Archives for March 2009

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What is Oblivious Investing?

The term “Oblivious Investing” is my way of acknowledging the fact that success in investing doesn’t require that you have some brilliant investment strategy that nobody else has ever thought of. It simply requires that you come up with an intelligent strategy and stick with it, even when things get tough.

In short, Oblivious Investing is about:

  • Coming up with an intelligent (if unoriginal) investment plan, and
  • Ignoring anything that might distract you from that plan (i.e., “the noise”).

Creating the investment plan is easy. Ignoring the noise is what’s difficult.

Coming up with your investment plan:

There’s really only a handful of things you need to worry about while developing an investment strategy:

Asset allocation: the single most important component of your plan. It will have an enormous impact upon both your rate of return as well as the year-to-year volatility of your portfolio.

Minimizing costs: For a young investor, the difference between investing in a fund with an expense ratio of 1.5% and a fund with an expense ratio of 0.2% could be measured in hundreds of thousands of dollars.

Diversification within asset classes: Greater diversification leads to more predictable results. I think most investors would agree that this is a good thing.

For most investors, an Oblivious Investing strategy looks something like this:

  • Dollar-cost-average into low-cost mutual funds (index or otherwise), and
  • Never sell them until you’re retired and need the proceeds to pay your bills.

Ignoring the noise:

While the plan itself is very simple, the list of things that could throw you off track is nearly endless. A few examples:

Short-term market volatility: It’s understandable that people worry when they see their account values decline. But if you aren’t planning on selling any time soon, you can ignore these price swings and focus instead on accumulating shares.

The financial media: Daily news about stock market performance is just noise. Better to ignore it.

Unscrupulous marketers: There will always be somebody trying to convince you how easy it is to pick stocks or time the market (both of which are far more difficult than they appear). These people are just trying to make a buck off investors’ gullibility. I’d suggest ignoring them.

Notice the pattern?

Over the years, many things will happen that could cause you to doubt your plan. Ignore them, stick with your plan, and you will succeed.

Taking Advantage of Investors

“If consumers have a less-than-fully-rational belief, firms often have more incentive to cater to that belief than to eradicate it.” –Thaler and Sunstein in Nudge

They really hit the proverbial nail on the head with that one. The examples in the investment industry are almost endless.

“It’s not hard to pick stocks!”

As far as I can tell, the circumstances that would provide a stock picker with the greatest probability of beating actively managed funds are circumstances in which the entire stock picking game is pure luck.

  • If it’s not luck, then actively managed funds, pension funds, and other institutional investors have got you beat on intelligence, time, and money. I don’t care how smart you are. It’s still true.
  • Alternatively, if stock picking success is based entirely upon luck, then I can’t imagine what anybody is doing using anything other than an index fund, as minimizing costs would be literally the only way to reliably improve returns on stock investments.

Note that neither scenario leads to the conclusion that stock picking is a wise move. And yet, countless books, magazines, newsletters, blogs, and other websites make money by telling people precisely the opposite: “Sure, you can pick stocks and beat the market. It’s easy!” All you have to do is buy their product. 😉

“Timing the market isn’t that hard.”

Again, we’re presented with a scenario in which the evidence indicates that something is impossible. Further, the most successful long-term investors have stated time and again that timing the market is a worse-than-worthless endeavor.

Yet, since people want to believe it’s possible, businesses can make a fortune by selling products based on false hopes.

[Related side note: Taking your money out of the market and “waiting until things settle down” is just a euphemism for timing the market.]

How to protect yourself:

Of course, the real question is how we can protect ourselves from such unscrupulous marketers. Admittedly, it’s rather tricky. What makes such pitches dangerous is the fact that data can be found that makes each of them sound believable.

My suggestion is to do your own research. Look for your own data, rather than considering only the facts that the marketer has presented to you.

For example, try reading something from each side of the argument: Read a book explaining why index funds are the best investment strategy, and read a book explaining why picking stocks is the way to go. Then, having read both sides, you can determine for yourself who has the more persuasive argument.

What about you?

In what ways have you seen businesses try to take advantage of investors’ misconceptions? And how do you protect yourself from being sold a lie?

Index Funds Need Stockpickers?

In reply to my post at MoneyNing last week, one commenter (a writer for FiLife) replied that:

“Index funds NEED actively managed funds or stockpickers in the market. The market moves when people have opinions on individual stocks, sectors and ideas.”

Am I missing something? As far as I can tell, this statement represents a flawed understanding of the nature of the stock market.

Sure, over the short-term, market returns are the result of changes in demand. But over the long run, market results have more to do with corporate earnings than they do with fluctuations in the demand for stocks.

Example: $100 invested in the market in 1928 would have been worth $112,990 by the end of 2008. Do we really think that demand increased sufficiently to drive the price of the market up by a factor of more than 1,000? Call me crazy, but I doubt it.

I suspect it has a lot more to do with the fact that the stock market represents a collection of companies, and (most of) those companies make money. That’s what businesses do.

To attribute long-term market results purely to increases in demand, rather than to the collective creative power of our entrepreneurs seems like a mistake.

And if active funds and stockpickers are only contributing to short-term movements (i.e., volatility) rather than adding significantly to long-term return, why on earth would index investors need them around?

Is there something I’m missing here? Something I’ve left out that gives this argument a little more weight?

Why the Stock Market is Unpredictable

The value of a stock is, essentially, a function of the amount of dividends it can be expected to pay in the future. Therefore, at any given point in time, the current market price of a stock reflects the sum total of the investment community’s expectations about the company’s future dividends.

Therefore, if the market’s expectations for the company’s dividends turned out to be precisely true, the value of the stock should not change over time.

