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Step 1: Active Investor
NEXT STEP: Step 2: Nobel Laureates
The first step on the index funds journey is to recognize active investor behavior. If all investors were lined up in a row, could the active investors be identified? Active investors actively engage in stock picking, time picking (market timing), manager picking, and style picking. They usually share the following thoughts and behaviors:
• Own or plan to own actively managed mutual funds. • Select stocks they think can outperform a market. We call this stock picking. • Think there are times to be in a market and times to be out of a market. We call this time picking, generally known as market timing. • Think that active managers with the best track records are the ones to select to manage their investments. We call this manager picking. • Shift in and out of styles or indexes in an effort to chase returns, e.g., from large cap to small value. We call this style picking. • Are primarily invested in the S&P 500, thinking this provides adequate diversification.
• Own or plan to own actively managed mutual funds.
• Select stocks they think can outperform a market. We call this stock picking.
• Think there are times to be in a market and times to be out of a market. We call this time picking, generally known as market timing.
• Think that active managers with the best track records are the ones to select to manage their investments. We call this manager picking.
• Shift in and out of styles or indexes in an effort to chase returns, e.g., from large cap to small value. We call this style picking.
• Are primarily invested in the S&P 500, thinking this provides adequate diversification.
If you show those signs, you are engaging in active investing and can benefit greatly from this 12-Step Program. If not, you are well on your way towards understanding the benefits of a diversified portfolio of index funds, which is the basis of Index Funds Investing. Keep reading, you will soon understand the wisdom of index funds, how much wealth you may have lost in the past, and how much you can accumulate if you learn how to change the way you invest. Let's start!
Active investing is a strategy that investors use when trying to beat a market or appropriate benchmark. Active investors commonly engage in picking stocks, times, managers, or styles. As later steps demonstrate, active investors who claim to outperform a market also claim the power to predict the future. When accurately measured, this is simply not possible. Surprisingly, the analytical techniques that active investors use can best be described as qualitative or speculative. They include predictions of future sales and earnings growth, and are often based on gut feelings and intuition. On the other hand, the passive index investing approach is best described as quantitative or scientific. Indexing techniques include statistical analysis of risk and return data of 20 years or more, in addition to extensive measurements of numerous performance criteria. Many indexes are now based on more than 83 years of risk, return, and correlation data.
As opposed to active managers, investment managers of index funds are far less active in the buying and selling of stocks, because they do not pick stocks or managers, time markets, pick styles, or make attempts to forecast the future. As previously mentioned, the analytical techniques that index funds managers use are best described as quantitative or scientific. Approximately 15% of all individual assets and 44% of all institutional assets are currently invested in different index funds. Many institutional funds are one hundred percent indexed. Even Charles Schwab and Company recommends that investors put 80% of their large cap assets into index funds. Mr. Schwab himself has 75% of his mutual funds in index funds. Other indexing proponents include Barclay's Global Investors, Dimensional Fund Advisors, The Vanguard Group, Warren Buffet, Peter Lynch, numerous academic institutions, Economic Nobel Laureates, and Index Funds Advisors (IFA). Insurance companies use a similar approach to indexing when setting premiums for the risks taken by insuring against thousands of different random events. Most of those premiums are also invested in index funds while held in reserves for the inevitable claim payment. Most investors believe that index funds investing means investing in familiar market indexes, such as the Standard and Poor's 500. S&P 500 funds are structured with the aim to provide the same investment performance as the S&P. By holding all the stocks in the same proportionate amounts as the S&P index, the fund index represents about 86% of the market value of all U.S. companies, mostly large blue chip stocks. The problem is that market indexes, such as the S&P 500, were not originally designed as investment vehicles. Since the late 1980’s, index funds have expanded and are based on more discrete customized indexes. Originally designed for very large pension funds, institutional-style index funds are meant to capture various financial risk factors