Burton Malkiel, the Princeton economist and author of “A Random Walk Down Wall Street,” says: “Index funds are so popular now that it’s easy to forget how courageous and tenacious Jack Bogle was in starting them. They were called Bogle’s Folly because all they did was replicate the returns of the market. But, of course, that’s a great deal. In the academic world many people saw the wisdom of this — but Jack is the guy who actually made it happen.”
Vanguard is really an inspiring company, which is all the more remarkable because of the industry they're in.
Apart from pioneering index funds, and from their strategy of observing a Nader-esque duty of loyalty to their customers, Vanguard is also unique because of its ownership structure, which is upside-down from what every other big mutual fund company uses: the funds themselves own The Vanguard Group (the company, which provides services to the funds), which mitigates an obvious principal/agent problem at financial firms.
It's important to note that they didn't open on Wall Street, instead they started in Valley Forge, PA. At the time it was seen as another bullet point which could be used against Vanguard ever becoming successful.
I mean who in their right mind started a company creating investment vehicles that wasn't at least in New York City?!!?
There are some important ideas in here. The truth is that a number aspects of finance are simply broken, and being heavily gamed for very short term gains (the Facebook IPO is an excellent example of some of this).
The reality right now, is that for the vast majority of people (anyone sub $500k in investable assets) getting the kind of quality advice needed to navigate the complexities of investing is virtually impossible. This type of high-touch service is almost exclusively reserved for the high net-worth marketplace.
In a bear market like this one the likelihood that the returns of most mid-level advisor's and fund managers will outperform the management fees is not exceptionally high. This is why Vanguard's funds have received so much attention recently, they are a relatively safe, and very, very low cost, which addresses a big problem in this market.
That being said, they don't perform exceptionally well either, at least not by themselves as a strategy. Investing in the value of the stock market is a volatile strategy in the best of times, and completely fruitless in the worst. Value investing has to be balanced by an income generation strategy, usually one focused on equities that pay solid dividends and other income-generating investments.
Even armed with that information, the truth is that people should ideally not be put in a position of managing their own finances. They regularly work against themselves, have emotional attachments to their losses and gains and often make out no better than a gambler. This is work for professionals in a position of trust with their clients. Unfortunately, professionalism and likewise trust seems to be in short supply in finance right now.
Furthermore, most people are not really even interested in being 100% responsible for their own finances. They may want a enough of an understanding of things to have some piece of mind, but most are no more interested in managing their investments than they are in fixing their own car or filling their own cavities.
For most people, investing in the whole market (a.k.a. index) is the right thing. Period.
It's not exactly rocket science either: Just buy the broadest index you can cheaply get. The MSCI World is probably a good candidate for that. The whole market is likely to be less volatile over the long run than any given segment.
Sure, if you want to do your research, maybe you'll end up thinking that a certain market segment is more attractive than another. But don't claim that all people must do this.
Having other people manager your finances is problematic, because that other person is not likely to have your best interests in mind, especially not if his income from this comes from kickbacks.
S&P 500 Price has returned -1.5%/annum on price alone since 1999, while S&P 500 dividend return has been 4.9%/annum over the same period.
Longer term, since 1971, S&P 500 Price has returned 6.3%/an, while dividend has returned 5.6%/an.
So, yes, if you are a lucky soul who was 21 years old in 1971, bought the market, and held it to today, you would be slightly better off than you would be with dividend.
But what if you were a 45 year old in 1999 who started their retirement savings and are nearing retirement with over a decade of negative returns?
Time horizon and suitability of your choice are often more important than what you actually pick.
Having other people manage your finances may be problematic if the fiduciary responsibility has been misplaced as you have pointed out.
When you go to a lawyer or an accountant, you do not question their advice, largely because they have been positioned as a services experts rather than sales folk.
Properly diversified portfolio will carry you through the ups and downs in the market, because it hedges your risk against those fluctuations. And for that kind of portfolio, you need a bona fide, unbiased expert's advice. The kind of advice that is currently NOT available to mid-networth market, and the kind of advice that the rich are paying a premium to obtain.
