Wednesday, September 10, 2008

En Garde!

I maybe an out-of-work academic (although I’m trying to stay in teaching), but I know faulty logic when I see it. Let me tell you, I saw it somewhere I didn’t expect to- on the 169th edition of Carnival of Personal Finance. Yup, Steadfast Finances rightfully called himself a black sheep as he tried to convince people that index funds are bad for your investment portfolio.

I love a good debate, when two people come with facts and logical arguments to discuss the finer points of an issue. I applaud BankerGirl for including a different point of view in her carnival; however, most of Steadfast Finances’ points aren’t well supported by the data.

The five supposed reasons Steadfast Finances thinks bloggers like index funds (and my responses):
1. Index funds are very easy to understand.

Once you’ve got a bit of financial knowledge under your belt, yes they are easy to understand.

2. They likely know little to nothing about the stock market.

Nope. I’d say most financial bloggers are financial bloggers because they are interested in finance. Besides professionals, I’ve found that most financial bloggers are serious about their hobby. I know I am. While I can’t say all financial bloggers understand the stock market, I think it’s safe to say most do.

3. They don’t want to recommend individual stocks or mutual funds for fear of reprisals.

Fear reprisals? No we don’t fear them. We know that most individual stocks are riskier than indexes. We're savvy, not fearful. Most individuals don’t have the capital or time to actively manage a balanced portfolio of individual stocks. Fear implies that people who prefer indexing are afraid of something. While no investor is Spock, indexers know that no one can predict the future earnings with complete accuracy, and indexers prefer methods that control risk to the point that makes emotional and intellectual sense.

4. It’s an easy answer to a difficult question because index funds require little to no research whatsoever.

Indexing still requires research. Every investor should know their portfolio. Does indexing take less time to research than a balanced portfolio full of actively traded stocks? Yes, of course it takes less time. That’s a good thing for an individual who doesn’t make finances a hobby or profession.

5. Everyone recommends them, so they feel safe passing along the same recommendation as the rest of the herd. So if the market tanks, they got fooled like everyone else and everyone likes to fit in.

First: Oouch! The tone here is harsh! Herd-mentality? Tanking-markets taking all indexers down! It’s hard to convince people that your point of view is better if you resort to animosity. Your audience in the Carnival of Personal Finance is varied- be aware that you just lost some audience by offending them.

Second: Good indexing requires a balanced portfolio. No one should be just in one index, because that negates the whole point of controlling risk. Every investor should research their options. No one should make financial decisions based on the current fad.

Next, Steadfast Finances makes an illustration to try and show that there are better options than the S&P 500. Using one fund, CGM Focus, he compares it to the last 10 years of the S&P 500. CGM Focus is a domestic large capital growth fund run by Capital Growth Mgt Ltd Partnership. On the surface it does look good. Top Morning Star ratings, acceptable expense ratio, and a return of 320% compared to 25% for the S&P 500 in the same time frame.

What Steadfast Finances didn’t say is that CGM is already regressing to the mean. It’s had a great first year yielding 71%, at three years it’s returning 38.5%, at five years 35%, and at 10 years 26%. It’s current year-to-date return is -5.12%.

While there is no way to know what it will be doing in another 10 years, statistical rules like regression to the mean, say the returns will go back to a more average amount. It may still be better than the S&P 500 index for a short while, but over a extended period of time it will probably make average returns. BTW over the life of the S&P 500 the return is around 7%, not the high 25% we’ve seen in these last ten good years (Jeremy Siegel in Farrell’s Right on the Money).

The problem with your argument is that you’re picking optimal times in the past to get into this fund. If someone had gotten in recently, they would be down and out of money. Very few funds can consistently beat the market in the long run. Without considering mutual fund expenses, only half out perform the market. Only 1 in 3 funds outperform the market when taking into account the fees (Zweig Your Money and Your Brain). That’s why it’s so hard for individual’s to make prudent picks, past performance doesn’t predict future success.

The Consumer Price Index increased at about 3% since 1914. The S&P 500 returned an average 7% return and that is after adjusting for inflation (Jeremy Siegel in Farrell’s Right on the Money). That’s not huge, but it will buy you gas and food. This is assuming you’re just in the S&P 500. Which, let’s be honest, isn’t the only index. You should have more variety than just the S&P 500 in your portfolio.

Steadfast Finances nicely illustrates a normal curve to show the variety you get when you index. He quotes “buying basic index funds - you get some good, some bad, but mostly average performing stocks.” This is a good thing! You’re getting average (7%) returns! This would be hard for individuals to do by picking individual stocks. Also, you’re getting a good rate of return without being extremely risky.

How do I make my money work harder? Steadfast Finances solutions and my responses:

1. Pick mutual funds with an excellent track record of out performing the S&P 500. Any website like Morningstar, Kiplinger’s, or blogs like mine will always cover the better performing mutual funds and exchange traded funds (ETFs).

The problem with this is that there are a lot of opinions of what is good. There are many professionals who are touting the next hot financial product. The problem for an individual investor is that there is a lot of noise out there. These financial gurus are passionately convinced that their way is the right way. It can be flat out confusing for a novice investor. Trying to find that 33% of mutual funds that outperform the market any one year means that 66% of funds picked won’t even get a 7% return.

2. Setup an account with a full service brokerage firm. These are more expensive, but like anything, you get what you pay for.