or dimensions of the market. Exposure to a risk factor such as company size or value constitutes a risk dimension of the market. Investors have been compensated with higher returns for risk exposure to these risk factors since 1929. These dimensions of the market can also be referred to as indexes. Indexes are groups of stocks that have common risk and return characteristics and comply to specific and clearly defined sets of rules of ownership. These groups of stocks include companies from the United States, foreign companies, and even emerging markets. There are additional indexes within these markets, such as value, large value, small growth, large growth, real estate securities, and many fixed-income investments, such as short-term and long-term treasury bonds, municipal bonds, and corporate bonds. Companies are purchased and held within the index when they meet the index parameters. Stocks are sold when they move outside of these parameters and no longer meet the index rules. An example of an index fund is Dimensional Fund Advisors' (DFA) Micro-Cap index fund, which invests in securities of U.S. companies whose size (market capitalization) falls within the smallest 4% of the total market universe. This includes all stocks traded on the New York Stock Exchange and the American Stock Exchange, as well as those listed in the National Association of Securities Dealers Automated Quotation Over-the-counter (NASDAQ OTC) market. Another example would be DFA’s Small Cap Value Fund, which invests in companies ranked in the lowest eight percent by size, as well as the highest 25th percentile by book-to-market ratio (value). DFA funds are now available to individual investors through a small qualified group of registered investment advisors who have demonstrated their understanding and commitment to the concepts described in this 12-Step Program. The overwhelming majority of investors are active investors. Extensive research by many academics and investment professionals has shown that investors cannot beat a market in the long run with stock, time, manager, or style picking. It is disconcerting that about seventy percent of all institutional money invested in U.S. stocks is still actively managed.
The table below summarizes the differences between the two approaches to investing.
Table 1-1
We reference the phrase “ beating a market” throughout this 12-step Program. This is defined as the attempt to obtain a higher net return on investments from a portfolio of stocks, bonds, or mutual funds than from a relevant and investable index or benchmark. The net return includes adjustments for all commissions, loads, fees, expenses, risks, and federal and state taxes. It is calculated over a reasonable period of at least five years, but preferably over 20 years. The net return of an active investor’s stock portfolio can then be paralleled to the index fund of a comparable index. The index may consist of the entire stock market or a more specific index, such as small capitalization value stocks. No investor over or underperforms an index. They simply invest in something other than the index. Since the index is the only source of long-term risk and return data, why would an investor subject hard earned savings to anything other than the index? The most basic tenet of all investing is that exposure of your money to a higher level of risk should be rewarded with a higher expected return. In contrast, lower levels of risk should correlate to a lower expected return. One of the problems with measuring the performance of stock market investing is the lack of a standardized system of benchmarks from which to measure performance. This lack of benchmarking is the black hole of investing. If there is no definitive benchmark, it is impossible to determine if exposure to risk has been properly rewarded. In other words, has the active investor really beaten a market with repeatable skill, or can it just be attributed to luck?
There are many terms used by investment professionals and academics in their quest to define risk. These include markets, benchmarks, asset classes, styles, style boxes, investment objectives, risk factors, market dimensions, market segments, categories, market averages, buckets of stocks, rules of ownership, slices of the market, industry classifications, and indexes such as Dow Jones Indexes, Standard and Poor's Indexes, Russell Indexes, Wilshire Indexes, Morgan Stanley Capital Indexes, Wired Index, and many more. Diversification and measures of volatility, such as standard deviation, are also used to describe risk. Every one of these is an attempt to identify common risk and return characteristics among groups of stocks included in that classification. To reduce confusion, market or index will often be substituted for these terms.
An appropriate challenge to the investment industry is a call to action to develop an SEC-approved standard to measure the risk of various investments. The three-factor model proposed by Eugene Fama and Kenneth French in 1992 would be an excellent starting point. This model is discussed later in Step 8: Riskese™.
