Millionaire Teacher (20 page)

Table 8.4
shows that with reinvesting the interest,
SmartMoney's
recommended bond funds would have returned an average of 32.8 percent from April 2009 to January 2011.

Table 8.4
Percentages of Growth (April 2009-January 2011)

Source:
Morningstar
9

How about gold, which was also recommended by that edition of
SmartMoney
? Its spectacular run would have seen it gain 46 percent during the same period, as gold was hitting an all-time high.

So far, it looks like the magazine was right on the money, until you look at what they didn't headline. Stock prices were cheaper, relative to business earnings, than they had been in decades. The magazine headlines should have read: “Buy Stocks Now!”.

Because they didn't, as demonstrated by
Figure 8.2
,
SmartMoney
readers missed out on some huge gains, as stocks easily beat bonds and gold from April 2009 to January 2011.

Figure 8.2
Bond Funds and Gold vs. Stocks (April 2009-January 2011)

Source:
Morningstar
10

The U.S. stock market (as measured by Vanguard's U.S. stock market index) increased 69 percent, Vanguard's international stock market index rose by 70 percent, and Vanguard's total world index rose by 70 percent during the same period.

The comparative results punctuate how tough predictions can be, while emphasizing that magazines cater for their advertisers and their reader's emotions to sell magazines.

Hedge Funds—The Rich Stealing from the Rich

Some wealthy people turn their noses up at index funds, figuring that if they pay more money for professional financial management, they'll reap higher rewards in the end. Take hedge funds for example. As the investment vehicle for many wealthy, accredited investors (those deemed rich enough to afford taking large financial gambles), hedge funds capture headlines and tickle greed buttons around the world, despite their hefty fees.

But by now, it probably comes as no surprise that, statistically, investing with index funds is a better option. Hedge funds can be risky, and the downside of owning them outweighs the upside.

First the upside

With no regulations to speak of (other than keeping middle-class wage earnings on the sidelines) hedge funds can bet against currencies or bet against the stock market. If the market falls, a hedge fund could potentially make plenty of money if the fund manager “shorts” the market, by placing bets that the markets will fall and then collecting on these bets if the markets crash. With the gift of having accredited (supposedly sophisticated) investors only, hedge fund managers can choose to invest heavily in a few individual stocks—or any other investment product, for that matter—while a regular mutual fund has regulatory guidelines with a maximum number of eggs they're allowed to put into any one basket. If a hedge fund manager's big bets pay off, investors reap the rewards.

Now for the downside

The typical hedge fund charges two percent of the investors' assets annually as an expense ratio, which is one-third more expensive than the expense ratio of the average U.S. mutual fund. Then the hedge funds' management takes 20 percent of their investors' profits as an additional fee to generate profits for fund managers or for the business offering the fund. It's a license to print money off the backs of those hoping for high rewards.

Hedge funds
voluntarily
report their results, which is the first phase of mist over the industry.
The Economist
reports the average (unaudited) returns of hedge funds on the back of each issue, comparing the results to various world indexes. I have been scanning the results for a decade or more, and generally the hedge funds compare favorably—from what I have seen—by a consistent percentage or two above the indexes.

But hedge fund data collectors don't crunch the numbers for the hedge funds that go out of business. They only report the results of those that remain. So what's the attrition rate for these investment products?

When Princeton University's Burton Malkiel and Yale School of Management's Robert Ibbotson conducted an eight-year study of hedge funds from 1996 to 2004, they reported that fewer than 25 percent of funds lasted the full eight years.
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Would you want to pick from a group of funds with a 75 percent mortality rate? I wouldn't.

When looking at reported average hedge fund returns, you only see the results of the surviving funds—the constantly dying funds aren't factored into the averaging. It's a bit like a coach entering 20 high school kids in a district championship cross-country race. Seventeen drop out before they finish, but your three remaining runners take the top three spots and you report in the school newspaper that your average runner finished second. Bizarre? Of course, but in the fantasy world of hedge fund data crunchers, it's still “accurate.”

As a result of such twilight-zone reporting, Malkiel and Ibbotson found during their study that the average returns reported in databases, were overstated by 7.3 percent annually.

These results include survivorship bias (not counting those funds that don't finish the race) and something called “back-fill bias.” Imagine 1,000 little hedge funds that are just starting out. As soon as they “open shop” they start selling to accredited investors. But they aren't big enough or successful enough to add their performance figures to the hedge fund data crunchers—yet.

