A Parable

• Successful investing is about owning businesses and reaping the huge rewards provided by the dividends and earnings growth of companies.
• Add as few helpers, who only take from this pie of earnings and dividends, as possible. They take fees, increase taxes and don’t add any returns in aggregate.

Rational Exuberance

• History reveals the remarkable, if essential, link between the cumulative long-term returns earned by business and the cumulative returns by the stock market.
• The reason stock markets are so volatile is largely because the emotions of investing. But over the long term, sentiment contributes nothing…see this chart:

• “It is like a tale told by an idiot, full of sound and fury, signifying nothing” Shakespeare could have been describing the stock market. The way to investment success is to get out of the expectations market of stock prices and cast your lot with the real market of business.
• The stock market is a giant distraction to the business of investing.

Cast Your Lot with Business

• Occam’s razor: when there are multiple solutions to a problem, choose the simplest one.
• An all-market fund is guaranteed to outpace over time the returns earned by equity investors as a group. Because of the costs of intermediation.

Turning A Winner’s Game into a Loser’s Game

• we investors as a group get precisely what we don’t pay for. So if we pay nothing, we get everything.
• Where returns are concerned, time is your friend. Where costs are concerned, time is your enemy.
• Over a 50 year period, all in costs of 2.5% p.a. consume nearly 70% of the potential accumulation available.
• Over the long term the miracle of compounding returns is overwhelmed by the tyranny of compounding costs.
• Financial intermediaries put up no capital and take on no risk, but confiscate 70% of your return.
• Arithmetic is the first of the sciences and mother of safety.

The Grand Illusion

• Equity fund returns lag the stock market by a substantial amount (costs) and fund investor returns lag fund returns by an even larger amount.
• Because of bad timing and bad fund selection.
• Good examples from early 2000 when flows in aggressive equity funds soared at just the wrong time. No one bought value.

Taxes are Costs, Too

• High turnover of active managers further reduces the return investors in those funds receive, because each trade incurs tax costs. Numbers quoted: investors in active funds paid an effective annual federal tax of 1.8%, compared with 0.6% in index funds.
• And inflation – you pay fund costs in current dollars, year after year, but accumulate assets only in real dollars, which is eroded all the time by rising cost of living.
• Index funds are tax inefficient in paying income. They pay almost all income they get out, which leaves the investor with an income tax bill. Active funds are more tax efficient, but only because they take a lot of costs out of the income they get. So yields are considerably lower, and paradoxically, more tax efficient.

When the Good Times no Longer Roll

• JB predicted an annual return, lower than the previous 25 years, of 8% over the next 10 years (from 2006). 2% div yield, 6% earnings growth (from nominal economic growth of 5-6%) and no multiple move.
• In a world of lower future returns, fund costs are even more detrimental given they take up a bigger portion of your pay.
• The humble arithmetic of fund investing: nominal market return, minus investment costs, minus taxes, minus assumed inflation. And then, minus counterproductive timing and adverse fund selection that bedevils the average fund investor.

Selecting Long Term Winners

• Records from 1970 to 2005. Of the 355 funds that started in 1970 only 132 survived. Nearly 2/3rds died.
• 60 of the survivors underperformed the S&P, 48 provided returns +/- 1% of the S&P.
• Only 24 (1 in 14) outperformed by over 1% per year. 15 of these between 1 and 2 percent more.
• Only 9 were ahead of the index by more than 2% a year for 35 years. Which is tremendous. But 6 of them produced the performance years ago when they were small, and have underperformed since peaking in size.

• Before going out to buy these 3 funds, what are the odds they’ll keep outperforming?
• Don’t look for the needle, buy the haystack.

Yesterday’s Winners, Tomorrow’s Losers

• Studies show that 95% of all investor dollars flow to funds rated 4 or 5 stars by Morningstar.
• Performance chasing during bull runs is ruinous. Example from dot com bubble then bust. Look at the returns leading up to 2000, then what happened how how dollar weighted money performed.

• Stars in the fund world all too often turn out to be comets.

Seeking Advice to Select Funds?

