New Highs in the Dow Part III – What Should I Do?

2013-02-05 13.27.30Please see New Highs in the Dow Part I – Indifference and Inevitability

And New Highs in the Dow Part II – What’s going to happen?

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First, if you’re actually an investor1  in public securities2, take a moment to be sad about these past two weeks and all the new highs hit in the Dow Jones Industrial Average.

All that it means when an equity index hits a new high is that it costs you more to purchase shares in the equity markets.  If you’re an investor and you plan to buy stocks ever again – in your life – these new highs are not to be celebrated, but rather be lamented.

Unless of course you like paying more this week than you did last week for the exact same product.  I know I don’t.

After you recover from your sadness, do what you should always do under any circumstances, which is blindly and reflexively take the monthly surplus you can reasonably afford to dedicate to long-term investing, and purchase low-cost, diversified, stock mutual funds.

And never sell until you absolutely must have the money to cover your lifestyle costs.

And that’s pretty much it.

For 95%3 of individual investors, 99.5%4 of the time, the rest of what passes for investing advice amounts to noise.5

Please understand I’m saying this as a guy who

1. Is not an investment advisor and I’m not selling mutual funds.  I can’t benefit in the least from you taking my advice.

2. I’ve been a bond salesman of credit default swaps, CDOs, RMBS, CMBS, ABS, IOs, POs, Inverse IOs, calls, puts, swaps, and swaptions.  I’ve sold sovereign emerging market debt and corporate emerging market debt.  I started and ran a distressed debt hedge fund.  I’m a fiduciary for a school endowment invested in hedge funds and mutual funds.   I know the products out there.  They have their place and their usefulness in the institutional investing world, or the ultra-high net worth world.

I’m saying all of that sophistication – outside of low-cost, broadly diversified, long-only equity mutual funds – is mostly irrelevant to personal investing.

So, embrace the simplicity that’s beyond sophistication.  Be child-like in your humility about what and how you invest.

Again, take the monthly surplus you can reasonably afford to dedicate to long-term investing, and purchase low-cost, diversified, stock mutual funds.

Do this when the market goes down.  Do this when the market goes up.  Do this when the market goes sideways.

Do this with a Fox.

Do this with a Peacock.

Fox-Business-News-logo“But I would not, could not, with these stocks.

I would not, could not, with a Fox,

I would not, could not, with a Peacock,” you say.CNBC Logo

When Fox and Peacock like Charlie Gasparino and Jim Cramer tell you to do other things, just do this.

Just try it.  You’ll like it.  You’ll see.

greeneggsandham

Please see my previous posts in this series

New Highs in the Dow Part I – Indifference and Inevitability

And New Highs in the Dow Part II – What’s going to happen?

 


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  1. Just to be clear: my statement is aimed at people who intend to be investors in their life, in the future.  If you’re a retiree drawing down on investments rather than adding to them, you of course celebrate new equity index highs like we’ve seen in the past week.  But in that case, you’re not an “investor” in the sense I’m using the word.
  2. Another caveat: Plenty of successful, wealthy, investors ignore public securities and do just fine.  I’m really just talking about one’s involvement in purchasing stocks and bonds.  Essentially, the kind of people who care about the Dow.
  3. I rounded down to be conservative.
  4. Ditto
  5. For the fuller explanation from a great book on why this is all you need to know, read this review of Nick Murray’s Simple Wealth, Inevitable Wealth, and then go buy the book.

Book Review: Simple Wealth, Inevitable Wealth by Nick Murray

Nick Murray’s Simple Wealth, Inevitable Wealth, [1] deserves to be the exception to my rule of never reviewing “How to Invest” books.

Stylistically, Murray’s prose is the Yin to Nassim Taleb’s Yang.[2]  Murray is gentle, meditative, and modest in affect, part financial advisor and part Zen master, contemplating the beauty of compounding investment returns[3] and inter-generational wealth-building.

Yet for all his gentle style, he’s no less sure of himself or passionate when it comes to what he sees as simple, but overlooked principles for building wealth over time.

Since I’ve come to adopt his views as my own, it’s worth highlighting the best of them here.

