Index Investing: How to Win the Loser’s Game (video tutorial)

– Posted in: Index Funds — overwhelming evidence

This video summarizes the evidence for index funds as the winning investment strategy. The outstanding documentary by http://sensibleinvesting.tv  contains interviews with some of the biggest names and brightest minds in the investment world. The aim is to provide ordinary investors with the information they need – and to challenge the industry to offer consumers a fairer deal. This is presented and produced by Robin Powell and was published on their YouTube channel  on Nov 5, 2014 and titled, How to Win the Loser’s Game. I have included a summary and transcript to help you find the spots that interest you and make the best use of your time.

Summary of this must watch video on Index Investing: How to Win the Loser’s Game


This remarkable 80-minute video is produced by http://sensibleinvesting.tv , an independent voice of passive investing, and features some of the biggest names and brightest minds in the investment world. It is presented and produced by Robin Powell and his team at SensibleInvesting.tv, and published on YouTube from August to Octover 2014. It is a great honor to include it in our collection of video tutorials about mutual funds.

Part 1: Are There “Star Performers” Than Can “Beat The Stock Market”?

Link down page to transcript about the myth that a good manager can outperform the market.

  • Studies show the vast majority of managers fail to deliver any outperformance—either from stock selection or from market timing.
  • Many ordinary investors are completely unaware of this scandalous situation. Reasons include:
    • This is a hugely powerful and largely self-regulated industry, which lobbies hard to protect its interests.
    • It also spends a fortune on adverting.
    • And the financial media, which is largely funded by that advertising, has an insatiable demand for stories, which the fund management companies are only too happy to provide.
    • We think we’re paying for better performance; that greater skill will produce superior results. But investing almost always works the opposite way around: The less you pay, the more you get back.
  • Investing has famously been called the loser’s game. This video shows you how to win it by using a low-cost index investing strategy.

Part 2: The Cumulative Effect of Paying Investment Management Fees.

(Watch on video starting at 5:14)

Link down page to transcript about the surprisingly enormous impact of investment fees.

  • Nobel Prize-winning economist Eugene Fama says: “If you’re paying big management fees, the cumulative effect of that, given the way compounding works, is enormous.”
  • Merryn Somerset Webb from MoneyWeek says: “Almost all fund management is a complete rip-off. We know that. We only have to look at prices relative to the performance.”
  • Gina Miller from the True and Fair Campaign says:”The very people who are being prudent and saving and investing are not the ones who are retiring with a comfortable pot. It’s the fund managers who are becoming millionaires and billionaires because of those profit margins.”

Part 3: The Dismal Performance Record of Actively-Managed Funds.

(Watch on video starting at 12:07)

Link down page to transcript about how index investing strategies consistently beat active investing.

  • Passive investing with index funds is not so much a theory as a massive a mathematical fact.
  • There’s a wealth evidence supporting it including the work Nobel Prize-winning economists.
  • Studies have consistently shown that when costs are factored in passive index fund investing produces better returns than active.

Part 4: What The Academic Evidence Says About Index Investing vs Active Investing.

(Watch on video starting at 21:17)

Link down page to transcript about evidence for index investing.

  • Jean-Michel Courtault: “The expectation of the speculator is zero.”
  • John Bogle says: “Paul Samuelson basically said, Show me the brute evidence that managers can outperform.”
  • Professor John Cochrane says: “Gene Fama’s theoretical framework is quite easy to understand. Competition means that prices reflect information.”

Part 5: The Optimum Index Fund Investment Portfolio is One That Holds Every Security Available in Proportion.

(Watch on video starting at 31:50)

Link down page to transcript about optimum index investing portfolio.

  1. Markets are competitive, and there are two sides to every trade.
  2. The price of a security is the very latest, best-guess estimation of its value by the entire market.
  3. Because it incorporates and reflects all the available information, markets are therefore very efficient.
  4. Asset prices respond to new information, which is, by nature, random.
  5. Price movements are therefore random as well.
  6. And because the prices of different assets go up and down at different times, it pays to be diversified.
  7. The optimum portfolio is one that holds every security available.
  8. The return you can expect from a particular security is related to the risk of holding it when markets fall, and that risk is known as beta.
  9. But there are different types of risk you can expose yourself to. Small company stocks and value stocks, for example, are generally more volatile than larger company and so-called growth stocks. But if you hold on to them for long enough, they should deliver a higher return.

Part 6: The Reason Index Investing is The Winning Strategy Boils Down to Simple Mathematics.

(Watch on video starting at 38:30)

Link down page to transcript about why index investing is the winning strategy.

  • Nobel Prize-winning economist William Sharpe says: “Net of costs, the active euro in the passive sector must outperform the average euro in the passive sector.”
  • Vanguard CEO Bill McNabb says: “When you think about the average investor, who’s also a consumer, and they’re used to ‘The more I pay, the higher the quality, typically the better the results I get’, you come to investing and it’s just the opposite.”

Part 7: Is There a Scheme Better Than Holding The Market Index?

(Watch on video starting at 50:00)

Link down page to transcript about alternate indexing schemes.

  • Is there an indexing scheme better than a cap-weighted or market value-weighted fund?
  • Where do returns come from ?

Part 8: Tilt A Portfolio of Index Funds To Get Higher Expected Returns With Greater Volatility.

(Watch on video starting at 56:30)

Link down page to transcript about the option of over-weighting particular risk factors.

  • All the evidence is stacked against active fund management.
  • Benefit by having exposure to all the different factors of risk.
  • Over-weighting a factor such as “small” or “value” is definitely worth investigating.

Part 9: Your Behavior As An Investor, is Critical

(Watch on video starting at 01:04:52)

Link down page to transcript about how decision between index investing vs active management is moot compared to having good investor behavior.

  • The secret, in a nutshell, to winning the loser’s game:
    • First, choose an strategy that’s based on evidence – ideally one designed to capture the returns of the whole market – and then tailor it to your attitude to risk.
    • Secondly, stick to your strategy through thick and thin. Rebalance your portfolio, yes, but most important of all, stay the course. You are going to be tempted every day—but don’t do anything.

Part 10: The Investment Industry is Failing Individuals, and Society as a Whole.

(Watch on video starting at 01:11:35)

Link down page to transcript about how the investment industry is failing to serve both individuals and society as a whole.

  • The fund management industry needs a huge reform
    • In fact, investing is remarkably simple—not necessarily easy, but simple—straight forward.
    • It doesn’t need so many different products.
    • It doesn’t need so much differentiation.
    • It doesn’t need quite so many people.
    • And, it doesn’t need to be so expensive.
  • “The ultimate object of all business should be to serve the consumer.”

***** ***** *****

Again, this is an exceptional video and I encourage you to watch and listen. But for those who prefer to read, I provide a transcript below. I tried very hard to create an accurate transcript for you, but if there are any errors they are mine. This took a lot of time, so I hope that it adds to your understanding of this important overview.

Lastly, while this was produced for a British audience, I encourage every American to listen and learn. Simply think “dollars” whenever they mention “pounds”. The key messages are universal.

Transcript of Index Investing: How to Win the Loser’s Game


Part 1: Are There “Star Performers” Than Can “Beat The Stock Market”?

(Robin Powell, reporter)

The City of London… The center of the financial world.

It’s here that some of the finest minds in global finance ply their trade.

The pressures are huge – with salaries and bonuses to match.

London’s financial sector encompasses a whole range of commercial activity – from banking and merchant banking to insurance and accountancy. But central to it is the fund management industry.

It’s fund managers whom the vast majority of us entrust with our long-term investments.

They choose which stocks and other assets to invest in on our behalf – and decide when the time is right to buy and sell.

And yes, they’re very well remunerated.

In fact pay has risen sharply in the last few years.

One manager, Richard Woolnough at M&G Investments, was paid £17.5 million in 2013 – 600 times the average UK salary.

Research by the FT shows that, in the same year, pay per employee in the sector outstripped even investment banking.

At one fund management company the average annual salary was £436,000.

The standard line from the industry is that it needs to offer such large financial rewards to attract the brightest talent.