The article pointed out that the financial services is broken and investing in broad index is a band-aid solution,
but wouldn't it be more appropriate for us to have a solution that solves the problem rather than the one that patches it?
What? Index funds don't steal the dividends from you, they contribute to the performance or are paid out.
Generally look at the performance index to evaluate returns, NEVER NEVER the price index, please.
The total return of the S&P 500 from January 1999 until now is 47.7%, or 2.91% per annum (EDIT: had incorrect numbers!). Not a good return, but you also picked one of the worst dates.
Please also note that the price and dividend returns ADD UP. You don't need to choose between one or the other.
You are completely correct. You should always look at the performance. In fact, you should be focused on your own performance.
I was merely displaying the parts of that performance and illustrating that one part of it is far more volatile and the other is less so. Knowing that fact alone, if you had invested in divindend paying securities and focused on the cash flow of the economy, you would have been personally better off.
Not all stocks pay dividends. Not paying attention to that can bring you closer to the -1.5%/an and farther from 4.9%.
>>Not a good return, but you also picked one of the worst dates.
I have picked the current situation. We can talk about historical rosy times in the market, but that is somewhat beside the point. This is our current reality.
With worst date i mean 1999. Well I guess 2000 would have been worse. It's a question of luck which date is good.
And no, picking the stocks with more dividend yield is NOT a strategy that is guaranteed to work, because these are usually low-growth companies. Now the market assessment of growth is unlikely to be right for all companies, but it's likely to be better than that of most people.
> S&P 500 Price has returned -1.5%/annum on price alone since 1999
This is a selective endpoint, creating bias in the result. 1999 was an outlier peak, so of course measuring from 1999 will show minimal returns. Measure from 1988 or 1995 or 2003 or any of the vast majority of possible years, and you'll see significantly positive return for stocks.
I'd just like to note, that anyone who starts saving for retirement at 45 isn't likely to have a great outcome. If they started in 1999, yes they got a rough deal, but that's what happens when you start 25 years too late. Index fund or great advisor isn't the problem here.
Not always. If you were 45 and entered the market in 2008, you'd be in a great shape now, probably better than a 20 year old who entered the market in 1999.
This is only possibly true if the 20 year old made his sole contribution in 1999. The more reasonable case is the 20 year old made his first contribution in 1999, and now has 13 years of contributions plus gains.
It's highly unlikely that 3 years of gains from 2008-present would outstrip 13 years of contributions + gains + reinvested dividends.
The S&P 500 is not "the market". It's certainly a better representative of the U.S. market than the Dow Jones Industrial Index (which has just 30 stocks) but it has nowhere near as many stocks as the Wilshire 5000. Not to mention none of those give you any international exposure.
And the the other question is, yes the S&P had a rate of -1.5% but considering the crashes of the past decade, would you be lucky to achieve -1.5% return rather than something much, much worse?
Yes, the S&P is diversified in the stock portfolios. What I meant was diversify into things like fixed income vehicles, first mortgage securities, real estate income trusts etc.
And yes again, most investors came out much worse over the past decade that -1.5%, but even the theoretical return is dismal enough to illustrate the point.
Negative returns, while a simple concept, can be a real jaw dropper for many a DIY investors. If you invest $100.00 and lose 10%, you'll have $90. But $10 out of $90 is 11%. So you'd need to return more in the positive just to make your money back. And the greater the negative return, the greater the positive required. If you lost 20%, you'd need 25% etc.
Could you elaborate on why that is the best thing for most people?
Also I did not say people should do their own research, I actually said the opposite, that even having done that most people will generally be their own worst enemies when it comes to investing as they are unable to remain impartial about their own money. I'm also admitting it can be hard, even impossible to get good advice at for a fee that makes sense. However the lack of the right service does not mitigate the need for it.
Could you elaborate on why that is the best thing for most people?
