It seems like 99% of the financial pages on the Internet are devoted to a single idea — that you can beat the market just by owning the right stocks at the right times.
That’s great marketing, I suppose. It’s action-oriented (do something!), specific (buy this stock now!) and utterly unfalsifiable. Nobody knows if a given stock will go up or down, so it can’t be proven that it won’t go up.
But flip that logic for a second. It also can’t be proven that the stock won’t go down instead. Investing history is littered with companies that lost market value and never, ever recovered. They just went out of business. It happens to a lot of “hot” investments.
A much larger number of companies have a moment in the sun and, years later, find their fortunes revived by chance, good management or both. The problem is, you spent a long, long time in that investment earning nothing — no dividends, no price appreciation.
Would you, could you hold on to a single stock in a large enough concentration to matter to your portfolio through a decade of poor returns? Probably not. In fact, the much more likely outcome is that you will wait until the stock hits its lowest point and then sell, locking in the loss forever.
Or the reverse, you buy a stock as it hits its all-time high point. From there, it’s often all downhill for a long, long time.
It’s for this reason that individual investors do so poorly, earning 2.5% compared to more than 9.2% for the S&P 500 over the 20-year period ending in 2013. Our brain tells us to buy what has gone up and sell what has gone down.
In fact, it’s the other way around. We should be selling the gainers in order to buy more of the relative “losers.” That’s portfolio management by rebalancing, a standard practice among the world’s top endowments and pension funds.
Investing secret weapon
As for the time aspect, that’s the key. Don’t wait for the “right moment” to buy. Instead, own the market all the time through a well-designed portfolio that includes stocks, bonds, real estate and foreign assets.
Rebalancing with discipline over long periods will bring you a stock-like return without the stock-like risk involved in owning just the S&P 500. You are more likely to stay in during down markets and more able to capture the upsides of strong recoveries.
More importantly, you will in time begin to accept the truth about all those Internet headlines telling to take action now — it’s a mistake. Rather, you are taking action prudently by staying invested in a risk-adjusted way. It’s your investing secret weapon: patience and avoiding emotional mistakes.
It’s one of those rare moments of humility on Wall Street, a placed where “indicted but never convicted” is a badge of honor. A hedge fund chief who lost all of his clients’ money told them he was sorry.
Owen Li, founder of Canarsie Capital, wrote to his clients to say he had run their accounts down from $100 million less than a year ago to just $200,000. Reportedly, he got into a hole and took on a string of high-risk bests to try to save his firm.
It didn’t work out. “My only hope is that you understand that I acted in an attempt — however misguided — to generate higher returns for the fund and its investors. But even so, I acted overzealously, causing you devastating losses for which there is no excuse,” he wrote.
Here’s the thing, though. Hedge funds are not supposed to be running extremely high-risk strategies. They’re supposed to “hedge” risk by investing in ways that protect wealthy investors from dramatic losses.
You might not get an amazing return from a hedge fund (and it’s interesting that people think that’s the goal) but instead get a reasonable return with minimal risk of big losses. That’s why rich people use them.
A hedge fund, if correctly operated, is in fact just one slice of a larger asset pie, one which includes stocks, bonds, real estate and commodities. There has been a lot of research over decades to support the idea that again, properly run, a limited hedge fund allocation can lower overall volatility in a very large portfolio.
That’s why universities and endowments use them. Of course, as with any hot investing trend, demand outstrips supply. CalPERS, the big California state pension fund, famously gave up on hedge funds in 2013, precisely because their high fees were unjustifiable in the face of shoddy performance.
Hedge fund alternative
For ordinary retirement investors, the risk is far, far too high and the hedge effect can be purchased much more cheaply in other ways. By simply owning a well-designed, well-allocated portfolio of index funds you get a lot of risk management at a very low price.
Rebalancing with discipline allows you to book gains as they occur, selling high and buying low in a timely fashion. All that’s left is to make sure that your exposure to higher volatility asset classes — chiefly stocks — is slowly lowered over time as you near retirement.