Active investors believe they are in control. They delude themselves that they have a special understanding of the market, a superior edge over less knowledgeable investors, making them immune to disaster. The truth is that all investors can access the same information as professional money managers through the Internet and many other sources. Still, many investors believe they are smarter and more sophisticated than the average investor. Those under this illusion fail to realize how much investment performance depends on luck. Most of them eventually pay dearly for this mistake. Active investing in the stock market is a lot like casino gambling. Take a look at the numerous comparisons in the various news articles below. (Note the references to addiction.)
New studies in the field of neuroeconomics confirm the release of dopamine when presented with the opportunity of a surging stock. This validates and confirms the addictive nature of Stockaholics™. The powerful allure of monetary reward leads to the overwhelming urge to trade stocks or funds. It has now been shown through brain imaging studies that the circuits that switch on at the prospect of big profits are the same as the ones that lead to the addictive nature of cocaine, casino gambling, alcohol, chocolate, and sex, just to name a few. The brain images below tell the story.
Figure 1-A (Chart Link)
In the October 2002 issue of Money Magazine, the highly respected journalist Jason Zweig writes a ground-breaking article about the new evidence of the release of addiction related dopamine in our brains. He declares, "the dopamine rush we get from long shots is why we play lotto, invest in IPOs, keep too much money in too few stocks and invest with active portfolio managers instead of index funds." He goes on to say that, "our brains are wired to force us into forecasting; it is a biological imperative. In fact, humans are born with what I've come to call "the prediction addiction." Zweig reports that there are several researchers working on nueroeconomics at this time. At Harvard, Hans Breiter is leading a project and has stated that they have discovered a "striking" similarity between the brain's reaction to cocaine, morphine, and the prediction of financial rewards. Please take the time to read Jason's new book on this subject, Your Money & Your Brain. Also see Center for Neuroeconomic Studies Duke University.
Follow up on above video: Tim Sykes, 25, ran a top-ranked, short-bias fund called Cilantro Fund Partners, which he founded in 2003 in his senior year at Tulane University in New Orleans. After suffering a roughly 35% loss over two years, on October 1, 2007, Timothy closed his hedge fund.
Meir Statman talked about his new book, What Investors Really Want: Know What Drives Investor Behavior and Make Smarter Financial Decisions, on Morningstar.com. When asked about index funds, he stated, "Well, index funds are fabulous. Now you say well can I do better than average? Can I perhaps exploit other people's cognitive errors? And the answer to that is probably yes. But the question really is how much does it cost you to exploit the cognitive errors of the others. Think about somebody who says there are $100 bills some place in the streets, so this is the equivalent of a cognitive error of other people, because they have left it lying down. Well, but it will probably take you three days to find that one $100 bill, if that. And so you're going to waste too much money looking to exploit other people's cognitive errors, and in the process you're going to really shortchange yourself by getting lower returns." Watch the full interview below.
In this new report from Barclays, The Role of Control in Financial Decision Making, the emotional mistakes investors make have been discussed and analyzed.
Figure 1-1
Table 1-2 illustrates some of the details of this unique study. The large gap between the funds' and shareholders' returns was a shock to even the researchers. The reason for this gap is attributed to active investors who followed the destructive behavioral patterns that Dalbar Research had been describing since 1994. These patterns include waiting for funds to have a good year or two followed by pouring in a flood of cash just before the fund reaches its peak. Then they ride the fund to near bottom and sell.
One encouraging exception was the Dimensional Fund Advisors (DFA) institutional index funds. DFA investors are limited to either large institutional investors or individuals who have been educated by specially trained investment advisors. Because the shareholders of these funds buy and hold diversified portfolios at all times, they ride out the market gyrations and end up obtaining market rates of returns. The table below shows the worst big funds ranked by how investors performed relative to the funds and five DFA funds listed in the article.