• Lots of studies to show advisers do a bad job of picking funds for their clients.
• New York Times ran a competition where they asked 5/6 advisers to pick a portfolio for 20 years (in 1993). By 2000 they closed the competition (not sure why), all were well behind the index. 40% as an average.

Focus on the Lowest Cost Funds

• Estimate that turnover costs equal 1% of the turnover rate. So 100% turnover costs you about 1% per year.
• Fund costs are a great predictor of performance. And lower cost has been proven to go hand in hand with lower risk too.
• Gunning for the average is your best shot at finishing above average.

Profit from the Majesty of Simplicity

• “My anecdotal stroll through the relentless rules of humble arithmetic”.
• To avoid the dangerous turns and giant potholes investing throws up, never forget the simple arithmetic.
• Do your best to diversify to the nth degree.
• Minimise investment expenses.
• Focus your emotions where they can’t wreak havoc.
• Rely on your own common sense.
• Emphasise all-stock market index funds.
• Carefully consider your risk tolerance and the portion you allocate to equities.
• Stay the course.
• When picking an index fund, choose the cheapest.
• Be careful venturing away from classic all market indexes.

Bond Funds and Money Market Funds

• Same principles apply to bond funds, arguably even more so because of their low return nature AND there’s basically only one thing that matters, the prevailing level of interest rates. Manager must make interest rate bets to beat market.
• Guarantee your fair share of returns by applying the same principles of diversification, low cost, no load, minimal turnover and long term investing.

Index Funds that Promise to Beat the Market

• Discussion about smart beta products.
• Strategies that weight portfolios by fundamental factors, not market cap.
• Reason: in a cap weighted portfolio half the stocks are overvalued half are undervalued.
• Issue: new paradigmists have never explained why these fundamental factors have been systematically underpriced in the past. And if they have, why won’t investors now take advantage of this and bid up their prices. So if it’s been right in the past, won’t it be wrong in future?
• Reversion to the mean is all powerful.
• Quote from Carl Von Clausewitz: “The greatest enemy of a good plan is the dream of a perfect plan”.

The Exchange Traded Fund

• If you’re making a single, large purchase of a broad stock market ETF, and holding it for the long term, you’ll profit from their low expense ratio (some lower than funds) and may even enjoy some extra tax efficiency.
• But if you trade them, you’re defying the relentless rules of humble arithmetic.
• If you like the thought of sector ETFs make sure you don’t trade them. You’ll just fall into the same old trap of chasing performance. This is the big risk of ETFs. Their turnover is huge. You have to use them appropriately. And watch for trading commissions.

What Would Benjamin Graham have Thought about Indexing?

• Wrote a lot, even before indexing was available, about simple, low cost ways to get a reasonable investment return.
• Graham quotes:
• “Wall Street is in business to make commissions, and that the way to succeed in business is to give customers what they want, trying hard to make money in a field where they are condemned almost by mathematical law to lose.”
• “The real money in investment will have to be made – as most of it has been made in the past – not out of buying and selling but of owning and holding securities, receiving interest and dividends and increases in value.”
• 1976 interview:
• “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities…in light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost”.
• “To achieve satisfactory investment results is easier than most people realise; to achieve superior results is harder than it looks”.

The Relentless Rules of Humble Arithmetic

What Should I do Now?

• Why do people not index? We’re sold funds more often than we buy them. We have far too much self-confidence. We crave excitement. We succumb to the distraction of the stock market. We fail to understand the arithmetic of investing, and the arithmetic of mutual funds.
• If you crave excitement, do exactly that. But not with a penny more than 5% of your investment assets. Call it your funny money account. Invest the other 95% in a broad index fund. Make sure you keep a track of how these investments compare. After 1,2,3,4 etc. years. Learn something!
• As for your serious money portfolio, Bogle outlines different portfolios you could have. Like 20% in an international index fund. Or 10% in value index and 5% in small caps (although he’s not convinced their superior performance can last forever – nothing does).
• Asset allocation, he favours same % of bonds as your age. He’s conservative. Or he likes target date.