Because the evidence for "Mutual funds, in aggregate, underperform the market by precisely what they charge in fees; past performance of mutual funds does not predict future results; no more fund managers beat the market than would be suggested by random chance; capital flows into mutual funds are virtually invariably poorly timed to surge after they have made their gains, hurting fund performance" is incredible. It's, um, shoot, I need an analogy... you know how science suggests that cigarettes might not be a good thing health-wise? That conclusion is tentative next to "actively managed mutual funds are a poor investment vehicle."
Index funds are virtually structurally guaranteed to outperform actively managed funds for any given equivalent investment classes, because index funds also underperform the market by fees, but their fees are about 100 ~ 250 basis points lower. Over someone's working life, that turns into "Your retirement account is several times as large as your neighbor who used actively managed mutual funds."
Just some alternative thoughts that are sort of nuanced, but no one talks about for some reason:
1) Synthetic ETFs could pose serious problems and most investors are not familiar with the difference between them and physical ETFs nor are they aware if they even have them in their portfolio. This is a quick read that summarizes part of the problem:
2) How do you choose the correct ETF. How do you choose between emerging markets nd US, etc. Picking a broad market ETF is probably safest, but there is even a variety of those with different features.
4) Compared with no load funds, ETFs can be expensive due to trading fees. Obviously if you buy and hold great quantities of money it isn’t an issue, but it should be considered in your investment.
Presumably patio11 is talking about both, and if he isn't, many people who read this will assume he is. The tracking error issue can still come up with index funds, the differences between them are minimal:
Why it's the best for most people? Because study after study shows that generating alpha (excess returns that are not attributable to buying stuff with debt, basically) is _hard_. And if the risk is too high, just buy more US treasuries and less stocks.
Just a few days ago I read that Bain Capital's nice 20-30% returns were mostly based on leverage in a favorable market environment... I think there are a few people who really are good at choosing market segments or individual stocks, but you or your advisor-for-hire are not likely to be them.
And if the risk is too high, just buy more US treasuries and less stocks.
US treasuries can carry high levels of interest rate risk if their duration is long. In otherwords if the maturity is really long, 10 years+, and interest rates go up, the principal value of your treasuries will fall dramatically.
Now, you can wait it out, but that won't help you in the long term when the market is paying out 10% and you are getting 0.25%.
Just a few days ago I read that Bain Capital's nice 20-30% returns were mostly based on leverage in a favorable market environment... I think there are a few people who really are good at choosing market segments or individual stocks, but you or your advisor-for-hire are not likely to be them.
Bain did this by taking companies private, then re-IPOing them. They are a private equity company and to my knowledge do not choose stocks and market segments like mutual funds do.
If you have huge exposure to technology through your career, it might make sense to underweight technology in investments. Maybe not as reasonable in the case of technology, but if I worked in something like print publishing, I'd probably not want much additional exposure to print publishing for my retirement.
Tobin's mutual fund theorem states that all investors should do their best to buy the market, and that risk-seeking investors should add leverage, while risk-averse investors should hold more cash.
For high-net-worth individuals, it's usually not worth actively managing most asset classes, but it might be worth scouting talent to run private equity, venture capital, and tech stocks, all of which are areas where the top quartile investors substantially outperform the bottom quartile.
For non high-net-worth individuals, it's almost never worth actively managing any asset class. The costs of management equal or exceed the probable excess returns.
Most people feel the inevitable urge to gamble in the stock market. Some advisers advocate a 10% allocation to "stock picks" for this reason.
Personally, I feel that a smart and tasteful person can outguess Wall Street in areas he's an expert in. I don't think anyone could have predicted the meteoric rise of Apple, but I think plenty of nerds could have looked at Mac OS 10.1 back in the day and thought, "this is a good bet". The ideas is that Wall Street can efficiently price financials (except in speculative bubbles, but if can't judge if a stock is in a bubble then don't buy it!) but doesn't have the computer nerd expertise to judge the long-term viability of a product line or engineering culture. Along similar lines, I made a tidy profit in 2008 on banks because I knew a few people at these banks and knew which ones worked and which ones were dysfunctional at a high level--a sort of perfectly legal "insider" information. Of course when you do this stuff you're assuming risk.
