Terror on Wall Street, a Financial Metafiction Novel (19 page)

Investing Tips by Gordon #10

The Five Enemies You Must Avoid

There are five traps awaiting the unwary investor:

· Actively managed mutual funds and the brokers that sell them

· The media, including financial newspapers and magazines, newsletters, radio, and TV

· Inflation

· Capital gains taxes

· The person you see in the mirror

   
 
Now, let’s take these enemies one at a time and see what you can do about them. You must simply avoid the brokers employed by full service brokerage firms. Simply stated, there is no financial product sold by these very nice people that should be in your stock or bond portfolio. I can assure you that you are no match for these highly-trained salesmen. You have no business meeting them in person or talking with them on the phone. They are in the business of transferring your money from your pocket into theirs and are extremely skilled at it.

     Free investment seminars are one place where you will meet these folks. Their presentations include a speech by the broker followed by a presentation by the mutual fund salesman. Here is how the scam works. A fund organizer starts 20 or so mutual funds. Each of these funds makes different bets on the direction of three years or so, they merge the unsuccessful funds into the best performer. The lousy fund’s poor record then disappears. Is this legal? You bet it is. When you look up a fund’s prior performance record in Lipper Analytics, you will note that when comparing them with the prior years’ various sectors of the market with different weights of individual securities. After the report, the fund will advance in its ranking. This is because under-performing fund are either liquidated or merged into successful funds. We call this 'survivor bias' and it has been estimated to average about 1.5%. Simply stated, fund data overstate the average performance of all mutual fund returns by 1.5%. The second enemy may be found in the next article.

Investing Tips by Gordon #11

The media ( including financial newspapers and magazines, newsletters, radio, and TV)

With very few exceptions, there is nothing in the media that you need to know to manage your portfolio. There is, however, a columnist who writes a regular column in the
Wall Street Journal which
you should read. His name is Jonathan Clements. His weekly column (and archived past columns) are available online at the following website:

http://online.wsj.com//files/18/07/42/f180742/public/page/0,,sundayjournal_index.html
.

     Look for the search box and put in “Jonathan Clements” to see his past articles. Mr. Clements is an index fund enthusiast and recommends index funds for the individual investor over all other strategies, and has many fine suggestions for the investor. The stuff you find in most other magazines and hear on the radio or TV is worthless financial pornography. It has been known for years that investment newsletters do not provide useful information for investors. You are cautioned not to subscribe to these publications unless you intend to lose money. When you are surfing the web for financial information and ideas, you are certain to draw attention to yourself, and you will become the target of salespeople willing to sell you schemes that tout increasing your profits by investing money. Hardly a week goes by that I do not receive solicitations of this type.

     I recently received a call from a young man offering me a computer program to select winning stocks. I am certain that he was sincere and truly believed in the program he was offering for only $3,000 (regularly priced at $6,000.) The program screened the history of 1,500 stocks on several hundred characteristics over the past 10 years and found the few that had extraordinary profits for the lucky investor. Any statistician can tell you that it is always possible to find in a history of data the few stocks that have outperformed all others. Unfortunately, this tells us nothing about the future.

Investing Tips by Gordon #12

Inflation

Inflation is built into our monetary system and has averaged 3.5% for as long as the Federal Reserve has managed the economy. I graduated from college in 1951.  The dollar earned in that year is worth 13 cents today. Some investors believe that one can partially protect against inflation by adding foreign securities to your portfolio. I subscribe to this camp. I believe that by investing in the stock of European Common Market countries, one can hedge against inflation of the dollar. My reasoning is that the controls that the common market countries must follow offer protection against inflation of the Euro. A security that allows one to invest in these countries is the Exchange Traded Fund called the Morgan Stanley Capital International (MSCI) European Market Union (EMU) Fund (symbol EZU). You buy this fund through a discount broker (a good one is Brown Co.: you can find them on the Internet). Another good way to mitigate some of the damage caused by inflation is to purchase TIPS Treasury Inflation Protection bonds. Vanguard has a fund for the individual investor that contains these securities.

The markets are open for trading and some five billion shares will trade today. Ninety percent of all trades will occur on the orders of professional traders; that is, the managers of pension funds, mutual funds, hedge funds, and trusts. The balance of ten percent will be transactions of individual investors investing for their own accounts. Exactly 50% of trades will be made by parties who believe the stocks they buy are underpriced and the other 50% are by parties who think the stocks are overpriced.