After 10 years, assume that 75 percent of them go out of business, which is in line with Malkiel and Ibbotson's findings. For them, the dream is gone. And it's really gone for the people who invested with them.

Of those (the 250) that remain, half have results of which they're proud, allowing them to grow and to boast of their successful track records. So out of 1,000 new hedge funds, 250 remain after 10 years, and 125 of them grow large enough (based on marketing and success) to report their 10-year historical gains to the data crunchers compiling hedge fund returns. The substandard or bankrupt funds don't get number crunched. Ignoring the weaker funds and highlighting only the strongest ones is called a “back-fill bias.”

Doing so ignores the mortality of the dead funds and it ignores the funds that weren't successfully able to grow large enough for database recognition. Malkiel and Ibbotson's study found that this bizarre selectiveness spuriously inflated hedge fund returns by 7.3 percent annually over the period of their study.
12

To make matters even worse, hedge funds are remarkably inefficient after taxes, based on the frequency of their trading. Plus, you never know ahead of time which funds will survive and which funds will die a painful (and costly) death.

Hedge funds are like hedgehogs. Nice to look at from afar, but you really don't want to get too close to their spines. You're far better off in a total stock market index fund.

When investing, seductive promises and get-rich-quicker schemes can be tempting. But they remind me of why I don't take experimental shortcuts when hiking. It's too easy to lose your way. I wonder if the famous French writer, Voltaire, would agree. In a translation from his 1764
Dictionnaire Philosophique
he wrote:
“The best is the enemy of good.”
13
Investors who aren't satisfied with a good plan—like indexing—may strive for something they hope will be “best.” But that path's wake is filled with more tragedies than successes.

Notes

1.
Benjamin Graham (revised by Jason Zweig)
The Intelligent Investor
(New York: Harper Collins Publishers, 2003), 146.

2.
Erin Arvedlun,
Madoff, The Man Who Stole $65 Billion
(London: Penguin, 2009), 6.

3.
Ibid., 85.

4.
“
Daryl Joseph Klein and Kleincorp Management Doing Business as Insta-Cash Loans,” The Manitoba Securities Commission, order no.5753: August 13, 2008, accessed April 15, 2011,
http://www.msc.gov.mb.ca/legal_docs/orders/klein.html
.

5.
Gilder Technology Report, accessed October 15, 2010,
http://www.gildertech.com/
.

6.
Mel Lindauer, Michael LeBoeuf, and Taylor Larimore,
The Bogleheads Guide to Investing
(Hoboken, New Jersey: John Wiley & Sons, 2007), 158.

7.
Ibid., 159.

8.
Calculated from 1801–2001 returns of U.S. stocks and gold from Jeremy Siegel,
Stocks for the Long Run,
(New York: McGraw Hill, 2002), then extrapolated further using gold's 2001 price,
accessed April 15, 2011,
http://www.usagold.com/analysis/2009-gold-prices.html
, and compared with its 2011 price,
yahoofinance.com
.

9.
Morningstar.com
.

10.
Ibid.

11.
Swensen,
Pioneering Portfolio Management, An Unconventional Approach to Institutional Investment,
195.

12.
Ibid.

13.
Voltaire quote: Famous Quotes,
accessed April 15, 2011,
http://www.famous-quotes.net/Quote.aspx?The_perfect_is_the_enemy_of_the_good
.

RULE 9

The 10% Stock-Picking Solution . . . If You Really Can't Help Yourself

Women might be better investors than men. Various studies around the globe comparing investment account returns for both men and women put women on top.
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Why is this? Putting women on the household investment podium doesn't make sense to a lot of men. After all, the fairer sex isn't as likely to gather around the water coolers at work, talking up the latest hot stock or mutual fund. They're not as likely to be drooling over CNBC's Becky Quick as she and her co-hosts spout off about stocks, the economy, and the markets on a daily basis. How can women's investment results beat men's results if there are fewer women taking advantage of all the ever-changing information out there?

Finance professors Brad Barber and Terrance Odean suggest that women's investment returns beat men's returns, on average, by roughly one percentage point annually because they trade less frequently, take fewer risks, and expect lower returns, according to a 2009 article by Jason Zweig in
The Wall Street Journal
.
2
Overconfidence, it appears, might be more of a male trait than a female's.