Of course, stock prices do change over time. In fact, they’re constantly changing. Why? Because people’s expectations for the underlying companies are in a permanent state of fluctuation. New information comes to light on a daily basis that either improves or worsens the outlook for the companies in which we’re investing.

In short–as we’ve learned all to poignantly over the last year–we’re not very good at guessing.

And on a larger scale…

The same difficulty exists with trying to predict the future profits of the entire economy. All day long everyday, there’s news being released that makes people either more or less confident in our economy. There’s a functionally infinite amount of information involved, far more than anybody–or even any computer program–could keep track of.

What should we do about it?

First, accept the fact that the market is not predictable over short periods. Anybody trying to tell you otherwise is simply trying to make a buck off your gullibility. Ignore them.

Next, develop an investment plan that doesn’t require you to be able to predict the unpredictable:

Why index funds are rarely at the top…and why I like them anyway.

Neal of Wealth Pilgrim added a comment on a post earlier today asking the following:

One question – No Load Fund X newsletter -is one of the most consistent top performing newsletters – and it ranks ETF’s and Index funds against active funds. The ETF’s and Index funds aren’t always at the top. What say you my friend?

I’ve got a few thoughts on that. Let’s run through them one by one.

First thought: There’s no use considering any but the lowest cost index fund in a particular asset class. For instance, within S&P 500 index funds, it’s easy to determine which one is best. So we might as well eliminate every other S&P 500 index fund from any comparisons. (Only possible exception: We’re talking about a particular person’s 401k, in which they can only invest in one particular S&P 500 index fund.)

Takeaway: Many of the index funds mentioned on any particular list are suboptimal index funds (due to having higher costs than other index funds tracking the same index), so the fact that these index funds were beaten is rather meaningless, as there would have been no reason to invest in them anyway.

Second thought: Index funds are typically “fully invested” in their particular asset class. That is, they hold very little cash balances, whereas most actively managed funds hold a significant amount of their portfolio in cash at most times. As a result, over any period in which the market moves downward, active managers will benefit simply from having a greater percentage of their portfolio in cash. (Of course, the opposite benefit accrues to index funds during periods in which the market moves upward.)

Takeaway: During any bear market, active funds’ performance relative to index funds will be inflated, though not necessarily as a result of skill. Therefore, it’s hard to assign any predictive value to such outperformance.

Third thought: Depending upon how the list groups mutual funds, we may be comparing apples to oranges. For example, if all equity funds are grouped together, then index funds tracking the S&P 500 will look particularly good during periods in which large cap stocks outperform small cap stocks, and particularly bad during periods in which the opposite happens.

Takeaway: In a comparison that includes all equity funds, it’s really only meaningful to include index funds that track the entire market rather than the S&P. Otherwise we’re going to end up drawing conclusions about active vs. passive management, when in reality the data is simply the result of how one asset class performed as compared to another over a given period.

Fourth (and probably most important) thought: The very nature of index funds is such that they’ll rarely be the best (except over very long periods). Rather, in a given year, the lowest cost index fund in a particular asset class will generally be somewhere in the 60-70th percentile of funds in that same asset class. Of course, that leaves a significant number of funds which did in fact outperform the index.

Takeaway: If you want a strategy that is almost certain to put you above average, indexing is the way to go. Alternatively, if you’d like to take a shot at being in that top 30% each year, have at it. Just realize that for most investors, the chances are less than 50/50.

The way I see it, betting on actively managed funds is like playing blackjack at a casino. In any given hand (ie, year), your odds aren’t terrible. They’re just slightly below 50%. However, if you play 30 or 40 hands, it’s exceedingly unlikely that you’ll come out ahead.

Indexing, on the other hand, allows you to turn the table. Now you’re the house, and your odds each year (against every given actively-managed fund) are greater than 50%. Compound that advantage over a few decades, and you’re looking at some hard to beat odds.

In short

Would I ever say that index funds are unbeatable? Of course not. Not even close. But as far as I’m concerned, any investment option that assures (via simple, unquestionable arithmetic) that I’ll come out ahead of more than 50% of investment options in the same asset class is really darned good.

Don’t believe me? Believe these guys.

When somebody tells me something from which they stand to profit, it often makes me a little skeptical. Conversely, when somebody makes a statement that is not aligned with their own personal interests, I’m typically inclined to believe them.

With that in mind, here are a few statements from investment industry professionals that aren’t in line with their own personal interests:

On the wisdom of frequent trading:

Joe Ricketts, founder of Ameritrade: “The best thing, really, for an investor to do is buy a good company and hold it…Trading often and heavy is not something that makes you a lot of money. That’s contrary to my own interests, but it is the truth.” [source]

My conclusion: When the very people who make money by investors’ active trading tell us that it’s not a good idea, maybe we should listen. 🙂

On Index Funds vs. Actively Managed Funds:

 

Peter Lynch, former manager of Fidelity Magellan: “[Investors] think of the so-called professionals as having all the advantages. That is total crap. They’d be better off in an index fund.” [source]

Charles Schwab: “Most of the mutual fund investments I have are index funds, approximately 75%.” [source]

John Fossel, former chairman for The Oppenheimer Funds:“People ought to recognize that the average fund can never outperform the market in total.” [source]

Douglas Dial, Portfolio Manager for TIAA CREF:“Indexing is a marvelous technique. I wasn’t a true believer. I was simply an ignoramus. Now I am a convert. Indexing is an extraordinary sophisticated thing to do. If people want excitement, they should go to the racetrack or play the lottery.” [source]

My conclusion: Active fund managers (or heads of active-management companies) stating explicitly that index funds will beat the majority of actively managed funds. Seems significant, no?

Did I miss any? Do you have any favorite similar quotes that I’ve left out?

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