But, time and again, research has shown that we over-estimate quite how talented fund managers are and how much value they add.

For all the talk of “star” performers, the empirical evidence shows that only a tiny fraction of them outperform the market with any meaningful degree of consistency.

Typical of the reports produced on this subject is this one by the Pensions Institute, based at Cass Business School in London.

Researchers examined 516 UK equity funds between 1998 and 2008, and found that just 1% of managers were able to produce sufficient returns to cover their trading and operating costs.

But even those managers pocketed for themselves any value they added in fees, leaving nothing for the investor.

The remaining 99% of managers failed to deliver any outperformance – either from stock selection or from market timing.

In case you’re wondering whether those managers were simply unlucky, the researchers found the vast majority weren’t; they were “genuinely unskilled”.

While a tiny number of “star” managers do exist, they are, to quote the report, “incredibly hard to identify”. Furthermore, it takes 22 years of performance data to be 90% sure that a particular manager’s outperformance is genuinely down to skill.

For most investors, the report concludes, “it is simply not worth paying the vast majority of fund managers to actively manage their assets”.

If you’re shocked and appalled by those findings, so you should be.

The Pensions Institute report is a damning indictment of the fund management industry which is completely at variance with the image that most of us have of the City as a center of investment expertise.

Since this is only the latest in a long line of reports that have said more or less the same thing, it also begs the question, why are so many ordinary investors completely unaware of this scandalous situation?

In fact there are many reasons.

  • This a hugely powerful and largely self-regulated industry, which lobbies hard to protect its interests.
  • It also spends a fortune on advertising.
  • And the financial media, which is largely funded by those adverts, has an insatiable demand for stories, which the fund management companies are only too happy to provide.

But ultimately, actively managed funds still hold sway over cheaper, passive investments such as index funds, because investors continue to buy them.

  • We think we’re paying for better performance; that greater skill will produce superior results. But investing almost always works the opposite way around. The less you pay, the more you get back.

Yes, it’s counter-intuitive, but it’s true.

In the course of this program, we’re going to be looking at just how much investing costs us; and at the performance that fund managers deliver.

We’ll be exploring more than 100 years of academic research into asset pricing and how markets operate.

And we’ll be examining long-term investment strategies that have been proven to work.

Investing has famously been called the loser’s game, and for most people, it is. We’re going to show you how to win it.

Part 2: The Cumulative Effect of Paying Investment Management Fees.

(At 5:14 start Robin Powell, reporter)

We love a bargain… We drive several miles out of our way to save a penny on a liter of petrol. We collect vouchers to save a few pence on grocery items. And we grumble when the Government slaps another penny in tax on a pint of beer.

And yet, when it comes to our pensions, one of the biggest financial investments we’ll ever make – often the biggest – we either don’t know what we’re paying or don’t even seem to care.

One explanation is that when you start a pension, retirement is so far off you’re not too concerned about the impact of charges on an investment you might not need for another 40 years. But another problem, at least here in the UK, is that charges are complicated and not always easy to calculate.

The True and Fair Campaign, which lobbies for fairer and more transparent charges, accuses the industry of using smoke-and-mirror tactics.

(At 6:10 start Gina Miller, founder, the True and Fair Campaign)

Campaign founder Gina Miller says: “The fund management industry is supposed to publish something called the ongoing charge. That was under an EU directive that came in in 2012. Most companies still only publish the annual management charge. Outside of that annual management charge there can be a myriad of other charges, between 11 and 13 layers. You’ve got jurisdiction fees, you’ve got bid offer spread, you’ve got administration fees, you’ve got taxes, stamp duty. In a way though, it doesn’t really matter what all these charges are. It’s not up to the individual investor to have to become a detective to find out those charges. It should be the industry doing the work and putting that into an understandable number—into a ticket price. When you buy a car you don’t expect to see a list of how much the wheels cost, and the engine, seats, doors. What you expect to see is the total price: how much is it going to cost.”

(At 5:14 start Robin Powell, reporter)

What we’ve seen in recent years is an “unbundling” of charges. The different fees applied now need to be broken down. That’s improved transparency, but it’s also added to the complexity. Unbundling has also made it look as though charges have gone down, when in fact, in many cases they’ve risen since the regulations came in.

Under the old system, annual charges were usually around 1.5%. But fund managers would pay some of that to third parties such as fund platforms or financial advisers.

Now, although fund management companies typically charge a more modest-sounding 1% or 0.75%, they keep all that for themselves. In fact, many funds are pocketing more in charges than ever before. And because there are still separate fees to pay on top of the management charge, investors are often worse off.

And of course, all that’s before trading costs. Research at Oxford University suggests that many fund managers have responded to regulatory pressure to reduce annual management charges by simply trading more and charging for it, in order to maintain their profit margins.

The combination of trading costs and the compounding effect of annual charges can take a very large chunk out of the average pension pot – even in America, where overall investment costs are significantly lower than in the UK.

Eugene Fama on index investing

Eugene Fama says: “If you’re paying management fees, the cumulative effect of that, given the way compounding works, is enormous.”

(At 8:35 start Eugene Fama, Nobel Prize-winning economist)

Nobel Prize-winning economist Eugene Fama says: “If you’re paying management fees, the cumulative effect of that, given the way compounding works, is enormous. So active managers basically charge on average 1% in the US on management fees and you never know what their transactions costs are because that’s not a reported number but they’ve gotta be way higher than for passive managers because they’re going in and out of securities all the time.”

(At 9:01 start Robin Powell)

As well as resisting calls to reduce their charges, fund managers have been accused by some of acting almost like a cartel.

One survey found that 68% of the UK’s largest retail fund sector charged an identical fee.

(At 9:17 start Mark Dampier, Hargreaves Lansdown)

Mark Dampier of Hargreaves Lansdown says: “I think it’s a fair point, it is very strange that most of the industry prices at the same point […] I wouldn’t go so far as a cartel, I don’t think that’s true, but a cozy club, well, maybe.”

(At 9:43 start Robin Powell)

Another trend that some have observed is the growing number of funds that claim to be actively managed, but in fact are virtually passive – in other words, they broadly track the entire index. Passive funds are cheaper to operate than active and should therefore have lower charges.

MoneyWeek on fund management

Merryn Somerset Webb, Editor-in-Chief of MoneyWeek, says: “Almost all fund management is a complete rip-off. I mean, we know that.”

(At 10:02 start Merryn Somerset Webb, Editor-in-Chief of MoneyWeek)

Merryn Somerset Webb, Editor-in-Chief of MoneyWeek, says: “Almost all fund management is a complete rip-off. I mean, we know that. […] ”

(At 10:27 start Robin Powell)

So what sort of impact do charges have on the value of our long-term investments?

Well, over 40 years, a pension fund worth almost £250,000 with no charges would be reduced to just £174,556 with an annual charge of 1.5%.

If overall charges reach 2.5% – and when trading costs are included, that’s not uncommon – this reduces the value of the fund to less than £140,000.

So, even at 1.5 percent, almost a third of your fund is lost in fees, rising to almost half when charges increase by 1 percentage point.

The True and Fair Campaign says fund managers are taking far too much out of people’s savings and they could easily afford to lower their charges.

It says inefficiencies are rife and, although the industry has grown, there’s been little or no attempt to pass on economies of scale to the consumer.

Fund managers are charging too much.

The True and Fair Campaign says fund managers are taking far too much out of people’s savings and they could easily afford to lower their charges.

 

(At 11:28 start Gina Miller)

Well the average UK small to medium size business is making between 9% and 15% profit, somewhere around there. The average UK fund management business is making 30% profit. Those figures speak for themselves. They are growing fat and rich while the consumer is losing out. The very people who are being prudent and saving and investing, are not the ones who are retiring with a comfortable pot. It’s the fund managers who are becoming millionaires and billionaires because of those profit margins.

Part 3: The Dismal Performance Record of Actively-Managed Funds.

(At 12:07 start Robin Powell)

Of course, the fund management companies could justify high fees and making large profits if they added significant value. Unfortunately, the performance of actively managed funds is consistently very poor.