Since 1976 the Wiltshire 5000 index has done better than 2/3 of money managers (Meir Statman in Farrell’s Right on the Money). While you can’t control the future earnings of a specific fund, you can control your fees. Money managers take a cut of your money. Whether you do well or poorly, they will get their fees- with most of them not outperforming the larger index.

3. Hire a financial planner. If you are looking for more better than average returns, let him/her know your goals and it’s just that simple.

Hiring a financial planner is smart. Talk to someone for a fixed fee if you need advice for a specific issue. Or if you are petrified by making a financial decision on your own, hire a planner and start investing something. It will be better to start investing early, than to wait until retirement is right around the corner.

4. Ask for advice from a trusted colleague/friend with investment experience. I learned how to invest from a family friend, and it’s one of the best financial moves I ever made.

Good idea. However, don’t confuse this with acting on friend’s advice. Your cousin may say he’s made $20,000 in the energy sector, but he may not as forthcoming with his losses. Asking advice is fabulous! Acting on partial information isn’t.

5. Do it yourself and build your own mutual fund. There are many websites and blogs that cover mutual funds or individual stock research, so grab a few RSS feeds, do your own research, and away you go. Just make sure you know what you’re doing, and start small in the beginning.

Also wonderful advice! If you have time to make your own mutual fund this is a fun activity. Take a small percent of your overall portfolio and play! Don’t make your financial goals contingent on these- you could be taking on extraordinary risk.

In summary: I like his closing comments.

“I’m merely pointing out that you shouldn’t close off the possibility of
owning several traditional mutual funds or ETFs that have superior historical
returns. By allocating a certain percentage of your overall portfolio to
higher risk investments, your returns could potentially be far better than using
index funds only.” - Steadfast Finances

His title is misleading if his ending sentiments are honest. However, with a little updating to his supporting evidence, I think we could have a nice little debate on our hands!

This is the balanced advice I wish made up the bulk of this blog. I was so relieved to find out he isn’t a day-trader or exults only managed funds. We have a lot more in common than I initially thought. We both want people to be fiscally-literate and to seek professional help when they need it. We both want financial peace of mind for ourselves and others. We just have a small disagreement over the best way to do that.

In all honesty, we’re probably both right. There are circumstances where one school of thought is better than the other. There are some great mutual funds out there and they can be beneficial for some people (a lucky 33% of people).

However, in my humble opinion and those of many indexing advocates, there are many people who would be better off with balanced indexing. It’s great for individual investors who are educated about the stock market and in ways to control risk. It’s a nice way for people who want to manage their own money to do so and still have a life. These are people who want to do all of this for little cost and great peace of mind.


Matt said...

Thanks for the link and the roasting.

I knew that post would not go over particularly well b/c anytime you challenge a popular thesis, it often gets rebuked. However, when you have spent time in the trenches doing the real work, you learn that broad market investing can have some serious drawbacks. Primarily, that you are a captive to what the U.S. economy (and international b/c everything is multinational these days) sends your way. In this case, a major weakness of index investing has been exposed.

I'm not trying to debate the topic b/c a decade long S&P chart really shows all one needs to see. Which by the way, many other investing colleagues and even a Vanguard rep agreed with me prior to writing the article, so calling it "faulty logic" is way out of bounds. No reason to take it to the personal level suggesting a contrarian point of view can't be published in the Carnival of PF.

If you pull the S&P chart going back to August 1998 to present (I chose this date b/c it's exactly 10 years from the date I wrote the post, not b/c I'm cherry picking dates to further my points) you will see the S&P is almost exactly where it started. Adding a well known fund like CGMFX as an overlay simply points out the how poorly the S&P has done compared to a WELL managed fund. The fact that it also provides a nice similarity to a heart monitor flat line is just a bonus. Which back to my original point - the S&P being dead money!

The major point I wanted to imprint upon people's minds, albeit I may have been too abrasive doing it, was getting people to consider the implications of having a dead money returns on your investments over a much longer period of time.

So Cal Savvy said...

Ahhh… faulty logic it is when you ignore the rule of regression to the mean! It’s nothing personal; I think we’re just arguing about different time frames. Over the long run, which retirement planning for 25-year-old is, very few mutual funds will beat the market. Some will, of course, but divining which ones those are is hard.

I’d say that while many companies are multi-national today, there is ample proof that adding large and small cap international indexes bring down the risk in a portfolio while adding additional unique return. With the advent of the internet, no one is confined to the US markets. Therefore, I see no weakness with indexing due to that point.

I think you are smart to write the article!

It makes people think about the methods they choose to invest in and the underlying assumptions they hold. Please don’t think I’m picking on you, we’re just both expressing opinions based on the lessons we have learned (professional or academic- both have their merits).

The only thing that I think you were guilty of was being a little harsh in tone! If you want to suggest an alternative point of view, it’s not nice to project anyone’s demise.

See the problem with the dates you picked (although with good intentions, being 10 years from your post) is that they happened to be good years in general. I’d say try running the same scenario with mutual funds over 40 or 60 years- timelines that retirement portfolios use (although that would be impossible with your current mutual fund pick as it is only a decade old).

So I guess the only thing left to clarify is: is 7% returns dead money? What about 10-13%? What do you think a person should expect of their portfolio returns and at what risk?