  • Murray questions the common journalistic narrative[4] as it mostly misleads rather than informs.  Even worse, the journalistic narrative rarely asks the key questions for wealth building such as “What is Risk?”, “What does wealth mean to me?” and “Who am I?” (I’ve hyper-linked to my earlier consideration of the latter two questions.)
  •  Timing the market is a fool’s game[5], whereas time in the market will be your greatest natural advantage.
  • The highest value of an investment advisor is often to tell you to not do anything.  This sounds a lot like advice from Benjamin Graham.
  • Only equities provide the possibility of growing wealth in perpetuity.  I would add – but Murray does not – some other risky assets in addition to equities for certain people and institutions.  Murray has a particular fondness for stock mutual funds, and, for the vast majority of people, I concur that that’s all you need to grow wealth.  My own definition of ‘equities’ would include ownership in not only stock mutual funds, but also allow for a broader variety of risky vehicles such as real estate, traditional business ownership, commodity investments, or other volatile assets.
  • For the individual investor, bonds are an “anxiety-management tool” but not a wealth-building tool.  Unfortunately – given current interest rates – this is truer now than it was when Murray first published his book in 1999.  At this time, fiduciaries who depend on managing money in perpetuity cannot afford to be in bonds, a big, under-recognized problem – in my opinion.

His strongest points, which he spends the bulk of the book proving to my satisfaction are the following:

First, owning a diversified portfolio of equities over the long-term does not carry significant risk of capital loss.  The diversified portfolio of equities is subject to volatility, but volatility passes away under long-term time horizons[6] and should not be conflated with risk.

Second, building wealth through the steady accumulation of equity mutual funds is simple,[7] and the result of this behavior, over a lifetime, is inevitable wealth.

Third, in contrast, bonds or riskless assets will not build wealth, but rather condemn the investor to a long-run loss of purchasing power.  If your goal is to build wealth – rather than provide current income – you cannot afford to be invested in bonds.

Murray’s main message – as restated above – may be manipulated, distorted, exaggerated or parodied, but cannot be proved wrong.

Professionally I’m a “fixed-income/bond guy” through and through,[8] so I believe in the uses and opportunities of bonds and safe cash-flows.  Despite my experience and biases, I believe Murray on his own terms, is absolutely, capital “R” Right.

Please see related post: All Bankers Anonymous Book Reviews in one place.

 

 


[1] Full title of the book: “Simple Wealth, Inevitable Wealth – How You And Your Financial Advisor Can Grow Your Fortune In Stock Mutual Funds”

[2] I greatly admire and recommend Taleb, but as I’ve written on Fooled by Randomness and Black Swan, his prose style can be abrasive.

[4] Also known as the “Financial Infotainment Industrial Complex”

[5] On timing, Murray writes: “Time in the market, as opposed to timing the market, is not a way of capturing the long-term returns of equities; it is the only practicable way.  You have to stay in it to win it.”  This makes a lot of sense if you understand the magical power of compound interest.

[6] He defines long-term as, at minimum, 5 years.

[7] Murray explains that, while the process is simple, simple is not the same as easy.  It’s incredibly hard, in fact, to have enough left over, after paying your bills, to constantly invest in equities month after month, year after year, for your entire life.  But if you can do that, wealth is inevitable.  Hence, the title of the book.

[8] I’ve been a bond salesman, and fixed-income hedge fund manager.  I have no professional experience with the stock market.  Mostly I find conversations about stocks and the stock market incredibly uninteresting.  But I still believe you have to have your money exposed to them, or other forms of risky equity, to build wealth.

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Who Killed Fund Performance? We All Did!

murder on orient expressEssay Review of “Murder on the Orient Express – The Mystery of Underperformance”

Once in a while I read something which crystalizes for me – with data and arguments better than I could hope to make – what I already suspected but hadn’t yet put into words.

Charles D. Ellis writes in Financial Analysis Journal[1] a research-based critique of the Financial Infotainment Industrial Complex’s myth of investment manager outperformance.

Using the literary conceit of Agatha Christie’s Murder on the Orient Express, Ellis plays detective Hercule Poirot to uncover everyone’s guilt – investment managers, investment consultants, fund executives, and investment committees – when it comes to paying unnecessary fees to managers who inevitably underperform ‘the market.’

If, like me, you kind of suspected all that, but wanted to see it demonstrated in black and white, I recommend the article.  If you want the Cliff’s Notes version, hey, that’s why you come to Bankers Anonymous!

The Problem

As Ellis points out, everyone wants to own funds with investment returns in the top quartile; this is statistically impossible for more than 25% of investors in any year.