The aim of fund management is to maximize investment returns. Over time, markets deliver returns on their own—they are what we call “the market return”. We pay managers to deliver more than the market return. In fact, after costs, they rarely do. One well-known expert of fund management famously described it as an industry built on witchcraft.

John Bogle is lifelong advocate of index investing.

The intellectual basis for indexing is: (gross return) – (cost) = (net return). Period. What is the intellectual basis for active management? I’ve never heard one. The closest I’ve heard is the manager who says, “I can do better.” They all say they can do better than the market, but 100% of them don’t. Probably about 1% of managers can beat the market over the very long term.

 

(At 12:48 start John Bogle, Founder, Vanguard Group)

We have the most prevalent rule that applies to fund managers everywhere, and that is reversion to the mean. A fund that gets way ahead of the market, falls way back behind it. It’s witchcraft in the sense that it’s managers hovering over the table thinking that they have the answer. […]

The intellectual basis for indexing is (as I’ve said), is gross return minus cost equals net return. Period. What is the intellectual basis for active management? I’ve never heard one. The closest I’ve heard is the manager who says, “I can do better.” They all say they can do better than the market, but 100% of them don’t. Probably about 1% of managers can beat the market over the very long term.

(At 13:39 start Robin Powell)

That figure of 1%, you may recall, is consistent with the findings of the Pensions Institute report. And that study found that even those 1% of managers kept for themselves the value of any outperformance in fees. Several other studies have reached a similar conclusion.

This is an independent report commissioned by the UK Government into the Local Government Pension Scheme – one of the biggest public pension schemes in Europe.

As you would expect, some active managers used by the LGPS have outperformed. But the report found “there is no evidence that, in aggregate, the Scheme has outperformed regional equity markets”.

In fact, in many cases active funds were trounced by passive ones. For example, over ten years, passive North American equity funds delivered average returns of 2.6%, as opposed to 1.7% delivered by active funds. Passive Japanese equity funds also recorded average returns of 2.6%, compared to 2.0% for active. What’s more, these returns do not take into account the impact of investment charges.

The report found that in 2012, asset management costs for the scheme amounted to £790 million – the vast majority of which was paid to active managers. Switching from active to passive investing would save the tax payer a staggering £660 million a year – and deliver similar, if not better, performance.

Michael Johnson is a public policy adviser with a specialist interest in pensions. He says the LGPS report is a wake-up call for the whole investment industry.

Johnson on index fund investing

Michael Johnson says: “Very few people enter that industry with the express purpose of enriching others, and they’re good at what they do, which is enriching themselves.”

 

(At 15:30 start Michael Johnson, public policy adviser)

Michael Johnson says: “[…] Very few people enter that industry with the express purpose of enriching others, and they’re good at what they do, which is enriching themselves.”

(At 15:52 start Robin Powell)

Alan Miller was a successful fund manager. But over the years he became disillusioned with the industry, and particularly with the poor performance that managers were delivering year after year.

(At 16:04 start Alan Miller

It used to be, the institutions would have a big advantage. They would see the companies first. They would see the management. If they would ask sensible questions, they would get information before other people. This does not happen anymore. There’s something called the internet. There’s something called information given to everyone. And therefore, to have an edge is much harder. It’s like drilling for oil where nobody has drilled before. It doesn’t mean they are not going to discover oil, but the vast majority are just going to discover fizzy water.

Alan Miller says: “The marketing budgets within the big retail companies are millions and millions of pounds, and they’ve created this image whereby the customer thinks that these big brands are nice and safe, nice and solid, and they think they’re getting something better. They’re actually getting something worse. The bigger the institution, the bigger the brand, normally the more you pay and normally the worse the performance.”

Alan Miller explains index investing

Alan Miller says, “…they’ve created this image whereby the customer thinks that these big brands are nice and safe, nice and solid, and they think they’re getting something better. They’re actually getting something worse.”

 

Michael Johnson says: “In a nutshell you have an industry of fund managers who are trying to out-compete one another in a giant negative-sum-game. […] They are extracting charges and fees on an annual basis which erode the capital of savers. […] It is nigh impossible to work out who is going to outperform the rest on a consistent basis. And therefore for near all investors: making a decision about which active fund to invest in is a pure lottery.

(At 18:11 start Robin Powell)

And that’s more or less what the Nobel prize-winning economist Eugene Fama has been saying for more than 50 years.

(At 19:19 start Eugene Fama, Nobel Prize-winning economist)

There are lots of studies of persistence in performance. One of my students did a very famous study for his thesis. He ranked the funds on five years of performance and then examined whether that predicted future performance. Nope. It doesn’t. so there is very little persistence in performance. But, if I take all the funds and look at them over their entire histories, then you are going to see that some of them did extraordinarily well. Books get written about those managers. But, in fact, that distribution is pretty consistent with chance.

(At 18:52 start Robin Powell)

We asked several of the largest fund management companies talk to us about performance but had no success. But the trade body, the investment management association, did agree to give us its point of view.

What evidence do you have that active fund management actually works?

(At 19:05 start Daniel Godfrey, Investment Management Association)

Ok, well over a long period of time active fund managers pitch stocks that they believe will [return] more than the market. But, of course, as a group as a whole we are the market. So, that’s why you will quite often see reports in the press saying “Active fund manager doesn’t outperform the market.” Well the fact is that active kind of is the market, and passive is the market too, so as a group they can’t outperform the market. What people are trying to do is to find managers that will outperform over long periods of time. And, in fact, most people are quite successful at doing that. Because what you’ll find is, that the managers that demonstrate an ability to outperform the market reasonably consistently have the bigger funds. And the ones that don’t, contract quite rapidly. So the lion’s share of new money, and switching money, goes into the funds of people who do outperform.

(At 20:05 start

But Michael Johnson is unimpressed.

(At 20:08 start Michael Johnson)

That’s mathematical nonsense! He’s suggesting that the majority of money is successful. How can the majority be outperforming the minority? Doesn’t make sense.

This is an industry that is a genius at obfuscation and bamboozlement, with terminology that is utterly meaningless. And it needs to be challenged.

(At 20:34 start Robin Powell)

So, what are the implications of all this for the investor? Well, the system needs active managers to set prices – to ensure we all receive value for value for money. But that doesn’t mean every investor has to pay for their services.

Indeed, the high cost of active management combined with its dismal track record – and the near impossibility of identifying the next star performer – should make the average investor extremely wary.

But, before investigating alternative approaches, we’re going to find out what the academic evidence says about investing – and how best to go about it.

Part 4: What The Academic Evidence Says About Index Investing vs Active Investing.

(At 21:17 start Robin Powell)

Investing is often referred to as a game that people play. And, the way most of us invest, that’s an apt description. As with many games, there’s a very large element of luck as well as skill involved, and it’s almost impossible to distinguish between the two. But investing shouldn’t be a game. After all, securing your financial future is a serious matter. And, although the industry and the pundits like to play it down, there’s been a wealth of empirical research on this subject that investors can draw on.

We’re going to touch on some of the key principles of investing established by a long line of academics including Nobel prize-winners. Investing will always involve a degree of risk, but basing your investment strategy on those key principles will allow you to sleep more soundly and enjoy life—safe in the knowledge that if you stick with it long enough, you will succeed.

Our story starts in Paris in 1892, where a mathematical student named Louis Bachelier study for a PhD. […] His specific focus was how stock prices moved. Detailed study of the data led him to conclude that all the available information is already included in the price of a stock prices react to new information which is, by nature, random, and therefore price movements are also random. […]

(24:25) Bachelier’s thesis, The Theory of Speculation, went largely unnoticed at the time, and it was only very late in his career that Bachelier was finally offered the professorial post he always wanted. But his thesis is now widely recognized as a brilliant work, and Bachelier as the father of financial mathematics.