Table 1-2
In one example from the study, the Firsthand Technology Value fund racked up an impressive annualized return of 16% from 1998 to 2001. However, the investor return over this period was a devastating 31.6% loss. In total it was estimated that investors lost $1.9 Billion in this fund over this period, while the fund reported time-weighted returns of 16%. The head of fund marketing for Firsthand stated, "... people lost a lot of money because they took oversized bets in technology at the wrong time." At some funds, investors missed the glory days and piled in just in time for disaster. Firsthand Technology Value earned fantastic returns for a relative handful of early investors. But fund's late, giant losses were shared by many more. A careful analysis of the chart below will reveal the tragedy of active investors behavior.
Figure 1-A
An annual study called the Quantitative Analysis of Investor Behavior (QAIB), which has been conducted by Dalbar since 1994, measures the impact of investor decisions to buy, sell, and switch in and out of mutual funds. Each year, the study has shown the average mutual fund investor earns significantly less than the mutual funds over the same time period. In fact, the report issued in March 2011 carried this headline: "Investor Behaviors Continue to Fall Prey to Market Forces." The study further concluded, "As this report has shown for the 17th time in as many years, mutual fund investors consistently underperform the relevant index. The report also shows that most of this loss in performance is due to psychological factors that translate into poor timing of their buys and sells (investor behavior)."
Figure 1-2 illustrates the results of the most recent 20-year Dalbar study, a comparison of the returns of an average equity fund investor to the returns of the market from 1991 to 2010. Permitting their decisions to be driven by short-term volatility, the average equity fund investor earned returns of only 3.83%, while the S&P 500 returned 9.14%. An investment of $100,000 made in 1991 grew to an inflation adjusted amount of $129,106 over the 20-year period for an average equity fund investor, while the same amount invested in the S&P 500 grew to an inflation adjusted amount of $350,141. Even better, an investor who owned an all-equity, small-value tilted, globally diversified index portfolio such as IFA's Index Portfolio 100 would have grown a $100,000 investment to an inflation adjusted amount of $555,538. Clearly, investor behavior can have a far more negative impact on investment performance than investors realize.
Dalbar has conducted previous similar studies. (See these Dalbar QAIB Charts created by IFA).
Figure 1-2
In John Bogle's Little Book of Common Sense Investing, Chapter 5 is titled the Grand Illusion: Surprise! The Returns Reported by Mutual Funds Aren't Actually Earned by Mutual Fund Investors. In this chapter he refers to two studies on this subject. Also on page 50, a 25-year period is referenced when the average fund investor earned a dollar weighted return of 7.3%, while the fund had time-weighted returns of 10.0%. So the average investor only earned 73% of the funds returns over this 25 year period. Also, an S&P 500 Index Fund earned a 12.3% return in this period, while the investors in that fund only earned 10.8%, only capturing 88% if the index fund return. On page 56, an analysis of 5 Aggressive Growth Funds revealed that the average investor did not capture any of the 7.8% annualized returns over the 10 years from 1995-2005. Instead, they actually lost 0.5% annualized for the 10 years. The average investor in the Vanguard Index 500 only capture 78% of that fund's return over this period, earning 7.1% of the 9.1% annualized return.
Investors can benefit from hiring a purely passive investment advisor, who provides quality education and mentoring, focused on changing their investing behavior, encouraging long-term investing, and discouraging the speculation and gambling practices of trying to beat a market. Morningstar, a fund tracking service, started disclosing these "investor returns" in 2006. On the Data Definition page of their web site, they state that "Morningstar investor returns (also known as dollar-weighted returns) measure how the typical investor in that fund fared over time, incorporating the impact of cash inflows and outflows from purchases and sales. In contrast to total returns, investor returns account for all cash flows into and out of the fund to measure how the average investor performed over time. Investor return is calculated in a similar manner as internal rate of return. Investor return measures the compound growth rate in the value of all dollars invested in the fund over the evaluation period. Investor return is the growth rate that will link the beginning total net assets plus all intermediate cash flows to the ending total net assets." Now that Morningstar is tracking such data, investors' bad behavior is finally quantified, as well the advantages of using a passive advisor who helps reduce investor error. In the Morningstar Indexes Yearbook: 2005, they analyzed how the average index investor did on their own versus those that are guided by an advisor using asset class index-type funds from Dimensional Fund Advisors. Here is what they had to say:
"Consider the success Dimensional Fund Advisors (DFA) has had in selling its funds through advisors who undergo training on the merits of passive investing and in portfolio construction theory. Consider that over the past decade the dollar-weighted return of all index funds was just 82% of the time-weighted return investors could have gotten with those funds. Yet, the figures for DFA are much better. In fact, the dollar-weighted returns of DFA funds over the past 10 years are actually higher than their time-weighted returns [see Table 1-3], suggesting advisors who use DFA encourage very smart behavior among their clients, even buying more out-of-favor segments of the market and riding them up, rather than buying at the peak and riding the trend down, which is usually the case with fund investors."