Sometimes, you don’t get what you pay for in an actively managed fund, and sometimes you get something you never bargained for — high risk and poor oversight from the managers themselves.
The billionaire investor Warren Buffett is a highly quotable figure, but perhaps the most revealing of his many statements on money management is also his funniest: “You only find out who is swimming naked when the tide goes out.”
That gem appeared in his 2001 letter to investors in his holding company, Berkshire Hathaway. Buffett’s point is that good times can cover up a lot of risk, yet markets have a way of balancing out that eventually reveals who is taking those risks.
It all ties back to the fundamental observation of Buffett’s mentor, Ben Graham, who likened the stock market in the short term to a voting machine but, over the long run, a weighing machine.
More simply, a lot of investments might seem like real winners in the space of a month or a year, but which ones will grow steadily and safely for long periods? That’s the question retirement investors should be asking, not who’s beating the market now.
What most people want, of course, is to “beat the market.” A lot of ink is spilled, digital and otherwise, explaining the millions of ways to do so.
Sadly, virtually none of those methods are replicable. They are what finance researchers call “form-fitting” arguments. That something happened a certain way over the recent past is absolutely no assurance that the pattern will continue. Past performance is no guarantee of future results.
In fact, often the opposite. A stock or other investment that has risen dramatically rarely has anywhere to go but down. Likewise, an investment that has fallen sharply could easily find itself moving back toward the middle ground in the near future.
There are exceptions. Some stocks fall and never recover. But the experiences of investors over long periods is more likely to be reversion to the mean — a return of an investment’s value toward a long-running average price, plus some.
Investors who strive to “beat the market” are often doing so at great risk. They are much more likely to get caught up in the story of a company or its CEO, much more likely to follow the crowd, lemming-like, over a cliff.
And, in time, they are much more likely to experience a total return that is below the market’s long-term average. At some point, the tide will go out and it will be plain who is swimming naked.
What’s the solution? There are two paths to consider. Either you know exactly which stocks will rise and which will fall, or you don’t. If you don’t, the logical path is to own them own in an index fund and trust that the market itself will give you a steady performance.
The long-term data suggests exactly that. Over decades, the market has returned roughly 6.6%, or double the rate of economic growth. Owning a portfolio of stocks, bonds and other asset classes and rebalancing can add a point or two to that.
Most importantly, diversification and low-cost investing protects you from the ultimate disaster: Getting caught naked in a low market tide.
Few things are more entertaining than when a presumptive sports superstar gets promoted to the big leagues and then unceremoniously handed his hat.
You know this guy, the great college quarterback who flounders in the NFL. The supposed savior of the NBA who can’t score anywhere near what his salary implies. The loudmouth skier who fails to medal at all.
Money managers can be like that. It is, after all, a sport known for its testosterone and braggadocio. Yet the data isn’t there to back up even a fraction of the trading bravado.
Mark Hulbert, the newsletter tracker, figures just 15.6% of active managers beat the broad market in 2014, using the Wilshire 5000 Index as a benchmark. That’s down from 33.1% just a few years ago.
Before you assume it’s because more people are using index funds, Hulbert points out that just under 20% of equity mutual fund assets were in index funds as of this past year — not anywhere near enough to matter, yet.
No, he concludes, it’s just getting harder to do. This is the natural and expected result of the vast amounts of information that’s available to the markets now in real time. Consider how automated and how very rapid trading is these days between major institutional investors, how deep and liquid most markets have become.
It’s startling, really, than anyone beats the market at all. But did they “beat” the market, or just get handed an accidental edge on their way in and out of their trades? The jury is out, since the only real measure that counts is turning in outperformance for many consecutive years. Increasingly, that doesn’t happen, even among superstar managers.
Modern portfolio theory is widely misunderstood in this regard. It is often simplified to mean that stock prices are accurate all the time. That’s clearly not the case if 15% of advisors can “beat” a benchmark.