It was the American economist Paul Samuelson who first recognized the significance of Bachelier’s thesis in the early 1950s, several years after the Frenchman’s death. The Theory of Speculation had a profound effect on Samuelson’s work. For Samuelson, unpredictability was a necessary characteristic of a well-functioning market. In turn, his work greatly influenced the founder of Vanguard, the company that pioneered the use of index funds.

(At 25:18 start John Bogle)

[…] Jack Bogle says: “Samuelson basically said, Show me the brute evidence that managers can outperform. If you can’t show me that brute evidence you should own a passive market index like the S&P 500.”

(At 26:15 start Robin Powell)

There’s one institution more than any other that’s contributed to our understanding of asset pricing and how prices work. Over the years the University of Chicago has produced an almost embarrassing array of Nobel Prize-winners who’ve researched and written about this subject. I’ve come to interview the university’s latest Nobel laureate.

It was the advent of computers in the 1950s which enabled researchers like Eugene Fama to take financial mathematics to the next level.

(At 26:48 start Prof Eugene Fama, University of Chicago)

[…] The mathematics work was made possible by the computer.

(At 27:01 start Robin Powell)

It was for his work on the Efficient Market Hypothesis that Professor Fama was recognized by the Nobel Prize Committee. The EMH reinforces the view of Bachelier and Samuelson that all relevant information is already incorporated in the price of a particular stock. […]

(At 27:40 start Robin Powell)

To what extent would you say the Efficient Market Hypothesis has stood the test of time?

(At 27:45 start Eugene Fama)

It’s a model. The word model implies that it is not perfect.

Clearly insiders have information that’s not in the market prices. Once you get past that group it’s very difficult to find people who do have information that’s not in the price. So the proposition that markets are efficient has stood up very well.

(At 28:08 start Robin Powell)

What do you say to those people who say that what happened between 2000-2003 and again in between 2007 and 2009 when markets fell 50% or even more—those who say that disproves the Efficient Market Hypothesis.

(At 28:24 start Eugene Fama)

[…]

(At 28:51 start Robin Powell)

As Eugene Fama says, the EMH is a hypothesis. It’s not meant to be perfect. And although assets are fairly valued today, they may still fall – or rise – sharply in price tomorrow, once new information is known. But it is generally accepted by academics who’ve researched this subject in detail that markets are fundamentally efficient. Yes, some experts do disagree with Professor Fama’s interpretation of the facts, but the evidence itself is indisputable.

(At 29:24 start Prof John Cochrane, University of Chicago)

Professor John Cochrane says: “The core of Gene’s research is really facts. […] His theoretical framework is quite easy to understand. Competition means that prices reflect information. […]”

(At 29:58 start Robin Powell)

It’s often said – by supposed experts – that the theories of Bachelier, Samuelson and Fama are outdated and don’t explain the complexity of today’s markets. True, their findings have been known about for a long time. But no one has been able to disprove them And, if anything, they’re more relevant now than they’ve ever been.

Again, it’s all to do with competition, with the principle of equilibrium on which Bachelier based his Theory of Speculation. Simply put, there are two sides to every trade. For everyone buying a particular stock, thinking they’re getting a good deal, there’s a seller, equally convinced that they are. Now think of the size of the global equity markets today, with millions of investors trading typically around $60 trillion every year. Think of the increasingly high frequency of trading. A decade ago, there was an average of around 20,000 trades every second, but that figure has increased nearly 100-fold to 1.8 million. Also, think of the growing number of professional stock pickers out there. In the US, for example, there are 14 times more mutual funds today than there were in 1979.

All these market participants are competing with one another, and each time they trade, they’re giving their estimate of how much a stock is worth. So we should see the price of a stock is the very latest best estimate of the entire market. That’s how efficient markets have become.

Part 5: The Optimum Index Fund Investment Portfolio is One That Holds Every Security Available in Proportion.

(At 31:50 start Robin Powell)

Of course investors don’t just buy one stock, one mutual fund or one asset class. Or at least they’d be taking a considerable risk if they did.

It was another Nobel Prize winner – Professor Harry Markowitz – who first emphasized the importance of studying the risks and returns of an entire portfolio.

Index-investing-for-diversification

Index funds provide diversification

Art Barlow from Dimensional Fund Advisors says: “The cornerstone of all of what we call Modern Portfolio Theory rests on this idea of diversification.”

 

Then, in the 1960s came another important breakthrough, when Professor William Sharpe developed what he called the Capital Asset Pricing Model.

The Cap M, as it’s often referred to, is a model for determining the price of a capital asset such as a stock or a bond in an efficient market. The price, Sharpe deduced, depends on two things – the risk of holding that security when markets fall and the expected return. Ideally, Sharpe concluded, an investor should hold all the available securities with a particular market.

And, just in case there are any doubts as to his academic credibility, Sharpe too won the Nobel Prize in Economics.

In the CAPM, Sharpe also introduced the concept of market beta – the measure of the volatility of a security, or portfolio, in comparison to the market as a whole.

Sharpe referred simply to market risk. But, in the decades that followed, fellow academics identified specific types of risk, or beta, often referred to as factors. This gave rise in the 1990s to the Fama-French Three-Factor Model.

Professor Ken French from Tuck School of Business says: “So there was the overall sensitivity to the stock market. We also knew small stocks had a higher premium than big stocks and small stocks tended to move together relative to big stocks. And then we also knew value stocks tend to have a higher average return than growth stocks.”

To the original three factors – market risk, size and value – French and Fama have since added two more, profitability and investment.

So, companies with higher future earnings will have higher stock market returns.

And, perhaps surprisingly, firms that increase capital investment tend to produce poorer subsequent performance than those that don’t.

Eugene Fama from Booth School of Business says: “Profitability and investment explain the value factor, so you can actually drop the value factor if you want to, and use a four-factor model. Will there be more factors in the future? Possibly… A model stands until a better one comes along.”

Now some of that might sound a little complicated. But these are the basic building blocks of what is often referred to as the science of the capital markets. These are very important principles with implications for every investor. So, before we apply these principles, let’s recap.

  1. Markets are competitive, and there are two sides to every trade.
  2. The price of a security is the very latest, best-guess estimation of its value by the entire market.
  3. Because it incorporates and reflects all the available information, markets are therefore very efficient.
  4. Asset prices respond to new information, which is, by nature, random.
  5. Price movements are therefore random as well.
  6. And because the prices of different assets go up and down at different times, it pays to be diversified.
  7. The optimum portfolio is one that holds every security available.
  8. The return you can expect from a particular security is related to the risk of holding it when markets fall, and that risk is known as beta.
  9. But there are different types of risk you can expose yourself to. Small company stocks and value stocks, for example, are generally more volatile than larger company and so-called growth stocks. But if you hold on to them for long enough, they should deliver a higher return.

Part 6: The Reason Index Investing is The Winning Strategy Boils Down to Simple Mathematics.

(At 38:30 start Robin Powell)

So, how can ordinary investors apply the academic evidence – the lessons learned from more than a hundred years of rigorous research? How can they apply that to achieving their financial goals?

Well, this might sound dramatic, but the work of Louis Bachelier, and the Nobel Prize winners like Samuelson, Sharpe and Fama, should make us question everything we thought we knew about investing, and almost everything, the industry and the media is telling us we should be doing.

Most of all, the evidence should make us extremely wary of anyone who claims that they have the knowledge to beat the market. Because, market is a fundamental efficient, consistent out performance is almost impossible.

So, instead of paying large sums in fees to active fund managers to deliver average returns, we should invest instead in passive funds that simply track an index at a much lower cost.

Ultimately, though, it is not about theories or intellectual arguments at all. It all boils down to simple mathematics.

william sharpe on diversification

Professor William Sharp, Nobel Prize winner, concludes that ideally: an investor should hold all the available securities in the market.

 

(At 39:43 start Prof. William Sharpe, Stanford Graduate School of Business, 1990 Nobel Laureate in Economic Sciences)

If you think about a market place and you think about a strategy in which an investor buys a proportion or share of all the securities. So, if you have 1% of the money in the market, you buy 1% of each of the stocks, you buy 1% of each of the amounts of each of the bonds outstanding. So, you have this truly representative market portfolio.

