Financial Predictions That Never Look Silly
Not long ago, a man I worked with suggested that I should be careful about giving financial advice. And he was right. Everybody should be careful about giving financial advice.
Too many so-called experts, for example, have tried to guess the stock market’s direction over the years, and despite the existence of entire careers based on that sort of endeavour, study after study has proven that professional stock market analysts have no better idea where the markets are going to go, than you or I do.
John Kenneth Galbraith, a former Harvard economics professor, and one of the most famous economists of all time suggested that “We have two classes of economic forecasters: those who don’t know—and those who don’t know they don’t know.”
Larry Swedroe, author of the superb investment book, The Quest For Alpha, adds a third type: “those that don’t know but get paid a lot of money to pretend they do.”
The third category of forecaster constitutes the financial planner who chooses to buy actively managed mutual funds for his or her clients’ accounts. Most of them are pretending to know which funds will perform well in the future, but they don’t really know.
There’s one piece of financial advice that I can give, and during every decade, regardless of the economy’s direction, a diversified account of low cost, broad market index funds will always outperform the vast majority of accounts comprised of actively managed mutual funds.
Why do most financial advisors sell actively managed mutual funds?
Because they get paid more money to do so.
In September 2006, I gave a seminar suggesting the superiority of index fund investing over actively managed funds.
Most of my colleagues at Singapore American School were losing too much money, through the following holes in their economic boats:
- They were paying sales fees (up to 5.75% to buy their mutual funds through a sales rep)
- They were paying wrap fees amounting to 1.75% of their assets every year (which mathematically, is worse than paying a 5.75% sales charge on money deposited)
- They were paying excess taxes because actively managed funds are less tax efficient than index funds. Considering that my American colleagues are expatriates, with the bulk of their assets in non tax deferred accounts, they get hit hard with taxes, when their actively managed funds make money.
I told the attendees that a rebalanced account of indexes would be a far more efficient way to invest. The odds of success would be higher.
And that advice will always hold water.
I also said that I would track a diversified account of indexes, using the portfolio tracker at SmartMoney.com and that I would annually rebalance the portfolio, comprised of three low cost, broad stock market index funds:
- Vanguard’s total U.S. Stock Market Index
- Vanguard’s total International Stock Market Index
- Vanguard’s total Bond Market Index
I’ll admit that I was a bit lazy about the rebalancing. I only rebalanced the account twice since September, 2006. But that didn’t hurt the results much.
I assumed that $200,000 would be invested in September 11, 2006, and that no new money would be added to it.
Then, as promised, I would track the results and make them public.
We have had some crazy markets since late 2006—the craziest part being the stock market crash of 2008/2009, the biggest drop since 1929/1930.
So let’s have a look at how this portfolio has fared.
So far, the $200,000 invested is worth $254,887.46.
That’s a gain of $54,887.46….with no money added, for a percentage gain of +27.44%.
When I created the online account for people to track, I assumed that the investor was 33 years old, and that they wouldn’t have a pension to look forward to.
For that reason, I placed one third of the money in the U.S. bond market, to roughly give the hypothetical investor a bond allocation that would be equivalent to their age.
You can see below, that the bond allocation currently sits at 28.62% of the account’s total, so I’m going to rebalance it.
Portfolio Value ……… $254,887.46
Gain / Loss …………… +$54,887.46 (27.44%)
The hypothetical 33 year old investor (in 2006) would now be 38 years old. So I’m going to increase their bond allocation to 38% of their total portfolio.
It’s best to increase a person’s bond allocation as they get older, giving them less and less exposure to the volatility of the stock market as they age.
To increase the bond allocation, I need to sell some of their stock market investments.
I want a portfolio that will look something like this:
- 38% Vanguard total bond market index
- 31% Vanguard total U.S. stock market index
- 31% Vanguard total International stock market index
Should anyone be giving financial advice? In that vein, we should all be careful.
But there’s one timeless premise that you can count on:
A low cost, diversified study of broad stock and bond market index funds will beat the vast majority of portfolios of actively managed mutual fund portfolios created by financial planners.
And the indexed account will be far more tax efficient as well.