How to Become Smarter (48 page)

A number of studies have shown that the absolute majority of fund managers (who are not amateurs, by the way) cannot beat the S&P 500 in the long run. That is, they cannot provide their clients with a long-term return on investment better than 10% per year. For example, a recent research article showed that only about 0.6% of mutual fund managers can grow your money faster than the S&P 500 index in the long run. The article examined a period of 30 years and it took into account fees and expenses [
508
]. People who are not professional investors are even less likely to pick a stock or a portfolio that will outperform the S&P 500. If the great majority of professional investors cannot outperform a broad stock index, then it makes sense to invest in the broad stock index and to hold it for decades. It also makes sense to avoid picking and choosing stocks and actively managing the portfolio. Thus, diversification, or simultaneous investing in a large number of stocks, is key to successful and safe investing. Warren Buffett, arguably the best investor in the world, holds a well-diversified portfolio of stocks. A recent study showed that his portfolio had outperformed the S&P 500 index by an average 14% per year, based on data from 1976 to 2006 [
509
]. Nonetheless, if copying Warren Buffett’s investing approach were easy, then there would be a far higher percentage of fund managers who outperform the stock market average.

The notion that it is easy to outperform the average market return is self-contradictory and fallacious at its core. The majority of people cannot be better than average in principle because the average reflects performance of the majority of people. In other words, based on the mathematical formula of the average performance, only a minority of investors can outperform the stock market index. In actuality, only a
tiny
minority of professional investors outperform the market average in the long run, according to the study cited above. Therefore, outperforming the market is not easy. Although Warren Buffett has often revealed his basic investing principles, the devil is in the details. It is also possible that he has some special talents that 99.4% of fund managers do not have.

Suppose one of the top-performing fund managers explains his or her successful investing approach in great detail to the public. In this case, the vast majority of people will still be unable to outperform the market. This is because the valuation of the stocks that fit the successful investing criteria will rise. This increase in price will make these investments average or below average judging by potential returns. The current holdings of successful fund managers are known to the public, but this knowledge is useless today. These stocks were a good investment 30 years ago and are average investments today (not better than a stock index). These corporations are now humongous and cannot grow at the same rate as before.

I am not a certified financial advisor, but you can do what Warren Buffett says unskilled investors can do: put your money in an index fund and hold it there forever. This is the precise quote: “By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” This investing approach is going to be successful if you are patient and going to hold this investment for decades, ignoring year-to-year fluctuations of the value of your portfolio. Don’t check on your portfolio every month or even every year. You shouldn’t be afraid of a stock market crash because it will let you buy the same index at a cheaper price. This implies that you are going to save and invest about the same amount of money each year. After several decades, your gains are likely to exceed your temporary losses with a vengeance. You can ignore financial advisers, hedge funds, and all financial literature and financial TV programs. The probability that you will find an outstanding fund manager and stay with him/her in the long run is negligible. If you decide to invest in Warren Buffett’s company today, you shouldn’t expect it to grow at the same rate as it did in the past 40 years. Today, Berkshire Hathaway is too large and therefore unlikely to deliver a higher than average return on investment.

Buying and selling of stocks in your portfolio will have tax disadvantages compared to holding your investments indefinitely. Also don’t forget about transaction costs (we will talk about trading later). Therefore, investing in a well-diversified portfolio, such as a stock index, and holding this investment indefinitely is a prudent investing approach. Many stocks pay dividends, and index fund managers reinvest them. Thus, the value of your portfolio will increase even if stock prices remain flat for some time. The legitimate question is: why should a stock index go up in the long run? In the case of the United States, the Federal Reserve expands the money supply at an average rate of about 6.9% per year [
510
]. (This is based on 50 years of available data, non-seasonally adjusted M2, Oct-1959 through Oct-2009.) All this extra money is bound to end up in the stock market, increasing its total value in dollar terms. This is a simplified picture and does not take into account international flows of funds. Although stock indexes in most of the developed countries have risen over the past decades, in some countries, stock indexes have performed dismally. For example, in Japan, the Nikkei 225 index is currently (February 2012) at the level where it was 28 years ago. In theory, there is a risk that a similar fate may befall the S&P 500 index in the future. An investment of 4,000 yen in the Nikkei 225 in the year 1990 would be worth approximately 1,000 yen today.

When stock indexes do go up, they do not go up in a straight line, and there are substantial year-to-year fluctuations. If you are uncomfortable with the fluctuations of stock prices, you can invest in government bonds, such as federal, state, or municipal bonds. State and municipal bonds yield higher income than federal bonds in the United States if you take into account their tax-exempt status. Interest income on federal bonds is not tax exempt, whereas that on state and municipal bonds is tax-exempt, with rare exceptions.

Research shows that investment in broad stock indexes has outperformed investment in government bonds in the United States during the last half a century. It is likely that this trend will hold true for the next half a century, although these things are difficult to predict with certainty. The example of the Japanese stock market (Nikkei 225) suggests that in rare situations, bonds
can
outperform stocks over a period of two or three decades. A small return on investment is better than a zero or negative return. To safeguard against extended periods of bad performance of a stock index you can invest in stock indexes of many countries simultaneously. Global diversification will not eliminate year-to-year fluctuations, but is likely to minimize the risk of negative returns over a period of several decades, i.e. what happened to the Nikkei 225 index. In the United States, the global diversification approach is available, for example, at the Vanguard Total World Stock Index Fund. At the time of this writing, the fund is tracking performance of 3,736 stocks in 47 countries and the minimum investment is $3,000 ($2,000 for education savings accounts).