Or is it? After all, all of the managers were trying to beat their benchmarks. Most did not, and a few did. What we don’t know is how much risk those managers took on in the attempt to “win” during the 12-month period of 2014.
Double the normal portfolio risk? Triple? And how much risk did the the “losing” portfolios assume on their way to a lower performance? Perhaps even more.
Modern portfolio theory doesn’t concern itself with this year or next. Rather, it concerns itself with adjusting the risk in a portfolio to gain the maximum return possible at an agreed acceptable risk level for the investor.
Why beat the market?
In that sense, a balanced, risk-adjusted portfolio might not exceed the broad stock index either, especially if it is designed for a near-retiree with five years left until leaving work. That portfolio would earn a reasonable return at a very reasonable level of risk — but do so repeatedly.
Likewise, a 25-year-old might not beat the market with a portfolio designed for the long-term. However, over time, that higher-risk portfolio will have higher, more-marketlike gains and, importantly, take only enough risk to help that saver reach his or her goals over decades of saving.
You don’t need to beat the market to retire with more. You just need a solid, repeatable game plan that doesn’t choke when the pressure’s on.
Now that the year is behind us and we have some nice round numbers, it’s a good time to look back and understand how building an ETF portfolio really works.
For this experiment, let’s use some widely held ETFs that track the major market benchmarks. The bottom line is simple: Taken in 12-month cycles, asset classes always surprise us. Things go in and out of fashion at different paces, but the big winner in any given year is never what we expect.
1. U.S. stocks
As a proxy, consider the SPDR S&P 500 ETF (SPY), which tracks the benchmark of the same name. It closed 2014 up 11.8%, well above the long-run performance of stocks. It was a bit of surprise result, considering that most pundits felt that stocks were due to slip after such a big run in 2013.
2. U.S. bonds
Here we’re looking at the iShares Barclays Aggregate Bond Fund (AGG), which is often used as a benchmark for bond fund managers. As a “total market” fund, it is meant to reflect not Treasuries but the entire investment grade U.S. bond market. It finished up 3.47%. Not bad at all, considering that many traders were signing the death warrant for bonds 12 months back.
3. Foreign stocks
Here’s where things fell apart, in theory. As a proxy, consider the iShares MSCI EAFE Index Fund (EFA), which follows a broad array of globalized companies based in Europe, Australia and the Far East. This is Nestle, Novartis, Toyota and Bayer, among other major foreign industrials. It closed down 8.6% for the year.
4. Foreign bonds
On the flip side, government debt in foreign lands was a winner in 2014. Consider the Vanguard Total International Bond ETF (BNDX). It holds investment grade bonds not denominated in dollars. This fund returned 8.76% for the period.
At this point, I could drill down into a half-dozen alternative choices to these funds, all of them inexpensive index funds trading as ETFs. And a typical money manager might begin to talk about where to “overweight” next.
There’s the rub. He or she really has no idea where to invest next, any more than they could guess the number of beans in a jar or the weight of a calf at a county fair. It takes a market of millions to determine these outcomes, and nobody gets a peek in advance.
Will foreign stocks roar back, or sink further? Is the performance of U.S. bonds a sign of capital markets strength or a signal that the bond market has topped? Nobody knows.
I do know this: U.S. stocks have a way of grinding higher and higher over the decades. Demand for U.S. debt, while not bottomless, is far less volatile than demand for corporate debt or foreign debt.
Owning a portfolio means holding those assets in a broadly diversified way and letting the outcomes dictate your next move. If the market bids up one asset class, you sell your gains and redistribute the money into the relative “losers” you hold.
That’s selling high and buying low. Along with keeping costs down and staying focused, that’s how you build a retirement for the long run.
Saving for retirement is hard work, especially starting out. It’s no picnic to sock money away you might spend instead.
But you have to do it, and the earlier the better. Getting started with retirement saving and investing is common sense, but the really important part is starting early.
