United World College Talk – Part II.

Yesterday afternoon, I gave a seminar outlining how much money a person would need to invest to reach a desired amount of future income for their living expenses, upon retirement. 

There were loads of variables, of course, but setting objectives and working towards them is always recommended.  What’s the trite expression?  If we fail to plan, we plan to fail.

At the end of the session, I mentioned that I’d be showing the attendees (next week) how to beat the vast majority of investment professionals, at the investment game.  I hinted that I was about to expose the financial service industry’s dirty little secret.

A gentleman approached me after the session and asked me how much time I spend on my own investments each month, researching what to buy.  When I told him, “about 15 minutes”, he smiled and said, “then I’ll see you next week.”

Well, it seems that I exaggerated a bit.  It takes about 4 minutes a month. 

Are you interested in how I do it?

First, we have to understand how the stock market and its products work. 

Like any asset, the stock market’s level is based on supply and demand.  When people are hungry to purchase stocks, the demand/supply table tips and stock prices rise.  It’s that simple.  It always has been that simple.

Second, when the stock market rises, say, 8% in a given year, it means that the average dollar invested in that market made 8% that year.

Half of the dollars that were invested in the market would have made more than 8% and half of the dollars in the market would have made less than 8%.  Simple stuff.

As a result of that irrefutable math, there’s something you might not have thought of.  Most of the money invested in the stock market is in the form of unit trusts (mutual funds) index funds, pension funds, university endowment funds etc.  These make up the vast majority of stock market invested dollars.

So here are some questions, and think about them before answering…

Question 1:  If the stock market made 8% in a given year, what return would the average professionally managed stock market dollar have returned in the stock market that year?

The answer to that question is 8%.  If the stock market made 8%, then the average professionally invested dollar would have made the same return.  No matter what the average professional did to bounce money around, trying to take advantage of stock market “opportunities” the average dollar invested by professionals in the stock market would have made 8%—because the money in the market is a direct result of the supply and demand component created by the buying and selling of professionals.  They have so much money in the market (unit trusts, mutual funds, endowments funds, pension funds) that they, as an aggregate, make up the market’s return.  Again, simple stuff.  But this leads us to Question 2.

Question 2:  If the stock market made 8% in a given year, would that mean that the average professional would have made 8% with their stock market investments?

The answer to that question is “No”—they would have made less. Here’s why:

The average professional investor (this is the person who actually runs the unit trust or mutual fund) incurs costs, when buying and selling stocks.  Those costs detract from his or her returns.  Then, some of the assets go towards the financial companies’ owners.  For example, Fidelity is privately owned by the Johnson family, and the family makes money based on a percentage of assets collected by investors.  If you invest with Fidelity, you are paying the Johnson family a percentage of your assets every year.  It’s a hidden cost.

Other fund companies are publically traded, so money also gets skimmed off the assets of the funds they run, put into the companies’ coffers and reported to owners (shareholders) as company profits.  As a mutual fund investor, you’re not an owner of the company.  The owners of the company take your money directly out of your funds, without you seeing it.  This “taken” money is justified as part of the company’s “expense ratio”.

Other layers of costs come from investors’ assets:  some of that expense ratio goes towards advertising (or in the U.S., there’s an additional, separate fee called a 12B1). 

And a further layer of costs derived from the expense ratio is taken to compensate the broker who sold you the fund.  And yes, brokers often choose funds based on how well they will be compensated.

Question 3:  So why does the average mutual fund (unit trust) underperform the results of the stock market, even though the average fund’s stock market money earns the same return as the stock market?

Fees.  After fees, the average professional investor is destined to lose to the stock market’s performance.  If you could just buy every stock in a given stock market, you would beat the vast majority of investment professionals by doing nothing at all.  You wouldn’t have to watch investment news or follow the economy.  You’d be destined to beat roughly 85%-90% of the professionals.  In a taxable account, you’d beat far more than that.  Trading (which occurs within unit trusts/mutual funds) generates higher tax consequences for taxable investors as well.

Question 4:  Don’t some investment professionals beat the stock market as a whole?

Looking in the rear view mirror, you can bring up charts indicating that about 15% of professionally managed funds beat the stock market average over the past 15 years.

But studies show that most of those that beat the averages over the past 15 years, tend to badly underperform the market over the next 15 years.  Nobody has determined how to pick “market beating” funds ahead of time.  An investment salesman may claim that he/she can do it.  But they can’t.

And when looking at financial service organizations, keep in mind that some of them are destined to do very poorly, comparatively, thanks to their additional fee structures.  Watch out for variable annuity products.  It might be tough to find anyone, anywhere, saying anything nice about them…other than a salesperson.  Don’t take my word for it.  Do some online research on them.

Question 5:  So what have I missed out on, by not getting my share of stock market returns?

I’ve been investing for 21 years.  During my investment lifetime, we have seen markets rise and fall, and rise and fall.  But how much has the stock market in Canada gained since 1990?  From 1990 to 2011 it has gained roughly 500%.  The U.S., Australian and British markets have had similar gains as well.

If your stock market money has not gained 500% since 1990, you probably know why.

The financial service industry has skimmed fees off the top, and they’ve promised you that they can dance around, find great funds for you, and make you a killing.

But the vast majority of people who go into the money management field don’t go into it to change the world.  A look at the Forbes list of richest people reveals that it’s the single most lucrative profession.  Check out America’s list for an example:  http://www.forbes.com/wealth/forbes-400/list

Question 6:  How do I get my share of stock market returns, without getting taken to the cleaners?

Your best odds of success come from owning every stock in a given market.  You can simulate that by purchasing products called broad (or total)  stock market index funds.  They’ll provide you with the highest statistical chance of success.

Question 7:  So do you just buy a single index fund, and be done with it?

It’s almost that easy.  I own 3 index funds:

  • My first index represents the Canadian bond market.  For stability, this money is more dependable, doesn’t grow as fast, and has no exposure to the stock market.  I’m Canadian, so I want exposure to “home dollars”
  • My second index represents a broad collection of U.S. stocks (it’s a low-cost U.S. stock market index)
  • My third index represents a broad collection of international stocks (it’s a low cost international index)

A broad stock market index owns a massive number of companies.  It’s cheap to own.  Nobody is paid to “trade” the stocks within an index fund.

Question 8:  So how much time does it take to make an investment decision at the beginning of each month?

It takes me about 4 minutes.  My decision is a mechanical one.  Once I show you, you’ll know exactly what I’m going to buy each month, even before I tell you.

And there’s one statistical inevitability:  No matter where the stock markets go, I will beat the vast majority of investment professionals.  That’s academically irrefutable.

You can easily build a diversified account of stock and bond indexes.  It’s a piece of cake.

And doing so will allow you to say, “No” to excessive fees, empty promises, and underperformances.

For more on index funds, check out what the experts say here

And if you want to see how some progressive employers are protecting their employees from the industry’s self-serving conflicts, have a look at what Google is doing here:   

In my next post, I’ll tell you which index I’ll be buying this month.  It’s not rocket science.