     Your worst enemy is looking right at you every morning in your mirror. Study after study has confirmed this indisputable fact. Every investor has to decide between a proven investing strategy backed by academic studies and data and hundreds of unproven ones marketed and sold by Wall Street.

    The majority of Wall Street hype centers on timing the market and recommending undervalued securities or hot mutual funds. There is at least one piece of historical data that should convince skeptics that trying to "time the market" is most likely an exercise in futility. Out of the 936 months  covering the period 1926 to 1933, the returns for the best 66 months (7%) averaged over 11%. The returns for the remaining 870 months (93%) averaged less than 0.02 percent per month.          Trying to time investment decisions doesn't work because most of the action occurs over such brief, (and unexpected) periods. So now we have established that a buy and hold strategy is best. What, then, should we buy and hold? The answer is to buy an index fund. Those who are taking title in a tax deferred account have a broad choice of funds  available.     

    However, those of you who are taking title in a taxable account should buy a tax managed fund or a total market fund that tracks the entire stock market. The reason for that is that you want to minimize transactions. Academics have found that low turnover small investors actually beat the market before trading costs, and high turnover investors underperform before costs. After costs, of course, underperformance was greater among high turnover investors. Evidence shows that the stocks people sell tend to outperform the stocks they hold. All this boils down to one simple rule: Buy an index fund and let it grow. Do not trade.

Investing Tips by Gordon #14

The Market

The markets are open for trading and some five billion shares will trade today. Ninety percent of all trades will occur on the orders of professional traders; that is, the managers of pension funds, mutual funds, hedge funds, and trusts. The balance of ten percent will be transactions by individual investors investing for their own accounts. Exactly 50% of trades will by parties who believe the stocks they buy are underpriced and the other 50% come from parties who think the stocks are overpriced.

     During the trading day, prices will move according to the supply and demand of these respective parties. The publication of new developments and news of specific companies is immediately incorporated into stock prices of individual companies and their sector. It is believed that prices migrate to the point of facilitating a trade and (in response to new information on specific issues, market sectors and the markets general) the opinion of the economy and foreign trade.

Investing Tips #15

Is the stock market a sum zero game?

First, investing is not a zero sum game. In fact, it is a winner's game, which is defined as a game in which everyone playing can win. They just simply have to accept market returns and they will earn the equity risk premium.

     Second, beating the market is a zero sum game before expenses, but a negative sum game after expenses. That makes it
a
loser’s game in the aggregate. A loser's game is one where the odds of winning are so poor it doesn't pay to try to win. The way to win a loser's game is to not play. In this case, not playing means accepting market returns.

Investing Tips #16

Understanding Risk

A typical actively managed mutual fund or a portfolio of stocks recommended by a full service broker has about 30% more risk than the market. Investors are risk adverse, which means they demand additional returns over and above the market return in order to hold the more risky securities. Please understand that the only way to beat market returns is to select those stocks that will overperform the market.

     When you adopt this strategy, your portfolio will contain uncompensated risk – that is: risk for which there is no concomitant return. Unless you are lucky, such a strategy leads to an underperforming portfolio. We have a very good (but not perfect) method of ranking stocks and bonds by their risk characteristics. It is simply a statistical measure of the securities volatility or how much its market price varies over time. More risky securities will exhibit higher volatility while less risky securities will have lower volatility.

     In 1953 a young college student named Harry Markowitz selected a statistical measure of volatility (called the standard deviation) to represent risk and coupled this expression to the securities average price. For the first time, Wall Street had a measure of risk. Further, Harry discovered that selecting securities whose prices did not move in tandem with changes in the economy could lower the risk of a stock portfolio. In fact, Harry showed (by means of a mathematical formula) that one could construct a portfolio that would obtain the highest return for any level of risk. We call this method Modern Portfolio Theory (MPT).

     Let me draw for you a parallel example that occurs in your wife’s kitchen every day. Let’s say she has decided to make you some cookies. Take flour, butter, sugar, and a pinch of salt, mix and add some chocolate chips in the correct quantities, pop the mixture into a 325 degree oven for 15 minutes, and a new product appears: the chocolate chip cookie. It has neither the appearance, texture nor flavor of any of its component parts. Well, portfolios work in the same way. Our components are asset classes of equities such as large and small cap stocks, growth and value stocks, and fixed income securities; and the quantities of each for various levels of risks are recipes called 'model portfolios'. In my book I show the investor a number of model portfolios designed using the principles of modern portfolio theory to capture the small-cap and value premiums.

     You do not need to know how these portfolios are constructed in order to use them, just as your wife doesn't need to be a food chemist in order to use and follow the recipes to obtain good results.