Why? Because time is money. You have to save and you should increase your saving levels as your income level rises over the years. But it’s that early money that gives your retirement plan a real boost.
In time, money makes money. People don’t realize this early on, when their savings balances are low. But those early years of saving begin to multiply in a variety of ways later on.
Here’s five ways your retirement money makes money as the years pass:
1. Interest earned
Money you set aside in a savings account, CD, money market or a bond fund is going to earn interest payments. The only questions there are the terms and the risk. A savings account or CD are lower risk and, usually, lower interest. A money market might earn you more with relatively little added risk, while a bond fund would likely pay the most but also expose you to the highest relative risk.
2. Dividend payments
A little further up the risk scale is owning dividend-paying stocks. If you buy a broad index fund of the stock market you are likely to earn dividend payments commensurate with inflation, more or less. An individual dividend stock will pay more while increasing your concentration risk. A diversified, dividend-focused fund can lower that specific risk but likely pays a bit less. In any case, as a stock holding the risks are greater than with bonds, CDs and savings accounts.
3. Tax deferral
This is a detail many people fail to consider, but any time you can defer taxes your money grows faster as a result. Using an IRA or 401(k) at work can allow you to earn more interest and dividend payments on money you would otherwise have paid in taxes while simultaneously avoiding those taxes until retirement, when your tax rate is likely to be lower.
Investors like to say they buy low and sell high. But do they do so regularly? One way to automate this best practice is to rebalance. By setting as specific weight of say, stocks to bonds, you can reset you portfolio periodically to regain the right mix as a percentage. That way, you automatically sell gainers and use the proceeds to buy the relative “losers” in your portfolio. That adds up to real gains over time.
Finally, the power of compounding takes small dollars and makes them ever larger with the years. A market rate of return is likely to double your money in 10 years or less as those dividend and interest payments are reinvested, and there’s price appreciation, too. Compounding simply means that the new total doubles again, that is, two becomes four, the four becomes eight, and eight turns into 16, etc. It’s how long-term investors retire, by saving early and letting compounding create real wealth.
The end of 2014 is closing in rapidly and it’s beginning to look like another double-digit year for the broad index of stocks known as the S&P 500.
At this writing, the index is up 10.65% year to date. If you owned it through an index fund such as the SPDR S&P 500 (SPY) you also got the dividends paid out, at this point a return equal to 1.79% on top of your price gain.
If the market stays at about this level, that’s comfortably over 12% on the year just for holding a single index fund. You didn’t have to buy and sell. You didn’t have to guess which stocks would do better or worse. All you had to do was match the market.
Yes, some individual stocks did much better. And some individual stocks did much, much worse. You might have picked the right 10 or 12 stocks — or not.
At the beginning of the year, more than a few pundits predicted a weak year for stocks, particularly after the huge run-up we saw in 2013. Many of them now call stocks “expensive” or “fully priced.”
Some are projecting a lower return from stocks for years to come. And maybe they’re right. All we know for sure is that if you spent 2014 sitting on cash, you absolutely missed another double-digit year and even lost a little ground due to inflation.
That’s the whole point of portfolio indexing. Guessing right the direction of any given asset class is not just hard to do, it’s nearly impossible. The pundits lose nothing by going on the air or taking to the Internet to predict bad times ahead or, conversely, by forecasting blue skies forever.
Rather, they only need to keep saying the same thing over and over and at some point along the way they are likely to be “proven” right by events. I could pick an NFL team as a sure playoff winner each season and, if I stuck to a single likely team, I would eventually be right, too.
More importantly, all the seasons I am wrong costs me nothing. To my friends, I’m just a fan. No big deal.
Real investors can’t afford to be “fans” of a given market prognostication. If you bet wrong, you lose big. If you do nothing, your money doesn’t grow at all.
Match the market and win
Most importantly, your money fails to compound. It’s when the cash stream from your investments begin to reinvest that the big growth kicks in. Taking time out of the market to wait for the “right moment” to invest is market timing, and it rarely works out.
