Archives for April 2009

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Investing in Actively-Managed Funds

  1. Outperforming the market by picking stocks and/or market timing is rather difficult.
  2. Less than 50% of actively-managed funds will beat a low-cost index fund.

So it seems to me that investing in an actively-managed fund is the rough equivalent of saying, “I don’t have an above-average ability to pick stocks, but surely I can do an above-average job at picking an actively-managed fund!”

Many investors–myself included for a few years–don’t seem to pick up on the fact that selecting an actively-managed fund must not be as easy as it looks–i.e., simply choosing a fund with great past performance.

If it were that easy, then everybody (including other fund managers) would already be doing it. And if that were to happen, then by definition the original outperforming fund could no longer be an above-average performer.

Takeaway: Just like with picking individual stocks, beating the market by picking actively-managed funds requires that you either:

  1. Get lucky, or
  2. Know something that the market doesn’t.

And I assure you, a fund’s past performance is never unknown to the rest of the market.

$100 Billion Down the Drain (Every Year!)

Nope. I’m not talking about any bailout-related spending. I’m talking about money that gets wasted every single year, financial crisis or otherwise. According to a study done by Kenneth French, $100 billion is the amount of money that U.S. investors collectively spent in attempts to beat the market in 2006 (the most recent year for which he has complete data).

What a shame. We spent $100 billion in an attempt to outperform ourselves–a goal that is, of course, impossible by definition.

Sure, some of that money was spent paying money managers who did in fact beat the market. But there’s no question that, as a group, we’re worse-off by exactly the total amount we paid.

Most industries “add value.” The financial services industry subtracts it. In other words, most industries provide goods/services that are worth paying for. This industry provides goods/services whose value is negative in precisely the amount that we pay for them.

Two noteworthy (but small) exceptions:

Of course, the financial services industry does in fact provide two services that are of value.

First, there are a handful of good advisers who actually help people focus on things that matter rather than promoting themselves as wonder-workers with some magical way of beating the market consistently. Second, the financial services industry connects users of capital (businesses) with providers of capital (investors).

However, it’s clear that the total amount spent paying for these two services is outmatched by the amount spent on our collective effort to outperform ourselves.

What if we stopped trying?

Just imagine for a minute what life would be like if the investing public were to catch on to the impossible nature of this endeavor.

A few direct results:

  • Actively-managed funds would disappear.
  • Full service brokerage firms would be completely replaced by discount brokerage firms.
  • Financial planners would have to charge reasonable fees, and they’d have to earn their fees by providing real service rather than selling false promises of performance.
  • As a group, we’d be $100 billion richer. Every year.

In addition to the direct results, there would be positive side effects. For example, as people abandoned actively-managed funds in favor of index funds, they’d also benefit from actually understanding what’s in their portfolios.

I know, I know. It’ll never happen. But a guy can dream, can’t he?

Why Read a Mutual Fund Prospectus?

Fund prospectuses look as if they’re intentionally designed to be as unappealing as possible to potential readers. They’re generally printed on low-grade paper, have no color, and are packed with charts, tables, and numbers that are difficult for many investors to understand.

At the same time, they’re usually paired with a nice, glossy brochure about the fund. No surprise, then, that so many investors tend to toss the prospectus straight in the recycle bin, while looking instead at the picture-filled brochure.

Guess which one has the useful information?

The brochure is simply marketing material. It’s (for the most part) only going to contain the facts that make the fund look good.

The prospectus, on the other hand, is required to include certain pieces of information. A few helpful nuggets that you’ll find in a prospectus:

  1. Portfolio turnover rate
  2. Expense ratios and other expense information (charges incurred for redeeming shares, for example)
  3. Size of the fund
  4. Asset allocation of the fund (This is typically expressed in a range, such as “up to 20% of fund assets may be invested in international equities.”)

Conveniently enough, these are precisely the factors to look at when selecting a fund. 🙂

Next time you’re considering investing in a fund, don’t let the fund company choose which facts do or don’t see. Go straight to the prospectus instead, and get the facts for yourself.

Long-Term Predictability and Short-Term Unpredictability

In a comment on a recent post, Ethan gave one of the best explanations I’ve seen for why long-term returns are predictable, and short-term returns are not.

Here’s my attempt at explaining the concept visually. It’s not exactly action-packed, but hopefully it’s easy to understand.

Long-Term and Short-Term Stock Market Returns from Mike Piper on Vimeo.

Summary of video in case you can’t watch it:

If a company’s P/E ratio stays constant over a given period, then the company’s share price must increase at precisely the same rate as its rate of earnings growth. Therefore, the total return on the stock would be equal to its dividend yield plus earnings growth.

And the same thing applies for the market as a whole: If the average market P/E ratio stays constant, the stock market’s return will be equal to the market’s dividend yield plus its earnings growth.

Of course, P/E ratios don’t stay constant. They move around. Sometimes the market is scared, and P/E ratios are low. Other times the market is confident, and P/E ratios are high.

Over short periods, changes in market confidence (as measured by P/E ratio) will determine market returns. But over long periods, changes in P/E ratios will mostly level out, and market return will be equal to earnings growth plus dividend yield.

Same takeaway as always: If you want predictable returns in the stock market, you must stay in the market for an extended period. None of this jumping in and out funny business. 🙂

Investing Virtues: Patience, Humility, and Confidence

Investing requires patience.

A long-term buy-and-hold strategy allows for fairly predictable results. The catch is that in order to earn those predictable returns, you have to stay invested for the entire period. Hopping in and out of the market might make your returns better, but it’s just as likely to make them worse.

Similarly, looking for immediate results can tempt you to try all kinds of high-risk investment strategies.

Moving your money around makes your results less predictable. Patience allows for predictability.

Investing requires humility.

The desire to be better than average often leads to poor investing decisions. It’s difficult for many investors to accept, but “average” (i.e., investing in low-cost index funds) is surprisingly hard to beat.

People often overcomplicate things in an attempt to make themselves feel sophisticated. In reality, the simplest investing strategy is often the best.

A little humility can go a long way when choosing an investment plan.

Investing requires confidence.

Being a buy-and-hold investor in a bear market requires ignoring not only your current account value, but also advice from countless “experts” and “friends” who will try to convince you that you need to take your money out of the market.

Ignoring the noise in a bear market requires a great deal of confidence.

Don’t want to be virtuous?

Fine. Being lazy and stubborn should get the job done too. 🙂

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