If you are thinking about that strategy and then you think about all the people engaging in other strategies, active strategies, holding these proportion amounts of these or that. Then you ask at the end of any period, a year, a month, you name it, what did the passive investors, the index fund folks, before costs, let’s say that 12%, just to take a number, and then you ask what did the average euro, or whatever currency it may be invested by all the active managers before costs? It has to be the same number. If the total made 12% and the subset made 12%, the other bunch, the average euro in that sector had to make the same amount before costs.

After costs is a different story. A well design indexed fund should have a very low cost of management. It should have a very low turnover, a very low transactions cost.

Actively managed funds, by their very nature, have higher management fees, they employ more skilled people. They also have transactions cost because they are active.

So net of costs, the average euro in the passive sector must outperform the average euro in the active sector. And that’s just arithmetic.

(At 41:36 start Reporter)

Despite the mathematical superiority of passive investing and the wealth of empirical evidence supporting it, the industry has always tried to discredit it. When Vanguard introduced its first index fund in 1976, the idea was slated.

(At 41:55 start John Bogle, Founder of Vanguard Group)

Mr. Johnson, the head of Fidelity said, “I can imagine our shareholders will ever settle for average results. They expect to be superior.”

Famous poster came out on Wall Street: stamp out index funds, they are un-American. And there was Uncle Sam with a cancel stamp, “bam, bam, bam, bam”, canceling all the stock certificates.

Among the many kinds of claims, you can imagine all of this, you wouldn’t settle for an average brain surgeon if you needed brain surgery, so why would you settle for an average manager? As if there is any relevance to those two very different things.

(At 42:28 start Reporter)

It was Bogle who had the last laugh. Vanguard now has more assets under management than any other company in the world – including Fidelity – which, incidentally, is now the second biggest provider of index funds.

And yet, even in the United States, where passive has a bigger market share than in the UK, active remains by far the most popular way to invest.

(At 42:53 start Prof. Eugene Fama, Booth School of Business, University of Chicago)

I laugh because, you know, I have been telling the same story for 52 years now. We had gone from zero passive investment up to about 20 or 30% in the U.S. market, so it is very slow. Penetration is very slow.

So, what I like to remind people of is that active management is a zero sum game before costs.

Trading stocks is a zero sum game before costs

“What I like to remind people of is that active management is a zero sum game before costs.”

 

(At 43:16 start Bill McNabb, Vanguard Asset Management)

The whole cost argument from an investment prospective is actually counter intuitive. You know, if you think about your life in other areas – so, if you are out buying a car and, you know, you can buy a Roll Royce and pay whatever Rolls Royce are going for today, or you can buy an inexpensive Hyundai. You are going to feel a difference in the car. Now whether it is worth, you know, that huge price differential to you, only you, as a buyer can make that decision. But, you are definitely going to feel the difference in quality in terms of durability and so forth.

In investing, that equation doesn’t hold. And so, when you think about the average investor who is also a consumer, you know, they are used to – the more I pay the higher the quality, typically the better the results I get. You come to investing and it is just the opposite and, you know, I think that it is really a hard behavior for people to unlearn.

(At 44:12 start Reporter)

Perhaps surprisingly, another long standing advocate of passing investing is the most famous active investor of all.

Warren Buffett once said: “When the dumb investor realizes how dumb he is and buys and index fund, he becomes smarter than the smartest investors.”

More recently, Buffett gave this instruction to the trusty of his estate. “Put 10% of the cash in short-term government bond and 90% in a very low-cost index fund. The long term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

(At 44:56 start Larry Swedrow, Author, Think Act & Invest Like Warren Buffett)

Warren Buffett is sort of a contradiction here. And so, people take what they want to hear from Buffett. And the contradiction is this. Clearly, Buffett believes the efficient market hypothesis is incorrect and he, himself, has said, “if it was true, I wouldn’t be here. And people like me and Charley Munger will not get the great results.”

index funds outperform the vast majority of investors.

Larry Swedroe reminds us that Warren Buffet said: “If you invest in an index fund, you virtually guaranteed to outperform the vast majority of investors, both institutional and individual; virtually guaranteed.”

 

On the other hand, Buffett has told people in advice in his 1996 shareholder’ letter, he said to people, he said the following: “If you invest in an index fund, you virtually guaranteed to outperform the vast majority of investors, both institutional and individual; virtually guaranteed.

Now, it’s only virtually guaranteed because, he doesn’t know if you are going to be able to stay the cost. If he knew you would stay the cost, which is the second part of it, he would say: “it is guaranteed. It’s simple math.”

Passive investors must outperform active investors in aggregate because they have less cost.

If you look in the mirror and see Warren Buffett, or maybe Charley Munger, or Peter Lynch, go and invest and try to pick stocks and beat the market. The rest of the word looking in the mirror doesn’t see such a sight and then I would suggest you should follow Buffett’s advice and you should invest in index funds or other passively manage funds.

(At 44:16 start reporter)

In recent years, even the great Warren Buffett has failed to beat index funds after costs. It’s little wonder then that increasingly fund managers themselves are starting to acknowledge that this really is a loser’s game.

(At 46:31 start John Redwood MP, Charles Stanley Pan Asset Capital Management)

I think I have realized it years ago when I was an active investor manager. And there were times when we could beat the index. We made the right calls and that was very satisfying. But it is extremely difficult to sustain it year after year.

And the more research I did into it, the more I realized there were very few people who were able to sustain out-performance sufficiently to cover all the extra costs of active investing. So, I gradually came to view that a fund should have more in index tracking than it was then common. In those days I think I favored some sort of mixture.

More recently, the more I have looked at the built up numbers, the more I think it is very difficult to find those star managers who are going to win.

Then there is always the danger that they had very good strategy that works for 2, 3, 5 years. You then buy in, because you were persuaded, and that may be just the point where that strategy starts to go wrong trough no particular fault of their own. Fashions come and go. And quite a lot of so called stellar management performance it is just being on the right particular theme at the time when that is popular in the market.

(At 47:36 start reporter)

So, the fund industry won’t tell you this – it has far too much to lose by doing so – but the most appropriate investment vehicle for the vast majority of investors is the humble index fund.

No, it’s not perfect – we’ll explain why later. And although it’s a relatively simple way to invest, requiring very little maintenance, there are still some very important decisions for index fund investors to make.

(At 48:03 start Merryn Somerset Webb, MoneyWeek)

There is really no such thing as passive investing, because you have to choose where the money is going to go. Somebody has to choose if the money is going in Japan, or South America, or you know, [inaudible] or Russia, or whatever it is.

Those decisions have to be made. Those are active decisions. Then, once you’ve made those decisions you are choosing the ETF or you are choosing the tracker, whatever it is, and in doing that, you are choosing your strategy.

(At 48:27 reporter

But there is another, much bigger, issue that needs to be addressed. As we’ve heard, passive investing is still far less popular than active. But what if that changes? What if passive continues to grow? And eventually, most people decided to invest passively?

(At 48:44 Prof. John Cochrane, Booth School of Business, University of Chicago)

Here is how the perfect world of the Chicago efficient market theory of finance works. We all get religion and we all just index.

And then, one guy thinks: “You know, the new Iphone is great. I would like to buy Apple. Apple is only 500 a share, it is worth a 1000. I am going to buy some Apple.” And says: “Hey guys, I am going to buy your Apple. I want to offer you 600$ a share.”

And we say: “We are just indexers. We are not going to alter our market. You must know something that we don’t know, so we are going to hold the Apple in its market. Oh gosh.”

“How about 700?”

“We are just indexers.”

And then finally, he beats the price up to a $1,000 a share.

The ideal world, this is not the real world, the ideal world – if we all indexed, we would never lose to the active managers because we would never sell. And they would just bid the prices up so prices reflect information.

You can see the hole in the story. The active manager should go drive a cab. He is not earning any money.

index investing is still far less popular than active

In the ideal world, if we all indexed, we would never lose to the active managers because we would never sell. The active manager is not earning any money. But we don’t live in that ideal world.