The further grim reality is that 60% of mutual funds underperform their benchmark every year, and that number climbs to 80% underperformance over a 20-year period.

Most troubling of all, Ellis cites research[2] which concludes that 24% of funds underperform their benchmark, 75% of funds match their expected market returns with no alpha[3], and 1% of funds actually offer risk-adjusted superior net returns, after costs.

So about 1% of actively managed funds are really “worth it.”  Think you can pick that 1%?[4]

Ok, that’s the problem.  Who’s to blame?  Everyone in the Financial Infotainment Industrial Complex.

Investment Managers

How are they to blame for underperformance?

  • They choose time horizons in their marketing materials specifically to show outperformance, ignoring those years which would show either ordinary market returns or underperformance
  • They ignore the proliferation of thousands of highly trained experts in every aspect of investment finance who ensure that almost nobody has an edge on anybody else.
  • They actively market their products precisely at the moment following short-term outperformance, despite their knowledge that performance almost always reverts to the mean in the medium-to-long-run.

Investment Consultants

How are they to blame for underperformance?

  • Consultants get paid to retain clients, by not meaningfully underperforming the market.  Consultants achieve this aim by emphasizing the importance of diversification, thereby ensuring that no single fund can noticeably impair the client’s portfolio, nor can any single fund make a meaningful contribution to alpha.[5]
  • Consultants inevitably recommend funds with recent outperformance – which limits the pool of funds – and ignores the mean-reversion inherent in most managers’ performance over time.

Fund Executives

How are they to blame for underperformance?

  • Fund executives often add a layer of extra fees by insisting on ‘separate accounts’ even when investing in long-only stock funds, when it makes little sense.
  • Fund executives typically are at an information and experience disadvantage when dealing with their counterparts at investment manager firms.  So they fail to ask pertinent questions or push back when necessary.  I’ve frequently observed the psychological barrier that prevents less experienced financial professionals in the room from asking the right question.  Investment managers know this and depend on this.  Traditionally we think ‘fear and greed’ drive the market and that’s still true.  But the ‘fear of appearing foolish’ drives the fee structure in many parts of the investment management world.

 

Investment Committees

How are they to blame for underperformance?

  • Investment committees, like fund executives, usually act at an information and experience disadvantage when reviewing investment managers.
  • Most investment committees have limited time and resources to do proper due diligence.  As a result, they tend to focus on recent past performance, which has little predictive power for future results, and suffers from the mean-reversion problem of markets and strategies.[6]
  • Investment committees mistake their role, imagining that it consists of investment decisions rather than governance decisions.
  • Investment committees stick with historic policies long past their “sell-by date,” because of the group-think inertia.

 

The result

The logical result of the “Murder on the Orient Express” discovery that “everyone is guilty” is that managers of pension funds and endowment tend to pay too much in fees for investment management.

The Financial Infotainment Industrial Complex continually reinforces the idea that outperforming managers may be discovered at any time and that the goal of investment managers is to ‘beat the market.’

But when you pay extra to ‘beat the market,’ you end up, in the long run, paradoxically underperforming the market by, at least, the amount of your fees.



[1] What?  You’ve let your subscription to Financial Analysis Journal lapse?  Well, thank goodness you have me to point this paper out to you then.  Here’s the Scribd link to the paper.

[2] Laurent Barns, Olivier Scaillet, and Ruiss Wermers, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas.,” Journal of Finance, vol 65, no. 1 (February 2010): 179-216.

[3] Sorry to get all Greek-lettery on you.  “Alpha” means “performance above your benchmark” in investment terms.  “Beta,” if you’re curious, means correlation to your benchmark.  Beta is easy to achieve, and it’s what most mutual funds do despite claiming to deliver alpha.  Getting alpha from an investment manager over time is hard, and rare.

[4] That sounds like a rhetorical question, but there actually is a correct answer.  The answer is “no.”

[5] It’s not in Ellis paper, but this point reminds me that ‘diversification’ often prevents significant wealth creation.  I’ve written this before, but truly wealthy people who made the money in their own lifetime, inevitably have extreme concentrations of risk in only one or two assets or businesses.  Concentration of risks creates alpha, diversification creates beta.

[6] Ellis points out that research supports only the predictive power of recent performance for the bottom decile of managers.  The worst 10% tend to maintain underperformance due to high fees and limited capability.

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