Investing Tips #17

Quotations from investing experts

"A low-cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth."
Warren Buffet

"Of the 355 equity funds in 1970, fully 233 of those funds have gone out of business. Only 24 outpaced the market by more than 1% a year. These are terrible odds."
Jack Bogle
"Most investors would be better off in an index fund."
Peter Lynch

"Only about one out of every four equity funds outperforms the stock market. That's why I'm a firm believer in the power of indexing."
Charles Schwab
 

"Index funds are perhaps the most underrated stock funds in existence."
Mutual Funds for Dummies
 

"The fund industry's dirty little secret: most actively managed funds never do as well as their benchmark."
Arthur Levitt, Former Chairman, SEC

"Over the long-term, the superiority of indexing is a mathematical certainty."
Jason Zweig, senior writer for
Money Magazine

"The media focuses on the temporarily-winning active funds that score the more spectacular bull's eyes, not index funds that score every year and accumulate less flashy, but ultimately winning, scores."
W. Scott Simon, author
 

"I love index funds."
William Sharpe, Nobel Laureate
 

"Indexing is for winners only."
Jane Bryant Quinn, author, syndicated columnist

"Most people should simply have index funds so they can keep their fees low and their taxes down."
Jack Meyer, CEO, Harvard Management

"Four years ago I was a fan of index funds. Today I am a true believer."
Jonathan Clements, senior writer, Wall Street Journal
 

"We find that on average, active management reduces a portfolio's returns and increases its volatility compared with a static index."
Vanguard Investment Counseling & Research Analysis
 

"They're just not going to do it (beat the market). It's just not going to happen."
Daniel Kahneman, Nobel Laureate

"I was not always an obnoxious indexing zealot. Ten years of believing in and selling active management strategies in the brokerage industry made me this way."
Rick Ferri, CFA, author
 

"Active portfolio management thus tends to generate lower returns and higher taxes."
John Haslem, author

"Indexing virtually guarantees you superior performance.”
Bill Bernstein, author, financial adviser
 

"Index funds save on management and marketing expenses, reduce transaction costs, defer capital gain, and control risk--and in the process beat the vast majority of actively managed mutual funds."
Good & Hermansen, authors

"In every asset class where they are available, index! Four of five funds will fail to meet or beat an appropriate index."
Frank Armstrong, author, financial adviser

"With an index fund--the certainty of keeping up with the market is a very worthwhile trade-off for the possibility of beating it.”
Jack Brennan, CEO Vanguard

"Searching through a list of 234 domestic equity funds that have survived for 20 years, only 31 did better than the Vanguard 500 Index. That means the odds are really, really poor that any of us will do better than a low-cost broad index fund."
Scott Burns, syndicated columnist

"Index funds offer much more than superior returns. They also provide maximum diversification, no overlap, no style drift, no manager changes, lower turnover, lower expenses, lower taxes, greater simplicity and peace of mind
." Taylor Larimore, author

"Choosing actively managed funds is the triumph of hope over reason and experience
." Larry Swedroe, author, financial adviser

"It's just not true that you can't beat the market. Every year about one-thirds of investors do it. Of course, each year it is a different group."
Robert Stovall, investment manager

"Giving up the futile pursuit of beating the market is the surest way to increase your investment efficiency and enhance your financial peace of mind
." Ron Ross, author and adviser

"It is basically impossible to beat the market."
Prof. Eugene Fama

"Indexing is a marvelous technique, I wasn't a true believer, I was just an ignoramus. Now I am a convert. Indexing is an extraordinarily sophisticated thing to do."
Douglas Dial, former CREF portfolio manager

"Simple buy-and-hold index investing is one of the best, most efficient ways to grow your money.
Michael Lebouf, Ph.D., author

"The best plan, for most of us, is to commit to buying some index funds and do nothing else."
Charles Ellis, author

"With the market beating 91% of surviving managers since the beginning of 1982, it looks pretty efficient to me."
Bill Miller, portfolio manager

"We should just forget about choosing fund managers and settle for index funds that mimic the market."
Pat Regnier, former Morningstar analyst

"Because active and passive returns are equal before cost, and because active managers bear greater cost, it follows that the after-cost return from active management MUST be lower than that from passive management."
Wm Sharpe, Nobel Laureate

"The most efficient way to diversify a stock portfolio is with a low fee index fund
." Paul Samuelson, Nobel Laureate

"We find that on average, active management reduces a portfolio's returns and increases its volatility compared with a static index implementation of the portfolio's asset allocation policy."
Vanguard study