 

Our world is one in which active managers do trade, and they trade and make money and they bring the information in. The big puzzle is who trades against them? Why don’t we defend, those of us that we don’t know anything, why don’t we defend ourselves just by indexing?

Part 7: Is There a Scheme Better Than Holding The Market Index?

(At 50:00 start Robin Powell)

So, we’ve explained how the academic evidence points overwhelmingly to indexing being the best way for the vast majority of people to invest.

Index funds should form the biggest part of every portfolio.

We’ve already mentioned the importance of asset allocation – deciding how much to invest in equities or bonds, for example.

Another key decision is what type – or types – of index fund to go for.

The traditional and still the most common type is the cap-weighted or market value-weighted fund.

One drawback with cap-weighted funds is that as the price of a stock goes up, so does its weighting.

That can sometimes leave you over-weighted in a relatively small number of stocks.

(At 50:45 Prof. Stephen Thomas, Cass Business School)

Go back to 1999, 2000, the technology bubble. You know, you suddenly had 6 to 7, 8% of the portfolio in Cisco and the next thing it’s bombed out. So the question then is: is there a better way of constructing a portfolio, a better way of constructing, if you like, an index?

And some experiments in the past – they’ve been going on for 10 years – have suggested there are better ways. I’ll give you a really simple example. Instead of weighting by the market capitalization of each stock, how about waiting by or making it equal-rated. So you’ve got 100 stocks in the FTSE. Put 1% in each.

So that’s the sort of thing that starts us researching, looking at the top 1000 US stocks, and asking, “are simple rules like that?” We call them heuristics. “Are they capable of forming portfolios that actually do better over time than buying, say, the S&P 500 or the FTSE 100?”

(At 51:37 Reporter)

You’ll remember we looked at different types of risk, or beta – often known as factors. Certain types of stocks are more volatile but do offer higher returns in the long run.

It’s now possible to buy an index fund comprised entirely of small-company or value stocks, for example, to complement conventional index funds. They’re more expensive than cap-weighted funds but still far cheaper than actively managed funds.

This sort of strategy is usually referred to as smart beta, though others call it alternative beta, fundamental indexing, factor investing or tilting. Whatever name you prefer to call it, it’s becoming increasingly popular.

(At 52:21 Prof. Eugene Fama, Booth School of Business, University of Chicago)

The overall cap-weight market portfolio – including everything, not just stocks -is always a legitimate portfolio in any asset-pricing model. It’s always one of the so-called efficient portfolios.

But if you take, for example, our work seriously, what it says is there are multiple dimensions of risk and you can tilt towards these dimensions, so you can move away from the market portfolio towards these dimensions depending on your taste for bearing different sources of risk. There isn’t one strategy that’s optimal or efficient in the sense as the whole spectrum.

(At 52:57 Reporter)

A staunch proponent of this approach is Yves Choueifaty, who runs TOBAM, an asset management company based in Paris.

For him, it’s all about diversification. Ideally, the investor should be exposed to all the different risk factors.

index investing and diversification

Yves Choueifaty says, “In order to build a diversified portfolio, you would want to try your best to have your own risk evenly contributed by all the risk factors that are available in the universe.”

 

(At 53:13 Yves Choueifaty, Founder & President, TOBAM)

In order to build a diversified portfolio, you would want to try your best to have your own risk evenly contributed by all the risk factors that are available in the universe. If every single source of this, if every single risk factor, evenly contributes to my own risk, by definition you will not be able to tell me that I am biased, and if you cannot say that I am biased, probably I will be able to say that I am diversified.

(At 53:40 Reporter)

Others are more skeptical about smart beta – or at least that particular label.

(At 53:45 Nick Blake, Vanguard Asset Management)

I think the name is unfortunate in that it seems to suggest that it’s a smart outcome, when in fact smart is a requirement when it comes to smart beta, as it is called. It is factor bet, it a ruled based factor bet, where somebody is choosing to index a part of the market, or a part of a broader market cap index. Now, that in itself can be fine, but I think it is important to understand that you are taking a very active decision at the start there, to actively go off to one factor of the market.

(At 54:16 Richard Wood, Barnett Ravenscroft Wealth Management)

I think it might seem more complicated for an investor, because previously you were active then passive. It has taken us a long time to get across what passive is, and I still don’t think many people understand what it is. Yes, we believe that smart beta is another way of getting an extra 1 or 2% return per year, but to the average person on the street, I think it does confuse them and just means that there’s more product for them to actually try to understand.

(At 54:43 David Swanwick, Dimensional Fund Advisors)

I think smart beta is another industry label that has emerged out of the fund management community, possibly out of some marketing departments, cynically.

The best question an investor can ask is: “where do returns come from?”

And really no one has studied this more deeply than the academic community. And so when it comes to investment capital, it makes so much sense to do with that capital only that which has been proven and that’s where dimensions of return become so powerful, because they have survived peer review. They have survived intense scrutiny.

(At 55:20 Reporter)

Complicated or not, is smart beta an option worth exploring? Well, it might be, depending on the level of risk you’re willing to take.

(At 55:27 Prof. John Cochrane, Booth School of Business, University of Chicago)

One touchstone to remember: the average investor has to hold the market portfolio. If you decide you are going to buy value, somebody else has to hold less value. If you are going to buy Microsoft, somebody else has to hold less Microsoft. The average portfolio has to add up to the market. And anybody who outperforms the market, somebody else has to underperform the market.

We need a better theory of why we should do anything but just hold the market index. I do think there is one. And that is if you view these as alternative dimensions of risk and that what we’re doing in asset markets is basically writing insurance to each other. Look at the stocks. Are you really the kind of investor who can bear that kind of risk? And what you are doing is writing insurance to other investors who don’t want to bear that kind of risk. What is the risk? Why are some people not willing to bear that risk? Why can’t I bear that risk? It is a good place to start thinking about what are the alternative betas you want to invest.

Part 8: Tilt A Portfolio of Index Funds To Get Higher Expected Returns With Greater Volatility.

(At 56:30 start Robin Powell)

Before moving on, let’s briefly summarize.

  • Mathematically, after costs, the average returns of a passive investor have to exceed the average returns of an active investor.
  • The market cap-weighted index reflects the consensus view of the market and therefore is the ideal starting point for a passive investor.
  • But the cap-weighted index isn’t perfect and, depending on how much risk they’re prepared to take, investors may want to tilt their portfolios towards other types of risk, or beta, such as small company or value stocks.

Beta, as we’ve said, is a measure of overall market risk. But what about alpha? that’s the name given to any return provided by a fund or an individual security over and above the benchmark index.

First and foremost you should be indexing. Alternatively you could tilt your portfolio towards different types of risk.

But is there ever a case for chasing alpha – either by choosing stocks yourself or by employing an active fund manager?

(At 57:38 start Ken French, Tuck School of Business)

That’s a great question. What I know, is the average investor who does invest in an active fund, has to expect to lose relative to a passive strategy. Why do I say that? What I know is, if one active investor chooses to overweight some stock, then at least one other active investor has to underweight that stock. One might win by over weighting. If he wins, [the other] loses by under weighting.

It’s a zero sum game before we start thinking about cost. And what I expect, but we see over and over again, is that active trading costs money. And active managers charge a lot for their services. Now notice, one of them might have been brilliant, but the extent that one of them is brilliant, the person on the other side must be whatever the negative of brilliant is here. Minus brilliant.

(At 58:39 start John Cochrane, Booth School of Business, University of Chicago)

I take a dim view of active management. For any investor to invest, you have to understand why the person you’re giving your money to, is in the half that’s going to make money and not the half that’s going to lose money. What’s special about him? What’s special about you, that you know how to evaluate him? Somebody has to have some skill.

There’s evidence on how much skill is there out there. How many good managers are there? How many bad managers are there? And it’s really depressing. If you don’t know what you’re doing, don’t step into the casino.

(At 59:06 Reporter)

So, let’s be clear about this. All the evidence is stacked against active fund management. But say for example, in spite of everything our experts have said, you still want to take a gamble with part of your portfolio. How do you choose an active fund, from the thousands of funds available?