There are bonds that yield higher interest compared to federal bonds, for example, corporate bonds, but they are riskier. If a corporation goes bankrupt, you will lose most of your investment, although diversification can reduce your risk to some extent. Government bonds are safer than corporate bonds. In the developed countries, governments can run large deficits and have astronomical debt, but they are extremely unlikely to ever go bankrupt. This is because a federal government can do two things that corporations cannot: it can levy taxes and it can print money. (Governments of the countries in the Euro Zone cannot print money because the
European Central Bank
controls monetary policy.) You may consider state and municipal bonds as an investment if you want higher interest income (after taxes) than what federal government bonds have to offer. The risk is somewhat higher because state and local governments can default on interest payments in rare situations. In most cases, this does not mean that you will lose your investment; it means that there may be some interruptions in the payment of coupons. In extremely rare situations a county or some other municipality can go bankrupt. Some companies (S&P and Moody’s in the U.S.) provide quality ratings of state and municipal bonds, which you can use in your investment decisions. State and local governments can levy taxes but they cannot print money and they must balance their budget by law. (Most federal governments in the world do not have to balance their budgets.) Nonetheless, state and municipal bonds are safer than corporate bonds and are a good investment. For example, a recent interview revealed that personal finance guru Suze Orman keeps most of her money in municipal bonds.

Keep in mind that investment in taxable bonds has some tax disadvantages compared to investing in an index fund. In the U.S., if you own stocks or shares of an index fund, the I.R.S. postpones your taxes on capital gains until you sell those investments. This postponement can take years or even decades, depending on how patient you are with your investments. This means that the uncollected taxes on capital gains will keep working for you, even though they belong to Uncle Sam. This is an important advantage that the buy-and-hold investment strategy has over trading and over investment in bonds. Another possible inconvenience of bonds is that the prices of bonds will go down if interest rates (such as the federal funds rate in the U.S.) go up. Therefore, you may sustain small capital losses or gains with bonds, if you decide to sell them before they reach maturity.

If you have high-interest debt, it will be wise to pay down this debt faster than your current payment plan, if you have some savings to invest. Let’s say the annual percentage rate of interest on your debt is 15%, and you are thinking about investing your savings in a stock index fund (S&P 500 has returned about 10% annually on average). You will increase your net worth faster if you use the extra money to pay down the debt instead of investing. On the other hand, suppose you have interest-free debt, you are making the required payments monthly, and at the same time, you are accumulating savings that you can invest. In this case it will make sense to invest your savings in government bonds or in a stock index fund. This way, your net worth will be growing faster compared to the situation when you try to pay off the interest-free debt faster than planned.

In conclusion, the efficient market hypothesis and the modern portfolio theory elaborate in great detail on many of the arguments presented above and below. The modern portfolio theory explains the relationship of risk and return and can help to select an investment portfolio that carries minimal risk and good return on capital. One of the major implications of the modern portfolio theory is that an investment with a high potential rate of return always involves high risk of losses (for example, an internet startup company).

The basic assumptions of the efficient market hypothesis are:

• prices of financial instruments always reflect all publicly available information;
  
• it is virtually impossible to profit from publicly available information.
  

For example, if you hear a positive news story about some company on TV, it makes no sense for you to try to profit from this information. The price of the stock will adjust quickly to any significant news. By the time you decide to purchase this stock, the price will have already risen enough to make the transaction unprofitable for you. Shares of stock of a promising company are usually more expensive than shares of stock of an unattractive company (according to the price-to-earnings ratio). In other words, investors price promising stocks at a premium, which reduces potential investment returns. On the other hand, “not promising” stocks have a lowered price, which increases potential investment returns. The good-quality company is more likely to grow and prosper than the low-quality company. Yet the difference in the price-to-earnings ratio of the two stocks usually eliminates the difference in potential investment returns. There have been times when the shares of low-quality companies were overvalued, such as the Internet bubble of the late 1990s. But this inefficiency of the market became evident only several years later,
after the fact
. During the boom, however, these valuations appeared reasonable to most market participants, based on all available information. One can argue that investing fads and bubbles would be less likely if more people were familiar with the efficient market hypothesis. One of the implications of this theory is that it is virtually impossible to outperform a broad stock market index in the long term. It’s no use trying to select “good stocks” for your portfolio or to trade stocks. Contrary to what the critics will tell you, the efficient market hypothesis is consistent with the ability of a tiny minority of people to outperform the market average in the long run. This can be the result of dumb luck or the result of unique
talents
(which are also in the category of luck). Recent research supports the major implication of the efficient market hypothesis, that it is unlikely that you or me can outperform the market average over a period of several decades [
508
]. A tiny number of talented people such as Warren Buffett are able to use publicly available information in ways that other people can’t. The probability that you and I are as talented as these exceptional investors is close to zero.

Although the efficient market hypothesis is correct for long-term investments, it may need modification or adjustment for short-term phenomena, such as day trading. Recent studies of day traders suggest that about 20% of these people can make money consistently. About 10% of them can make a living and the majority (65-75%) loses money [
511
,
512
]. These data do not contradict the efficient market hypothesis: we will discuss trading in more detail later.