"Buy and hold. Diversify. Put your money in Index Funds."
Justin Fox, Fortune senior writer

"Index funds save on management and marketing expenses, reduce transaction costs, defer capital gains, and control risk--and in the process, beat the vast majority of actively managed mutual funds."
Good & Hermansen, authors

"You should switch all your investment in stocks to index funds as soon as possible, after giving proper consideration to any tax consequences."
Chandan Sengupta,
author

"I am somewhat skeptical about anyone's ability to consistently beat the market
." Moshe Milevsky,
author

"With an index fund, the certainty of keeping up with the market is a very worthwhile trade-off for the possibility of beating it."
Jack Brennan, Vanguard CEO

"With a very simple and basic understanding of index funds, you can consistently beat 70% to 80% of all professionally managed index funds."
Tweddell & Pierce, authors

"Invest in a stock index mutual fund. It's a brilliant, ingenious, common sense idea that I can't take credit for, but can religiously pass along to those of you who want to unclutter your financial lives and own a sophisticated portfolio."
Bill Schultheis, author

"For most of us, trying to beat the market leads to disastrous results."
Prof. Jeremy Siegel, author
 

"The surest way to make money in the stock market is not to work very hard at it. Don't try to outsmart the market; settle for matching it. Put most of your money in an index mutual fund."
Gary Belsky, author

"My strongest commitment in the mutual fund arena is to index funds."
Richard Young, editor

"I recommend that the long-term buy-and-hold portion of your equity portfolio be invested in equity mutual funds."
Sheldon Jacobs, author

"The smartest thing people can do if they want money in the equities market is buy an index fund that is run for 30 basis points a year and then forget about it."
Elliot Spitzer, NY Attorney General

"The only consistent superior performer is the market itself and the only way to capture superior consistency is to invest in a properly diversified portfolio of index funds
." Rex Sinquefield, researcher

"It's extremely difficult to beat the market
." Peter Brimlow,
Forbes senior editor

"There can be no question that indexing for most categories of taxable investor and for most marketable conditions will outperform conventional active management
." Robert Arnott, CEO First Quadrant

"A passive index fund managed by a not-for-profit investment management organization represents the combination most likely to satisfy investor aspirations."
David Swensen, author

"The S&P index benchmarks outperformed their active peer funds in all nine Morningstar-style boxes over the past ten years."
Gus Sauter, Vanguard

"It's amazing to me that, by one estimate, only 14% of money is indexed in this country!! What a shame."
Lynn O'Shaughnessy, author

"I continue to believe that unless you are extremely skilled (and lucky), for most investors, index funds remain the simplest and most efficient vehicle for investing in stocks."
Annette Thou, author

"When you realize how few advisors have beaten the market over the last several decades, you may acquire the discipline to do something even better: become a long-term index fund investor."
Mark Hulbert, newsletter tracker

"If it weren't for noise, 98% of investors would see what's going on and buy passive strategies."
Kenneth R French

"Scholarly work by Burton Malkiel, Eugene Fama and others has proved that it is the rare investor who can outperform the overall market
." Ben Stein, NY Times

"Choosing actively managed funds is the triumph of hope over reason and experience."
Larry Swedroe, author

"Indexing virtually guarantees you superior performance."
Bill Bernstein, author

"Indexing is an extraordinarily sophisticated thing to do."
Douglas Dial,
CREF

"With the market beating 91% of surviving managers since the beginning of 1982, it looks pretty efficient to me."
Bill Miller, portfolio manager

"Buy and hold. Diversify. Put your money in Index Funds."
Justin Fox, Fortune senior writer

"For most of us, trying to beat the market leads to disastrous results."
Prof. Jeremy Siegel, author
 

"A passive index fund managed by a not-for-profit investment management organization represents the combination most likely to satisfy investor aspirations."
David Swensen, author and Yale portfolio manager

"Most people should simply have index funds so they can keep their fees low and their taxes down. No doubt about it."
Jack Meyer, Harvard portfolio manager

"Beating an index is no piece of cake anywhere in the style box."
Russel Kinnel, Morningstar Director of Fund Research

"Index funds. They aren't perfect, but they are better than all the other forms that have been tried."
Scott Burns, syndicated columnist

"Just 19 percent of U.S. mutual funds that have existed since mid-1980 were able to beat the S&P 500 through May of 2006."
Lipper

"Most investors should simply invest in index funds
." Robert Rubin, Former Secretary of the Treasury