In fact, the worst thing that can happen to you is to have market-timing work once early on in your investing life. That only emboldens the stock picker into greater and greater risks — until reality slaps them hard.
It shows up in the long-term data. Individual investors over the 20 years through 2013 experienced a personal return of 2.5%. During the same period the stock market averaged 9.2% a year.
Added up over the years plus compounding, that’s a huge difference. The patient indexer who stays invested retires on time by steadily reducing stock exposure as he or she gets closer to retirement. The market timer goes through feast and famine and ends up stuck with a return that adds up to nothing or not much.
Retiring on time is no accident. It’s the work of long-term thinking and careful planning, whether you go about it on your own or hire an advisor to help out.
Even those who do hire advisors would be better served to understand the mechanics of saving and investing. Think you know a thing or two about the matter? Take this five-question financial savvy quiz and find out:
1. A retirement account of $200,000 means you can safely withdraw what amount on an annual basis and expect it to last for 30 years?
Answer: C. $8,000. Financial advisors counsel taking no more than 4% of your retirement savings per year ($200,000 x 0.04 =$8,000). Conservatively invested, that level of withdrawal means the money should last for three decades. Take more, and you are counting on a higher, and thus riskier, investment return. Or you run out of money sooner.
2. The longer I wait to take Social Security, the more I will get paid once I begin benefits.
Answer: A. True. Many people take their retirement benefits beginning at age 62, the earliest possible age. However, if you were born in 1943 or later you will be paid an estimated 8% more money for each year you wait until the ultimate retirement age of 70 (your “full” retirement age may be sooner). You are likely to collect for fewer years, it’s true, but you might want to work for a few years past 62 in order to build up private retirement savings in a 401(k) or IRA.
3. A reasonably risk-adjusted portfolio that holds more stocks than bonds is likely to double your investment within what period of years?
a. Around 12 years
b. Around 10 years
c. Around 4 years
d. Around 7 years
Answer: B. Around 10 years. Many investors nearing retirement today have become used to stock market returns of 10 percent or more and doubling every seven years. However, the long-term return on stocks with dividends reinvested is about 6.6%. Held with bonds and rebalanced regularly, such a portfolio is likely to double your money in 10 years, not seven.
4. My 401(k) plan at work has fees that cost me what percent of my retirement savings balance every year?
a. Zero, it’s free.
b. Less than a half of 1%.
c. About 1%
d. Easily more than 1%
Answer: D. Easily more than 1%. In fact, 401(k) plan fees average 1.5%. Large-company plans tend to be the least expensive, while small company offerings can cost as much as 3.86%. That money is deducted from your total portfolio balance, not from the potential earnings in a given year.
5. The single most important investment I can make for retirement is to…
a. Own good life insurance
b. Have a paid-up mortgage
c. Maximize tax-deferred and tax-free savings
d. Build a cash emergency fund
Answer: All of the above, but mostly C. Maximize tax-deferred and tax-free savings. Life insurance is useful if something happens to you, but that is unlikely. Paying off a mortgage is great, but your interest rate is probably very low and there are tax benefits to paying it down slowly. Everyone needs a cash emergency fund of at least three months (six months is better). However, all of these pale in comparison to a 401(k) or IRA which earns you a tax break now or is tax-free later and compounds at a market rate of return.
Feeling better about your financial savvy? Great! Didn’t do so well? I recommend a trip to the public library. Try The Elements of Investing to start. It’s a short read and easy to understand, yet the concepts are important and timeless. Then start making choices that will get your retirement game plan on track.
Can you beat the market these days? Should you even try? Increasingly, the resounding answer for retirement investors is “no” and “save your money.”
Wall Street blows a lot of cash on the idea that everyone should somehow beat the market. Try $600 billion a year in fees. Yet the financial research theory, now decades old, has finally proven true. Your odds of getting a better return than the overall market are now vanishing small — less than one manager in 100 can do it.