Table 1-3
Note: This represents the 10 years ending 12/31/2009 Source: Morningstar To compare this data with the IFA Index Portfolios, see below and HERE, and for a sample client over most of this period see HERE.
The emotions of active investors go up and down like a roller coaster, leading them to negative returns on average, after expenses and taxes are deducted. The lessons in this 12-Step Program should allow investors to resist the behaviors that have caused them such despair and poor results in the past.
Figure 1-4
As a contrast, passive investors invest whenever they have the money to invest, regardless of market conditions, as seen below.
Figure 1-4a
To make things even better for passive rebalancers, they do the opposite of active investors and sell a portion of indexes that have grown beyond their target allocation and buy more of indexes that end up being under their target allocation. (see Step 12, paragraph 12.2.3 Rebalancing Portfolios) In addition, there are added tax savings for taxable accounts due to tax loss harvesting.
Figure 1-4b
We have created this chart to summarize the above studies.
Figure 1-4C
Active investors, like casino gamblers, often do not account for their total return properly. Common mistakes include the exclusion of loads, commissions, taxes, and cash flows in and out of their portfolios. Another common error is quoting the returns of only the portion of their portfolios that performed well. Then there is the problem of hearing only from the winners and not hearing from the losers who seem to disappear into thin air. Since 1961, twenty-eight percent of mutual funds have vanished from the record. There is no accounting for their returns.
The stock market moves with new information. News is unpredictable and random; therefore, the stock market moves in an unpredictable and random way. The Random Walk Theory describes the way stock prices change unpredictably as a result of unexpected information appearing in the market. This "random walk" of changing prices has created a misconception among investors that stock prices change randomly for no rational reason. The news is random and unpredictable by nature. Investors react to the news, thereby effecting stock prices. The year 2000 marked the centennial of the Random Walk Theory of stock market prices. Many scholars have confirmed and refined the research of Louis Bachelier, the hapless unsung hero of financial economics. On March 29, 1900, Bachelier presented "The Theory Of Speculation" as a thesis before the faculty of sciences at the Academy of Paris. He anticipated what was to become standard fare in financial theory: the random walk of financial market prices. One hundred years since the theory's conception, the vast majority of investors are still not convinced that the markets are random. In 1964, MIT professor Paul Cootner published a 500-page book of reprints of all research on the randomness of the market. The book was titled, "The Random Character of Stock Market Prices." It contained the first full text English translation of Bachelier's 1900 thesis.
The Efficient Market Hypothesis explains the process of free and efficient financial markets. First, information about stocks is widely and inexpensively available to all investors. Second, all known and available information is already reflected in current stock prices. Third, the price of a stock agreed on by a buyer and a seller is the best estimate of the true value of that stock. Finally, stock prices change almost instantaneously as new unpredictable information appears in the market. All of these factors make it nearly impossible to capture returns in excess of a market return without taking greater than market levels of risk. As discussed in Step Eight: Riskese™, the only issue of concern is the relationship between risk, return, time, and correlation.