> I don't think anyone could have predicted the meteoric rise of Apple, but I think plenty of nerds could have looked at Mac OS 10.1 back in the day and thought, "this is a good bet".
Honestly, this is why I'm skeptical I can beat the market. This was exactly me: I sat down at OS X Jaguar 10.2 and thought, "boy howdy this is great!" and bought Apple stock at less than $40/share.
But you know what? I was wrong. I made money, of course, but for the wrong reasons: the meteoric rise of Apple as a company was due almost entirely to the iPod and then-unannounced iPhone.
Nowadays, of course, after the increase in stature of the company, they're making money from their computers and laptops, but I'm not sure where Apple would be if they didn't make it big with those other products.
Investing in Apple back then would have been like investing in a startup--investing in the engineering culture that made Mac OS X, not the product line itself. They were a company that secured a future from oblivion by making best-in-class stuff in a class with a huge upside for profit. I think a hacker could have seen potential that Wall Street did not.
And, like a startup, they took a number of swings before hitting the iOS home run, except they were also turning a modest profit during the swings.
Everyone should be skeptical that they can beat the market because it is true, there is overwhelming amount of evidence that few people can do it on a consistent basis, even some of the best fund managers.
Also, I think you picked up Apple for the right reason, even if it wasn't the immediate source of their success. For most of us (non-financial types), it is best to gamble on companies that we are familiar with. I play around with stocks on the side, and it should be no surprise that most of my winners were stocks for companies that I was familiar with (i.e used their product), and most of my losers were from stocks that I picked up after reading a crappy financial advice column.
As a computer nerd, I really felt like AMD was on it's way to great places in the early 2000s and believed in their product over Intel, as most of my friends who built their rigs were leaning towards the former. Alas, I couldn't have predicted them fizzling out so badly after the mid-2000s.
I've found that my weakest bets on fundamentals are with tech stocks. With anything else, I'm right as much as I expect to be - about 50% of the time.
With tech, I find I'm much closer to being wrong 80% of the time. I think our knowledge of the industry makes us believe we have more information than everyone else, and thus that we're in a better position to make bets. In reality, the things we know that your average investor doesn't aren't as crucial to the bottom line.
> I feel that a smart and tasteful person can outguess Wall Street in areas he's an expert in
The problem is telling the difference between luck and skill. It is very rare to have a sustained period of getting things right. And survivorship bias muddies things even further http://en.wikipedia.org/wiki/Survivorship_bias
Here is an (illegal) way of appearing to have skill. Send a newsletter to a large number of people telling half things will go up and telling half things will go down. Then send the next newsletter to the half you were right about. Rinse and repeat. To the group you are still sending several newsletters later you'll look like a genius with an incredible string of correct insights/predictions.
An investor is best served by keeping things as simple as possible. The most they should be concerned with is the simple ratio of stocks/bonds/cash that meets their risk tolerance and time horizon. This can be easily determined through some simple survey questions[1] or comparison charts[2]. Most fund companies even offer target date funds, which make this simple decision even easier. And by keeping things so simple, the investor is discouraged from doing harm to their investments by repeatedly transferring it between the latest fads, something which advisers are definitely prone to do.
Basic investing is only made to look complicated by people who depend on selling expensive advice and guidance that most people don't need. Paying an adviser 1% per annum means you lose 30% of your balance in 40 years, not including any bad decisions they make with your money in that time.
I am not a financial consultant, but some general guidelines for retirement investing that anyone can follow with minimal effort. This is only applicable if you believe that the world economic growth rate in publicly traded markets is growing at a rate greater than the safest investments (close to nothing as of late):
- Invest first in employer-matching 401K. Even if the fund choices aren't 100% ideal, they're almost never awful, and you're getting free money. Invest second in IRA/Roth IRA, the choice won't make a huge deal of difference to most people, but do your own research to see what's best for your situation. If your employer doesn't match for 401K, fill that up after your IRA. The reason for all of this: tax benefits. If you still have money left over after these limits for your retirement plan, it probably is time to consult a financial professional.