(At 59:26 start Daniel Godfrey)

Well certainly not just by looking at past performance. A Consumer would need to do a number of things. Firstly, they can just offset the decision making altogether and go to an independent financial advisor. And many do. And they will select funds for them. And that may be a mix of active and passive funds. And that’s a perfectly sensible thing to do. But they may also, if they wish to make decisions for themselves, wish to look not only at a manager’s track record but to actually read about what they say about themselves, their style of choosing stocks, and to read what the people in the media say about them.

(At 01:00:08 start Bill McNabb, Vanguard Asset Management)

What they want to look for are generally broadly diversified portfolios. They want to look at the portfolio manager and the company behind that manager and make sure that they’re long-tenured. That they’ve had a consistent process and a consistent philosophy. You don’t want people who change their stripes every couple years or every market cycle. The other thing you want to look at is what price you’re paying. Morningstar did some really groundbreaking work a couple years ago, where they found the best predictor of future performance is actually cost. If you get the right manager, with a long-term philosophy, and a consistent philosophy, and you have a low price portfolio, your chances of actually performing as well or better than the index go up.

(At 01:00:55 start Reporter)

An example of a fund management company that does take a long-term view and which keeps costs down by trading less is Edinborough-based Saracen Fund Managers.

(At 01:01:05 start David Keir, Head of Research, Saracen Fund Managers)

I think in the old days, everyone tried to take a long-term approach but it feels with the advent of hedge funds, costly numbers, a lot of the fund management industry has been getting caught up in the short-term noise and volatility caused by costly results and news flow. We try and strip that out and actually take a long-term view. What we do here is we forecast out five years, which is much longer-term than the market does. To try and take advantage of and identify opportunities.

(At 01:01:33 start reporter)

Statistically, small funds, like those run by Saracen, tend to perform better than very large ones and their managers are more likely to invest their own money in them, which is always a good sign.

(At 01:01:45 start Graham Campbell, chief Executive, Saracen Fund Managers)

Many of the large firms, the managers aren’t allied with the investors, because they’re paid by bonuses for performance, not for how well the fund does directly. One thing that Warren Buffett certainly has, is a huge amount of his own personal savings involved with his fund. And an investor should be almost considered as a fund manager allied with them as much as they should be.

(At 01:02:08 start reporter)

Also, remember the benefit of having exposure to different factors of risk. Value investing is particularly worth investigating. As are the writings of the man usually credited with founding it, British-born, American-academic, and professional investor, Benjamin Graham. For an insight into Graham’s investment philosophy, we visited the university where he studied and taught, Columbia in New York City.

(At 01:02:34 start Prof. Bruce Greenwald, Columbia Business School)

You’re looking for cheap, ugly, disappointing, obscure, and otherwise orphaned stocks. Portfolios formed on those bases, significantly outperform portfolios of glamour stocks. And I think there are three fundamental human characteristics that account for the persistent, out performance of those portfolios.

The first is that people will systematically overpay for the dream of getting rich quick. And that’s why these glamour stocks get overvalued. And remember the average return has to be the average return on all stocks. People who specialize in the glamour stocks are going to under perform the market. And so staying away from them will benefit you.

Second thing is people don’t like to look closely at ugly. The behavioral finance name for this is loss aversion. And you look at these portfolios of cheap stocks, 2/3 of them go bankrupt. But the ones that don’t, do so well that the portfolios of these stocks substantially outperform the market.

The third thing that I think cements the first two effects: human beings are not good at dealing with uncertainty. And therefore, when they think about situations, they try and assume the uncertainty away and are overconfident.

(At 01:03:59 start reporter)

Like Bechellies, Samuelson, Sharp, and Fama, Graham’s aim was to take the guesswork out of picking stocks. He famously inspired one of his pupils, Warren Buffett, and Buffett’s subsequent success is testimony to the validity of Graham’s approach.

Warren Buffett has described Benjamin Graham’s book, The Intelligent Investor, as, “By far the best book about investing ever written.” In it, Graham wrote that, “Investment is most intelligent when it is most business-like.” In his preface to the fourth edition of the book, Buffett said, “The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you’ll profit from folly rather than participate in it.”

Part 9: Your Behavior As An Investor, is Critical.

(At 1:04:52 start Robin Powell)

And that brings us to another important aspect of successful investing. Whichever route you choose to go down; rather it’s passive, active or somewhere in between, your behavior is absolutely critical. Especially at times that emotions are running high.

(At 1:05:11 start David Booth, Founder, Dimensional Fund Advisors)

One of the big difficulties is getting people to stay the course when results are disappointing. It should come as no surprise to people that markets go up and they go down. When they go down, there’s a tendency people go, gosh, are we on the edge of an abyss. Will things really get bad from here? Like in 2008, 2009 it was difficult to get people to stay the course, and my heart goes out to these people that were investing in equities, lost half their money, and then got out and missed the rebound. It may take quite a while for them ever to get back even again.

(At 1:05:47 Reporter)

Everyone knows the idea is to buy low and sell high, but time and again we do the precise opposite. This chart shows how much money US investors are put into and taken out of equity funds since the late 1990s. The graph peaks in January 2000, in other words, investors were piling in just as the market reached the top. Then, even worse, they bailed out just as prices reached the bottom and were about to rise again. That kind of behavior is sadly all too typical, and even the professionals are prone to it. The effect on the long term value of our investments can be catastrophic.

So how do we as investors curb that sort of self-destructive behavior? Well one way is to have an automated approach to investing. So, you choose your strategy and the level of risk you’re prepared to take, and then you leave your investments exactly as they are. Either once, or at the most, twice a year you re-balance your portfolio to realign it with your tolerance of risk, but again, that can be done automatically.

(At 1:06:59 start Merryn Somerset Webb, MoneyWeek)

There a lots of styles that work over the long term. Value works, dividend investing works, momentum investing works, if you get it right. All sorts of things work. But they only work if you stick with them, and one of the problems that active fund managers have is it’s very very difficult for them to stick with any kind of style because they get buffered around by opinion, by different methods of evaluation, by markets, by what people say from in the pub, by what their colleagues are doing, etc. It’s very hard for them to stick to a strategy. You know, what I see fund managers, and I see a lot of fund managers, they pretty much will tell me the same thing. They have a strategy, they outline their strategy, it’s very often quality or value or income based. They have back tested it, they show me their back testing. It looks great, they go away and you think, well if you do that, that’ll work out very well, but they never do it. Or if they do do it, they do it for six months, or eight months and then they’re distracted by something, the strategy changes, and their performance suffers as a result. But what fundamental indexes do, or indexes that are based on any one particular factor, is they force consistency. You have to choose a style and then the computer makes you stick to that style, and that’s when it works.

(At 1:08:06 Reporter)

It also helps to have a financial adviser to keep you on track, but not just any advisor. Far too many advisers believe, wrongly, that their primary role is to pick the right funds to persuade their clients to switch to a different fund, when inevitably their original recommendation under-performs.

(At 1:08:25 start Charles Ellis, Investment author)

There are two great roles for an advisor. One is to help individuals understand themselves and what their real financial purposes are, and what their anxieties would be and anticipation so they can lay out really sensible long term investment program. That’s one, and the second is to hold hands and encourage staying the long long long term. Because the long term and be very very positive. If we only had the ability to stay with it through the thick and the thin, through the exciting positives through the terrifying negatives that cause most of us to make mistakes.

(At 1:09:03 start John Bogle)

Why in the name of peace do we pay attention to the stock market? The stock market is a derivative. The stock market is a derivative of a what? Is a derivative of the earning power and dividend yields on, in the case of this nation, of U.S. corporations. The dividend yield plus the earnings growth that follows is what creates the fundamental return on stock. The speculative return on stocks, compared to that investment return, is how much people are willing to pay for a dollar’s earnings. That carries the market up and down and in the long run, in the last hundred years, the contribution of speculative return, the total market return is zero. The contribution of investment return, we happen to have had 4.5% dividend yield, 4.5% earnings growth, that’s the 9% you read about in the past for the US market. The stock market is a giant distraction to the business of investing.