When I've given seminars on indexed investing, many of the women learn to put together a diversified portfolio of indexes. But what has been the greatest risk to their indexed accounts, from what I've seen? Their husbands.

Men more often run the risk of imploding their investment accounts, of chasing get-rich-quick stocks, of trying to second-guess the economy's direction, and of feeling they can take higher risks to gain higher returns.

It sets up the potential for a matrimonial investment war, which might involve the need to compromise. Whether you are a man or a woman, if you really can't refrain from buying individual stocks, then set aside 10 percent of your investment portfolio for stock picking while keeping the remaining 90 percent in a diversified basket of indexes.

When buying individual stocks, do it intelligently. You're not likely to beat the indexes over the long term, but you're sure to have the odd lucky streak, and you might really enjoy the process.

Using Warren Buffett

In 1999, I joined a group of fellow school teachers who pooled some of their money into an investment club. We started out as a rudderless boat. Thinking we were smart, we watched the economic news, subscribed to stock-picking newsletters, followed financial websites, read
The
Wall Street Journal
and listened to “experts” on television. And like most people who follow the manic depressive, schizophrenic news of the investment media, our account got hammered.

But then we became Warren Buffett disciples. Unlike the other stock market “gurus” we previously followed, Buffett never claims to know where stock prices are going to go over the short term. Nor does he pontificate about future interest rates or whether a certain company is going to report stronger-than-expected profit earnings that month, quarter, or year.

What he does give us, however, is far more valuable. He teaches how to think clearly and logically about buying businesses at rational prices, suggesting that a business has an intrinsic value and that valuation could always be higher or lower than what the stock market is quoting. In other words, a stock could be worth much more than its current market price. Finding great businesses at fair prices—or better yet, at great prices—is how Buffett has made a fortune in the stock market over time, and our investment club hoped to do the same.

Investment club follows the sage

By the end of 2000, after a rough start, our investment club of school teachers was officially following the Gospel of Warren. We selected stocks based on Buffett-like criteria and we've done well, averaging 8.3 percent annually from October 1999 to January 2011.

In 2004, I began showing our investment holdings and results to Ian McGugan, then editor of
MoneySense
. In 2008, he suggested we “go public” with the story, and I wrote about the club's results and methodology in the November 2008 issue of the magazine.
3

Since 2008, our club's investments have continued to perform well. But here's the most important part: we don't have any illusions that we will beat the stock market indexes over the long haul. Time has an eroding effect on anyone bold enough to consider beating an index. Loads of smarter investors than us have outperformed the market for a number of years, only to be force-fed a piece of humble pie when they've made a wrong move. Lance Armstrong, the seven-time winner of the Tour De France, wasn't able to keep winning the world's greatest race—as much as he wanted to. And most investors (no matter how they might initially dominate) eventually get spanked by a diversified portfolio of indexes. For that reason, all of my retirement money is tucked away in indexes. That said, if you're still tempted to battle the stock market indexes yourself, let me share what lessons we have learned. Just remember this: no matter what kind of early results you achieve, don't get romanced by the notion that it's going to be easy to beat the market—and don't allocate more than a small portion of your portfolio to individual stocks.

Commit to the Stocks You Buy

I don't believe most millionaires trade stocks. If they own any shares at all, I believe they buy and hold them for long periods, much like they would if they bought a business, an apartment building, or a piece of land. Numerous international studies have shown that, on average, the more you trade, the less you make after taxes and fees.
4
So forget about the high-flying, seductive rants and quacks on CNBC's financial program Squawk Box, convincing you to react to any market hiccup. Forget about fast-paced online newsletter pontifications touting the next hot sector or trading method. Most rich people are committed to their businesses. After all, stocks are businesses, not ticker symbols online. They should be purchased with care and held for years.

Two things you need to have

There are a couple of things that individual stock investors should master. For starters, they need to understand that when stock prices are falling, this is a good thing. Secondly, they need to learn how to identify a great business when they see it.

Hopefully, after reading Chapter 4, you'll have the first part licked. A rising market is a pain in the backside for a long-term investor. If you're going to be buying stock market investments for at least the next five years, you'll prefer to see a stagnating market, or better yet, a falling one. When you've selected a great business, and when the market sends that business into a spiral, you will celebrate and buy more of it. That's what we've done with the investment club. If we choose a solid business, the odds of its eventual recovery are high and short-term market fears let us take advantage of irrational prices.