Could you pick that manager? Does he or she even take clients with your level of retirement savings to grow? Probably not.
Could you do it yourself instead and save the money? Only if you believe that you have the skill and the stamina to outlast all of Wall Street and beat them and the market consistently, year after year. The data shows it’s just not true, for them or for you.
The University of Maryland took a look at what’s called “true alpha,” that is, a market-beating return that cannot be attributed to chance. You know the old story of the stock-pickers who use a dartboard. Every few years, someone sponsors a contest with 5th-graders, or a cat pawing at toys or something utterly random, like coin flipping.
The resulting “nonprofessional” portfolio inevitably wipes the floor against highly paid managers, making the point quite clear: The managers are in the business of packaging sheer chance wholesale and marking it up to sell retail.
It wasn’t always so. Before 1990, there was a pretty good opportunity to beat the market. Then, 14 out of 100 managers could do it consistently. Soon, though, index funds and ETFs really took hold. Computerized information became more widely shared and constant. Many more mutual funds entered the market.
The result was the rapid destruction of the ability of talent to win over coin-flipping. Yet the “talent” is still in business, still charging high markups and still maintaining the faulty argument that investments must be picked and managed.
Are managers necessary? Not when just 0.6% of managers can pull off a true win. Think of it this way: If that tiny minority of traders is able to beat the market, by how much will they do so? Not much, it turns out, once you subtract their fees.
Retirement photo finish
Why not just own the market, get second place in a photo finish and keep those fees in your portfolio, where they can do you some good by compounding? That, in essence, is the argument of index funds.
Unsurprisingly, index funds and index-style exchange-traded funds (ETFs) have exploded in popularity since. What’s more, price competition has set in, driving down the cost of holding an index ETF to well under one-tenth of 1%.
That move represents the savings of hundreds of billions of dollars, money that remains in the accounts of investors themselves. And that’s how retirement is reached these days by prudent, long-term investors.
Investors love the idea of being able to predict the future. People who wouldn’t be caught dead engaging a roadside psychic or fooling around with tarot cards nevertheless are convinced that some months are “good” for stocks and some months are “bad.”
We saw this happen once again in October of this year. Pundits far and wide wrote in the late summer and early fall that the market was due to correct, if not crash, in October.
How would they know that? They wouldn’t, but as it happens three of the biggest market collapses in history occurred in October: The Panic of 1907, the Great Crash of 1929 and Black Monday in 1987.
Convincing, right? Yet there’s really no evidence to support the idea that October is to blame. Almost every month has its periodic declines at some point in history. Like the “June swoon” and the “Santa Claus rally,” these trends are reinforced by repetition: They tend to happen because we expect them to happen.
Crowd psychology is a funny thing. If you look at last month, our most recent October, you see a huge slump in the S&P 500. Nevertheless, there were similar (albeit not as deep) slides in February, April and August.
Oddly, though the market recovered from the October decline this year and went on to new highs, nobody talks about November being a perpetually “great” month for investing.
Why would they? The presumption by many investors is that stocks will rise in the future, a trend supported by long-term statistical studies. In fact, equities have beaten all other investments handily, returning 6.6% annually.
That’s about twice the rate of growth of the economy, a result researchers suggest is a reflection of reinvested dividends. Put another way, held for the long run, stocks keep up with the economy in terms of appreciation and return double that on reinvested capital.
Yes, an individual investor can be caught out when markets crash. But the risks can be and should be limited.
First of all, own the right level of exposure to the stock market. If you are investing for the short-term, cash or money market funds are more appropriate. If you are investing for just a few years, you might be better off in bonds.
But if you expect to own an investment for decades, stocks are the right choice. As your time horizon shrinks and you need the money for living expenses, that’s when you dial down your risk and hold less in stocks.
In the meantime, let the Octobers come and go. They don’t mean anything to serious retirement investors. Focusing on the occasional slip in equities is a recipe for waiting, and waiting is a sure way to miss the upside from prudent, long-term thinking.