- If you're using your employers' 401K, and the options are limited, choose the one that reaches the most diversity (type of asset, all types of market caps of companies, and definitely with global reach). I'd stay away from money market funds (with such a small rate of return, I feel it's a waste of your tax-haven dollars), and focus on equity, real estate, and a smaller amount of government bonds. The reason for diversifying is that the more types of asset categories you are in, and the more diverse the assets inside of each of those categories, the less unnecessary risk you take on.
- If you're choosing assets for your IRA, follow the same sort of guidelines. The easiest way to do this is to use ETFs, which track various markets. A very simple example ETF IRA portfolio might look something like this: 30% in a NYSE tracking ETF, 20% in a NASDAQ tracking ETF, 40% in a "non-us market" tracking ETF, 10% in a real-estate ETF. If you want to diversify with precious metal assets or bond assets, feel free to mix in whatever share you like, or make those investments outside of the IRA (if you've filled your IRA quota already).
This is a simple guide that anyone can set up in a couple of hours, and maintain with a half hour or so per month. It's less risky and more financially sound than "picking stocks", and will very likely not be a loser by the time you retire unless the worldwide economy is, overall, a loser between now and the time you retire.
The content of this post is for general information purposes only and does not constitute any investment advice.
I'll add that even in the high net worth category, buyer beware. You really need to do your own research as the quality of advice is uneven at best -- and quite likely to be self-serving (to the profit of the adviser). And if you believe in the Bogle-low-fee approach, you will not find a receptive audience.
For anyone interested, I highly recommend David Swensen's book "Unconventional Success: A Fundamental Approach to Personal Investment." Swensen is the highly successful manager of Yale's endowment. While no book on investing is without flaws, I have found it to be some of the most understandable, well-argued and supported advice around.
Short answer: he recommends a portfolio of low-cost index funds/ETFs covering several asset classes and regular rebalancing to target allocation weights. I have generally followed his advice to good effect using Vanguard index funds.
What do people think of the permarment portfolio (http://en.wikipedia.org/wiki/Fail-Safe_Investing). The proposal is to diversify your investments equally across stocks, bonds, gold and cash equivalents. The idea is that for any particular market condition (inflation, deflation, stagnation and growth), 3 of the asset classes won't do too well, while the fourth will do spectacularly well and average out the losses in the other 3. The other benefit (unlike simple stock/bond investing) is that the portfolio seems to be pretty immune to variance from start date (ie, while investing in the S&P has consistently yielded around 7-8% real returns, their is pretty high variance in this number depending on when you start the calculation). For example, here are some backtesting results showing that the portfolio averages 9.7% - http://crawlingroad.com/blog/2008/12/22/permanent-portfolio-..., which is pretty competitive with 100% stock allocation.
I'll quote one of Berkshire Hathaway's early Insurance CEOs
> There are no such things as bad risks; just bad rates
The problem I perceive with most people and finance is that they simply do not think about it sensibly at all.
An example:
I love Coca Cola (the soft drink). But it costs $3 a can right now. I will wait until it is $1 and buy up as much as I possibly can. I'll get more value that way.
Now a stock market example:
Coca Cola (the stock) just fell 75% to $1 a share, I won't buy it because the market is clearly telling me something (during a economic crisis). Oh wait it just went up to $3 - I will now buy.
That's insane. But that's how it works. Think of stocks like computers, tablets, food and clothes. Just buy good quality ones cheap and know that they money you put in is never coming back out.
Index funds get one thing right - buy cheap, don't sell and know the money you put in is untouchable. But they get another thing wrong - diversification doesn't exist.
Vanguard is really an inspiring company, which is all the more remarkable because of the industry they're in.
Apart from pioneering index funds, and from their strategy of observing a Nader-esque duty of loyalty to their customers, Vanguard is also unique because of its ownership structure, which is upside-down from what every other big mutual fund company uses: the funds themselves own The Vanguard Group (the company, which provides services to the funds), which mitigates an obvious principal/agent problem at financial firms.