So How Do You Identify a Great Business?

The first thing you need to know is what you don't know. Bear with me on that paradox. Defining what you don't know can keep you from falling into the black hole of investing. Understanding what a business makes and how much money it generates in sales isn't enough. You need a strong knowledge of how the company works. Obviously, you will never know everything about an individual company. Investors in individual stocks always need to take a leap of faith, but it's much better to understand as much as you can about a business you've elected to buy.

Even when a stock is really popular—such as the current technology favorite Apple <
www.apple.com
>—if you don't intimately understand the business it's important that you don't buy the stock.

This is the reason our investment club hasn't invested in Apple shares. There's no doubt that it's an amazing business, but we don't know enough about Apple. We don't understand how it plans to keep its competitive advantage. We do know that it was practically a dead company in 2001, and we know that today it's a darling business thanks to trendy, easy-to-use products that have taken the world by storm, but we can't tell you exactly how the business works. We can't tell you what it is developing and why. We can't tell you what big visions it has for its future, and we can't tell you whether those visions will materialize. Most importantly, we can't tell whether it will continue to sell the world's most popular products a decade from now. Maintaining its popularity and technological advantage is imperative to its success. And because we can't gauge how well it can do that in the future, we're not (and probably never will be) qualified to buy Apple stock.

You might be shaking your head as you hear my confession. Perhaps Apple runs within your circle of competence. Perhaps you work in the industry and you have a strong grasp on Apple's products, its future, and its internal finances. If that's the case, then fabulous. You might be fully capable of purchasing and holding Apple as an intelligent investor and business owner. But if you're technologically challenged (like I am) you might want to find more suitable investment waters to wade in.

Simple Businesses Can Ensure More Predictable Profits

The famous U.S. stock picker, Peter Lynch, who led Fidelity's Magellan fund <
http://fundresearch.fidelity.com/mutual-funds/summary/316184100
> to superb returns in the 1980s, once suggested that you should buy a business that any idiot can run, because one day an idiot will be running it.
5
This is the way it works in business. You won't always have fabulous leaders at the helm of your favorite companies. For that reason, my investment club has always preferred businesses that are simple rather than those that are rapidly changing.

Businesses that change rapidly are complicated, and they're tough for outside investors to analyze. What's more, they're usually more expensive than other businesses. Microsoft's Bill Gates suggests that tech companies should actually be cheaper than old economy businesses, because of their unpredictability. (Old economy refers to older blue-chip industries.) But they aren't. Speaking to business students at the University of Washington in 1998, he said: “I think the [price to earnings] multiples of technology stocks should be quite a bit lower than the multiples of stocks such as Coke and Gillette because we [those running technology companies] are subject to complete changes in the rules.”
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What will a technology business be doing in the future? Will it be bigger? Smaller? Or will it be extinct?

What's a Price-Earnings Ratio?

A price-earnings ratio (P/E ratio) indicates how cheap or expensive a stock is. The quoted price of a stock, alone, is irrelevant. For example, a $5 stock can be more expensive than a $100 stock.

Here's an example outlined in
Table 9.1
. Imagine two businesses, each generating $1 million in business profits each year.

Table 9.1
When a $5 Stock Costs More Than a $100 Stock

Business One is comprised of 5 million shares at $5 each. So if you were to buy the entire company, it would cost $25 million ($5 a share x 5 million shares = $25 million).

If the company's business earnings are $1 million a year and if the price for the entire company is $25 million (at $5 a share), then we know that the price of the company is 25 times greater than the firm's annual earnings.

When a stock trades at a price that's 25 times greater than its annual profits, we can say the stock's P/E ratio is 25.

Imagine Business Two making annual profits of $1 million as well, with shares valued at $100 each on the stock market.

Assume that the business is comprised of 20,000 shares. To buy every share, thereby owning the entire business, would cost $2 million (20,000 shares x $100 per share = $2 million).

Because the company also generates $1 million in business earnings, we can see that, at $2 million for the entire business, it's trading at two times earnings, for a P/E ratio of two.

Therefore, Business One is far more expensive than Business Two.

When you look at today's technology companies compared with old economy businesses, you can see that the investor in tech stocks takes two types of risks:

Table 9.2
Comparative P/E Ratios as of January 2011

Source:
Yahoo! Finance, price-to-earnings ratios as of January 2011
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