Risk is the source of investment returns, yet investors want to avoid it. It serves investors well to learn about and embrace risk in accordance to their capacity level. Risk Capacity™ defines the risk level that is appropriate for a particular investor. Many investors invest in portfolios that are mismatched to their Risk Capacity™. A thorough analysis, such as the one in Step 10: Risk Capacity™, looks at an investor’s investment time horizon, net worth, income, investment knowledge, and attitude towards risk. With this analysis, an investor can then review investment choices and make a selection that matches personal Risk Capacity™. An investment policy or portfolio is a statement of the Risk Capacity™ assessment and the resulting risk exposure, in the form of an asset allocation of indexes.
Most investors do not get around to fully assessing their Risk Capacity™ and find themselves without an investment policy for their short-term and long-term investing. Without this policy, they are easily persuaded to change their course. They lose out on the long-term returns that would result from subjecting their capital to risk.
High turnover creates short-term capital gains in a mutual fund or a portfolio of individual stocks. In taxable accounts this can create an insurmountable barrier to beating an index. The average mutual fund turns over ninety percent of its stock each year. This high percentage forces the distribution of capital gains by the fund, which become tax liabilities for the fund’s shareholders. Active investors incur far greater federal and state taxes, since almost all of the capital gains are short-term and are taxed up to forty-six percent. On the other hand, index fund investors buy and hold, so they rarely incur capital gains. When they do, they are long-term gains that are taxed at twenty percent. New tax managed funds harvest losses to offset gains. By their passive nature, they have lower turnover rates. These tax-managed funds nearly eliminate federal and state taxes.
Investment returns are far more dependent on investor behavior than the performance of the investment. Investors generally make bad decisions under the pressure and stress of trying to outperform a market. These shortfalls are directly attributed to investors overreacting to constantly changing conditions in financial markets, resulting in brief holding periods for mutual funds. The tendency of investors to bail out of stock funds during market downturns and buy back in too late when the markets recover obviously harms performance.
In fact, trading patterns analyzed by a Dalbar study showed that most investors invariably buy high and sell low. The more an investor buys and sells mutual funds, the lower the expected return. All these findings were also true of bond fund investors. According to the study, a buy-and-hold strategy outperformed the average investor by more than three to one after ten years.
When the stock market performs well, as it did for most of the 1980's and '90's, investors are more prone to believing they can beat a market. When they get lucky and make a profitable investment call more than once, they are lured into thinking they are successful market forecasters. Unfortunately, this false sense of confidence leads them to the poorhouse. The media continues to foster and encourage the high emotions of active investing. Many ads lead investors to believe they can beat a market through stock picking and time picking. In a September 1999 advertisement from Ameritrade (Online Broker), an image of a scowling young woman was displayed. Her quote read as follows: "I don't want to just beat the market. I want to wrestle its scrawny little body to the ground and make it beg for mercy." It goes on to say, "Ready to take on the market? The sooner you do, the sooner you can show that lily-livered stock market who's boss." Finally, it ends with, "Believe in yourself."
Watch this short interview, where James Altucher, managing director of Forumula Capital, says that day trading is a mistake.
The lack of investor education has generated a lot of recent interest. Most school systems have not incorporated an educational program for investing. The average investor is unprepared to make decisions about investing hard-earned money. Investors usually receive their education in bits and pieces from advertisements, television, magazines, newspapers, or books. These sources are created by an industry that generates huge margin interest, fees, and commissions from the trading of active investors. Most of the promotion and education provided by the investment industry encourages investors to gamble in the stock market. Money Magazine and the Vanguard Group conducted a study in 1997, which randomly selected 1,555 investors from across the United States, and asked them twenty basic questions on investing. The investors received a sixty-seven percent, or an "F" grade! In a 2000 update of the survey, the average score dropped to only thirty-seven percent correct answers. Why do investors continue to invest in something they do not understand?
