stocks. Once the stock market crashes, dump the bonds back into stocks.

    3) Try to forecast what the decade will be like. If you think it's going to be a dog decade because of sovereign risks etc… then hold less stocks and hold more bonds. ;)

    What do you think, Andrew? Where does your strategy fit in? If I were to take a guess, I would say it's somewhat like #1, with a dash of #2 thrown in.

  4. avatar
    Kevin@InvestItWisely

    I just remembered that I mentioned this on http://www.investitwisely.com/living-to-100-and-b… under "Beating the market with bonds". You are the original inspiration, of course.

    Here was a key paragraph that I wrote:

    "However, let’s say that you have a deep portfolio in stocks, but keep 25% in bonds. After the crash, you don’t stick with your 75/25 allocation ratio, but you go all-in stocks. This way, you sell your now relatively-high bonds to buy cheap stocks, which can potentially increase your long-term returns beyond what a simple split would have returned. Andrew Hallam calls this “beating the market with bonds“, and it can help you increase your returns over time. I think a comparison needs to be done to see if it beats a 100% stock allocation over the long run, but this strategy certainly does beat sticking with a fixed stock/bond ratio even through a crash."

    So the follow-up to this here is to analyze the 100% stock allocation over the long run and compare that to different bond strategies.

  5. avatar
    Andrew Hallam

    @Kevin@InvestItWisely

    Hey Kevin,

    Normally the 100% stock portfolio would kick butt. You're right there.

    But for the guy like David Swensen (luck? cool and impartial?) the market might be beatable with crafty rebalancing.

    Have you read "Value Averaging"? You likely could have done it with his strategy.

    Did you check out the performance data on that MoneySense couch potato link I put in:

    It's pretty amazing: http://www.canadianbusiness.com/my_money/investin

    But after everything I've said, the full equity index probably does have the greater chance of whupping the blended one. But I guess the fun thing is looking at possible exceptions.

  6. avatar
    Kevin@InvestItWisely

    Hey Andrew,

    Value averaging is a pretty cool technique when you're holding different sectors and classes of investments in your portfolio. I have to read your post about it again to refresh my understanding of the difference between it and simple asset reallocation!

    Gotta put some numbers together and run a historical simulation at some point… do you know of any good tools to automate some aspects of this?

  7. avatar
    Andrew Hallam

    @Kevin@InvestItWisely

    Hey Kevin,

    I don't know of any tools that would automate a historical look back. I guess, too, we can also take history with a grain of salt. Who knows if it all will work out as well going forward. THe Motley Fool guys sure found that out with the old Foolish 4 Portfolio (a strategy that will likely work again, now that it has been abandoned and labelled as "ineffective")

  8. avatar
    Andrew Hallam

    @Kevin@InvestItWisely

    Hey Kevin,

    You're right, I think I would choose between the number one option you gave, with a dash of #2.

    And yeah, during a rip roaring bull market, bonds would be a bit of a drag.

  9. avatar
    Kevin@InvestItWisely

    "Past Performance is No Guarantee of Future Results"

    Indeed, this is true. We can still get an idea by looking at the past, but it is no guarantee of things that are to come. We could have 10 more dog years like we just had, or we could have 10 years of stellar boom once the economy recovers and as technology progresses.

    You know I believe in the great potential of technology; only the profligacy of governments (and by extension, the voters) has the potential to mess things up for a while with bailout after stimulus after debt rollover…

  10. avatar
    Andrew Hallam

    @Kevin@InvestItWisely

    Hey Kevin,

    I hope we have ten more dog years. Wouldn't it have been great to have been investing from 1965 to 1982? You would have picked up loads of assets on the cheap, and then…. KaBooom! 17.5% annual returns for nearly 20 years. Now that's worth waiting for.

  11. avatar
    Kevin@InvestItWisely

    I thought you would say that, Andrew! You make a good point… maybe 10 more dog years aren't so bad, and then a boom after that will nicely coincide with my own plans to get out of the rat race! ;)

  12. avatar
    The Biz of Life

    I've been fortunate enough to have bought and held for a long period of time some conservative funds that have beaten the market over the long-haul such as Mutual Global Discovery, Oakmark Balanced, T. Rowe Price Capital Appreciation, and FPA Crescent. Whether this was luck or skill, who knows, but I sought out value oriented funds with a consistent investment philosophy that played defense first and didn't try to hit home runs. They underperformed in bull markets and overperformed in bear markets. These days I split my investments between indexes and these conservative value funds. The drawbacks on the funds are that you are always substitutable to management turnover and asset bloat….. nothing breeds failure like success in the mutual fund world.

  13. avatar
    Andrew Hallam

    Hey Biz,

    You bought some great funds–but your last statement rings very true about success perpetuating a greater and greater size, thus potentially reducing returns through "elephantitis"

    That said, as big as those funds may be getting, they're reasonably "low fee" funds, so they might not be favorites with advisors. That's a good thing!

    The American Fund class of funds (with their 5.75% front end load) will likely be sold by advisors to new investors before your funds are. That's a good thing, don't you think.

    Check out a little known fund called The Sequoia Fund. http://www.sequoiafund.com

    I think it's up your alley.

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