(At 1:10:09 Reporter)

Of course it doesn’t help that we’re constantly hearing about the markets. There are specialist magazines, almost every major newspaper has a money section. There are radio shows, and of course entire television channels devoted to the latest on the markets, and where the so-called experts think they’re heading.

wealth management and index investing

Igors Alferovs says, “When it comes to investor returns, the media is definitely a bad influence on investors.”

(At 01:10:28 start Igors Alferovs, Barnett Ravenscroft Wealth Management)

When it comes to investor returns the media is definitely a bad influence on the retail investor. What the media does is encourage activity. It encourages people to buy and sell. Invariably it’s not just the unnecessary costs involved in a lot of buying and selling, it leads to people making bad timing decisions. For their own benefit, I think investor should block out as much noise as possible.

(At 01:10:57 Reporter)

And that, in a nutshell, is the secret to winning the loser’s game. First, choose a strategy that’s based on evidence, preferably one designed to capture the returns of the whole market and then tailor it to your attitude to risk. Secondly, stick to your chosen strategy through thick and thin. Yes, re-balance your portfolio, but most important of all, stay the course.

When you look at the bigger picture, the investment industry isn’t just failing individual investors, it’s failing the economy and wider society as well. So, what could be done about it?

Part 10: The Investment Industry is Failing Individuals, and Society as a Whole.

(At 1:11:35 start Robin Powell)

Our journey is almost done. We’ve explained how the odds are heavily stacked against the ordinary investor and how by settling for an average return and refusing to pay a small fortune in charges you can end up as one of the winners, saving yourself a great deal of time, effort, and worry in the process.

There is a much bigger issue here. It’s not just we as individuals who are losing out. The whole world faces a pensions crisis. We’re living longer and although most of us will work longer, there’ll be huge numbers of people retiring without enough funds to sustain them throughout their later lives.

In deciding to dispense with active management for its local government pensions scheme, the UK has joined a list of governments including Australia, Norway, and California which have started to question the traditional way of doing things.

(At 01:12:35 start Michael Johnson)

Governments are realizing that to the extent that pensioners have small pensions, they ultimately fall back on the state for assistance. There is a very strong economic rationale to have pension funds perform better.

(At 01:12:51 Narrator)

The investing sector has become a key component of the global economy. Here in Scotland for example, hundreds of fund managers, brokers, advisory firms, and consultants have concentrated around Edinburgh, now Europe’s 4th largest financial center. Yes, the sector does make a significant contribution to economic wealth and tax revenues but as we’ve seen, it also takes a great deal from ordinary investors through the charges it levies. So has the investment industry simply grown too big for our own good?

(At 01:13:46 start Merryn Somerset Webb)

Merryn Somerset Webb from MoneyWeek says: “The fund management industry needs huge reform, of course it does. There are way too many funds. There’s way too much attempt to produce difference out of nothing. This is a huge problem in the financial industry. If you want to sell things, you need to differentiate yourself from the next guy along.

But in fact, investing is remarkably simple—not necessarily easy, but simple—straight forward.

  • It doesn’t need so many different products.
  • It doesn’t need so much differentiation.
  • It doesn’t need quite so many people.
  • And it doesn’t need to be so expensive.

(At 01:13:59 David Tuckett)

I think the real problem is there’s far too much expectations in this whole arena. This will be disappointing news for people in finance in a way but we’ve got too many people employed in it, doing too much, trading too much for very small amounts of gain for the population as a whole but of course a very large transfer of finance into the hands of the people doing it.

(At 01:14:25 Narrator)

The industry says that it accepts that passive approaches to investing are likely to become more popular but not surprisingly it doesn’t like the idea of the active funds sector contracting.

(At 01:14:37 Daniel Godfrey)

I don’t fear for the future because I think that active will maintain a very strong role in investment management as a whole but I think that it would be detrimental to the operation of the market, to capital investment in corporate UK if active were to become too marginalized and I don’t believe that will happen.

(At 01:14:57 Narrator)

It’s true that the market system needs active managers to function but the academic consensus is that a global fund industry just 20% the size it currently is would be more than sufficient to maintain market efficiency. Many of our experts also believe that the huge financial rewards offered to fund managers are counterproductive in that they incentivize very short-term outperformance when most people are, or at least should be, investing for the much longer term.

In 2013, the average Wall Street bonus rose by 15%, bringing the overall industry total to a staggering 26.7 billion dollars. Remember, that’s not salaries, that’s just bonuses.

(At 01:15:44 Merryn Webb)

The bonus system is absolutely ridiculous. The very idea that we should be paying people extra if they perform well I always find absolutely infuriating on the basis that we’re already paying them for them to do their best, if they do do their best, why should be have to pay them more?

(At 01:15:59 Narrator)

If there were fewer fund managers earning more modest pay packages, perhaps more of our brightest graduates would shun the city and pursue careers instead in sectors where they really can make a difference. As John Bogle likes to say, “It’s not the speculators or the markets that add value. Ultimately it’s successful businesses that drive investment returns.” Despite the lazy way in which business and the markets are often lumped together by journalists and politicians, those are in fact two very different things.

(At 01:16:36 John Bogle)

The function of the securities markets is to allow new capital to be directed to their highest and best use. That’s true, but think about the math for a minute. We probably get in the last couple years maybe 300 billion a year that goes to new offerings, IPO’s, and additional offerings. We trade 56 … most recent number … 56 trillion and that means something like 99.5% of what the stock market does … of what we do as investors is trade with one another and 0.5% is directing capital to new business. There is a system that has failed society. Period.

(At 01:17:22 Narrator)

There’s wide agreement that the investment industry needs to change but where will change come from?

(At 01:17:28 Michael Johnson)

I believe the industry realizes a lot more than it’s ever willing to fess up. Underneath the surface, the individuals in the city in general realize that they’ve had it too good for too long. Now will change from within? Pretty unlikely. The trade body is, of which the IMA is one, are masters at doing just enough to keep the show on the road in terms of hinting at change and improvement for the consumer is around the corner.

(At 01:18:04 Richard Wood)

The IMA, Investment Management Association, is a trade body that is there for its members. It is financed and supported by the members which is the fund management industry and the banking industry. Is it doing a better job of protecting the investor and making things more transparent for an investor? Definitely not.

(At 01:18:24 Narrator)

Michael Johnson sees a key role for journalists and educators in bringing about change for the better.

(At 01:18:32 Michael Johnson)

There’s a strong campaign for example to increase education in schools … financial literacy. Maybe that’s a starting point and the media could usefully attune itself to the level of technical understanding of the man in the street in an explaining role as well as an inquisitive role rather than simply reporting the stories that it’s given by highly paid PR agents actually on behalf of very wealthy clients.

(At 01:19:04 Narrator)

Ultimately though, it’s up to us, ordinary investors, to demand a better deal. Yes, we do need to put more into out pensions and other long term investments but we also have to start questioning why the industry is taking so much out … to start insisting on a fairer share of investment returns, especially as those returns in future are likely to be smaller than they have been in the past. We need to wise up, to be more realistic. We have to be less gullible and yes, perhaps a little less greedy as well. There are no magic shortcuts to successful investing but over the last 120 years or so we’ve learned so much about how it works that it’s simply not necessary any more to pay expensive experts to gamble with our money. Together we will win this game in the end.

(At 01:20:06 John Bogle)

There’s this great quote from Adam Smith in The Wealth of Nations that says, “there’s one principle that is so simple and so universal we don’t even need to defend it and that is the ultimate object of all business should be to serve the consumer.

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Footnotes and Video Production Credits

The video on this page is the best I’ve seen on this topic. It was produced by Sensibleinvesting.tv and they own the copyright. They have given me permission to embed this via YouTube onto this educational website.

Sensibleinvesting.tv provides information and opinion on low-cost, evidence-based (passive) investing. They are based in the United Kingdom, but their lessons are universal.

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