I am Mark Hebner, president of Index Funds Advisors (IFA), a registered investment advisory firm. Years ago I learned some painful lessons when I sold my previous business and turned the profits over to active managers. I woke up one morning crestfallen, realizing that my decision to do so had cost me $30 million in lost opportunity. After thoroughly researching the science of passive investing and index funds, I came to the conclusion that I needed to withdraw all of my investments from several stockbrokers and place them in index funds. I concluded that a 12-Step recovery program for active investors was critically needed. Today, I am passionate about educating investors about the benefits of index funds
The concept of a 12-Step Recovery Program originated in 1935 and today is used to treat more than thirty addictions, including gambling, alcohol, overeating, drugs, and sex. Millions of people rely on such programs.
In the early 1930’s an American alcoholic named Rowland H. (only the last initial is used to keep him anonymous) traveled to Switzerland to undergo treatment from the world renowned Dr. Carl Jung. After a couple unsuccessful trips, Dr. Jung told Rowland that he needed a "profound spiritual experience" to enable him to stop his drinking. In other words, he needed to find a higher power. Other patients with these experiences had overcome their addictions and changed their behaviors.
The 12-Step Program is partially based on the replacement of an addiction with a higher power, whatever that may be for a person. As investors become more familiar with the Nobel Prize winning stock market research outlined in this book, many may experience investing epiphanies and transform their thinking and investment behaviors. Many “Stockaholics™” are already beginning to see the light.
Rex Sinquefield, a director at DFA, attended the University of Chicago in the 1970s. He said, "Every time one of my professors talked about efficient markets, I thought I was looking at Moses coming down from the mountain, and I took that seriously." DFA is now known as the “mecca” of indexing. Maybe Sinquefield had his profound spiritual experience there in the classroom. I had my epiphany when I heard Professor Eugene Fama of the University of Chicago, and a Director of Research at DFA discuss the Three Factor Model at a financial conference. After reviewing Step 2, which describes the research of Fama, French, and many others, readers will know why.
When the founder of Alcoholics Anonymous, Bill W., needed a vehicle to carry his message to millions of alcoholics, a book was the only affordable method. So, he wrote Alcoholics Anonymous in 1938. That book has become affectionately known as “The Big Book.” Coincidentally, 1938 was the same year that Alfred Cowles created what was later to become the Standard & Poor’s 500. (Cowles did not know that his creation would go on to become the first index used to establish an index fund by Rex Sinquefield.)
This book is a modified 12-step Program designed to educate investors on how to overcome the emotional desires to actively invest. Some refer to it as the “Big Book on Investing.” In 1938, Bill W. was limited to books as an affordable method of communication. But, today we have the Internet. It’s a medium I take full advantage of in my mission to lead investors to a highly efficient, tax-managed, low-cost and risk appropriate portfolio.
Warren Buffet stated in a February 1996 investment letter to his Berkshire Hathaway shareholders: “…the best way to own common stocks is through index funds….” In his 1997 letter he writes: “Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” In February 2003 he gave this advice to investors in his shareholder letter: “…those index funds that are very low cost (such as Vanguard’s) are investor friendly by definition and are the best selection for most of those who wish to own equities. And, his February 2004 letter states: “Over the [past] 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback corporate America in a diversified, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.”
Even though some professionals outperform a market, it is a different group of professionals that do so each year. A consistent methodology to identify them in advance has yet to be discovered.
Benjamin Graham, the father of fundamental stock analysis, and a man revered by Warren Buffet, also relinquished the idea that investors can expect to beat a market. Shortly before his death in 1976, he was interviewed by Charles Ellis and said: “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago when [the Security Analysis by] Graham and Dodd was first published; but the situation has changed.... [Today] I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost.... I’m on the side of the ‘efficient’ market school of thought.”
Several other questions and answers from this interview are shown below: "In the light of your 60-odd years of experience in Wall Street what is your overall view of common stocks? Common stocks have one important characteristics and one important speculative characteristic. Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings--incidentally, with no clear-cut plus or minus response to inflation. However, most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble--i.e., to give way to hope, fear and greed."
Can the average manager of institutional funds obtain better results than the Dow Jones Industrial Average or the Standard & Poor's Index over the years? No. In effect, that would mean that the stock market experts as a whole could beat themselves--a logical contradiction. Do you think, therefore, that the average institutional client should be content with the DJIA results or the equivalent? Yes. Not only that, but I think they should require approximately such results over, say, a moving five-year average period as a condition for paying standard management fees to advisors and the like. What about the objection made against so-called index funds that different investors have different requirements? At bottom that is only a convenient cliche or alibi to justify the mediocre record of the past. All investors want good results from their investments, and are entitled to them to the extent that they are actually obtainable. I see no reason why they should be content with results inferior to those of an indexed fund or pay standard fees for such inferior results. Source: “A Conversation with Benjamin Graham.” Financial Analysts Journal, vol. 32, no. 5 (September/ October 1976.):20–23. In AN HOUR WITH MR. GRAHAM, by Hartman L. Butler, Jr., C.F.A. La Jolla (see page 36), California, recorded on March 6, 1976, Mr. Graham described a value index fund.
Graham: ... "The main point is to have the right general principles and the character to stick to them.
...The thing that I have been emphasizing in my own work for the last few years has been the group approach. To try to buy groups of stocks [this is what an index does] that meet some simple criterion for being undervalued [Fama/French would call this riskier, not undervalued] - regardless of the industry and with very little attention to the individual company [Don't try to pick winning stocks]. My recent article on three simple methods applied to common stocks was published in one of your Seminar Proceedings.
I am just finishing a 50-year study-the application of these simple methods to groups of stocks, actually, to all the stocks in the Moody's Industrial Stock Group. I found the results were very good for 50 years. They certainly did twice as well as the Dow Jones. And so my enthusiasm has been transferred from the selective to the group approach. What I want is an earnings ratio twice as good as the bond interest ratio typically for most years. One can also apply a dividend criterion or an asset value criterion and get good results. My research indicates the best results come from simple earnings criterions.
Hartman Butler: I have always thought it was too bad that we use the price/earnings ratio rather than the earnings yield measurement. It would be so much easier to realize that a stock is selling at a 2.5 percent earnings yield rather than 40 times earnings.
Graham: Yes. The earnings yield would be more scientific and a more logical approach. [Fama/French use Book-to-Market Ratio as a Value Criteria]
... Hartman Butler: I understand that you have about completed this research.
Graham: Imagine - there seems to be practically a foolproof way of getting good results out of common stock investment with a minimum of work. It seems too good to be true. But all I can tell you after 60 years of experience, it seems to stand up under any of the tests that I would make up."
Investors in index funds usually win over active investors over long periods of time. The path to recovery for active investors begins with understanding the following steps outlined in this book.
About 85% of investors engage in active investing. This 12-Step Program comprehensively addresses the emotional hurdles an active investor needs to clear. The first step of every 12-Step recovery program is admitting to the existence of a problem. My hope is that this first step has helped you recognize active investing behavior, and realize that harmful behaviors can be changed. In Step 2, Nobel Prize winners and other academics are discussed. These legendary individuals have committed most of their lives to researching the stock market in order to develop the ideas that today determine how trillions of dollars are invested. Once these capital market ideas are understood, the investor can start ignoring stock pickers, market timers, last year’s winners, Wall Street strategists, technical analysts, and investment media gurus who attempt to make stock market predictions. I trust that you will be inspired to see the stock market in a whole new light.
Please answer the following questions before moving on to the next Step:
1. Investment managers of index funds engage in:
2. A Dalbar Study showed that the average investor earned 3.90% per year over a 20-year period while the S&P 500 gained:
3. PriceWaterhouseCoopers found that one of the largest hurdles keeping investors from index funds is:
4. In his 1997 letter to shareholders, Warren Buffet stated that "… the best way to own common stocks is:
5. When 1,555 investors were given a test of 20 basic questions in 2000 regarding investing, the average score was: