Is Dogbert your Financial Advisor?

Have you really reviewed what your investment fees are?

Many dont even know what they are paying due to hidden fees in mutual funds and the way many advisers bill their clients.

A fee-only advisor will openly disclose all the fees you are paying and how you are paying them.

To find a Fee-Only advisor in your area go to: http://www.napfa.org/

For more from Dilbert's creator Scott Adams read this great piece from the WSJ:

http://online.wsj.com/article/SB10001424052748704913304575370913870866820.html?mod=ITP_thejournalreport_0 

VERY SIMPLE YET VERY POWERFUL

The following quote is from Mike Pipers book "Investing Made Simple"
It is a simple expansion on Nobel prize winner William Sharpe's explanation of why index funds beat most other investors.

Why Index Funds Win: If the entire stock market earns, say, a 9% annual return over a given decade, and the average dollar invested in the stock market incurs investment costs (such as brokerage commissions and mutual fund fees) of 1.5%,  …then the average dollar invested in the stock market must have earned a net return of 7.5%.

Now, what if you had invested in an index fund that simply sought to match the market’s return, while incurring only minimal expenses of, say, 0.2%? You would have earned a return of 8.8%, and you would have come out ahead of most other investors. It’s counterintuitive to think that by not attempting to outperform the market, an investor can actually come out above average. But it’s completely true. The math is indisputable. John Bogle (the founder of Vanguard and the creator of the first index fund) refers to this phenomenon as “The Relentless Rules of Humble Arithmetic.”

Piper, Mike (2009-10-01). Investing Made Simple: Index Fund Investing and ETF Investing Explained in 100 Pages or Less (Kindle Locations 453-458). Simple Subjects, LLC. Kindle Edition.

The Truth is "I Dont Know"

Above is from the brillant Ally Bank commercial.

Below is a quote from the 1940 investment book "Where are the Customers Yachts"

For one thing, customers have an unfortunate habit of asking about the financial future. Now if you do someone the signal honor of asking him a difficult question, you may be assured that you will get a detailed answer. Rarely will it be the most difficult of all answers - "I Dont Know"

The lesson is that as much as we crave AND PAY for financial prognostications. In the long run, we really dont know. In fact, what we do know is embedded in the price of the security. In other words the expected is built into the price. The problem comes when the expected fails to happen. Then we have volatility in our investments.

I am often confronted by investors that think that if they pay high expenses to large firms they will get some insight into the future. Unfortunately, after all their charts and graphs and analysis they do not prove to know more than the market as a whole. And, after the fees for the crystal ball gazing, the big firms underperform the market over time.

This reminds me of the Malcom Gladwell piece in The New Yorker. He tells the story of the brilliant investor: Victor Niederhoffer, who in 2001 was predicting that the markets would be quite. He had his fortune invested that way. Then planes flew into the world Trade Centers.

http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm

In the end: we just cant predict what tomorrow will bring.


What I do know is this: The best thing one can do is build a stock portfolio that looks like the market, then balance it with short term bonds based on the amount of risk you need to mitigate.
This can be done with low cost index funds and ETFs and the help of a fee-only advisor who can help you determine how much risk you are comfortable with and who can then gude you to an appropriate portfolio - all at a reasonable cost.

Where Are The Customers Yachts?

Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said "look, those are the bankers' and brokers' yachts."
"Where are the customers' yachts?" asked the naive visitor.

-Ancient Story

The above is the epilogue to the classic investment book: "Where are The Customers Yachts."

 Many feel that they have to pay large sums to large firms to help them with the elusive idea that their investments will consistently beat the market. Unfortunately, nobody has found the formula to beat the market. The only ones getting rich are the banks and brokers. So why not just be the market?
The best thing one can do is build a stock portfolio that looks like the market, then balance it with short term bonds based on the amount of risk you need to mitigate.
This can be done with low cost index funds and ETFs and the help of a fee-only advisor (if needed).

The Power of Hope Over Probability

Las Vegas, Reno, Atlantic City are built on the simple premise that humans want to believe they will end on the winning side of a bet -  even when the bet is rigged against them. Gamblers know the house is always a net winner. Some will win and more than half will lose. They know that the Vegas strip was not built because casino's have been lucky. They just hope that luck will be on their side.



The same can be said in the investment world. The  investors who place their money with active managers are analogous to the swarms of gamblers hoping for the big pay off.

Investors place their money with active managers even though many know that over 10 year periods, active managers underperform indexes almost 90% of the time. Investors are willing to incur high fees and transaction costs in the attempt to beat the market. But year after year only 1/2 of active managers beat their index benchmark, the other 1/2 underperform. This is a mathematical fact. When you add in fees and transaction costs well over 1/2 of active managers/mutual funds underperform their respective market index.




Why do investors ignore this mathematical certainty and continue to pay high fees for active management?

It is the power of HOPE over PROBABILITY.




Like a gambler at a casino, many investors ignore the probabilities and hope to find a way to beat the market. They pay for stock and mutual fund picking advice, they pay high mutual fund fees, they pay for expensive newsletters, all in the hope that they can have an edge in outsmarting the market and be on the winning side. Unfortunately, to date, there is no system that exists that will outperform the market on a risk adjusted basis. If there was wouldn't we all be following it?????

When it comes to your future does it make sense to put hope over probability?

Remember these 5 truths about capital markets:

1. Higher return means higher risk. Your friend who talks about his big returns is taking a bigger risk than you. That means that when times are bad he is likely losing more than you.
2. The index return of a market is the average of all investors returns in that market. That means about 1/2 outperform and the other 1/2 underperform that particular market.
3. Net of fees, more than 1/2 must underperform the respective index of the market.
4. Over time very few stock pickers or mutual funds  consistently outperform the market -  the one who outperforms in a given year is not the same who outperforms in the following year.
5. It is impossible to predict the winners ahead of time.

When investing in the stock or bond markets why not invest in index funds and be like the casino - knowing that math is on your side and that over time you have a high probability of outperforming the average active investor.

NOTE: This does not mean that you are guaranteed to have a positive return with index funds. It simply means that over time, net of fees, indexes outperform the  majority of active managers with the same investment style.

Are you an investing Ahab?

"I need Facebook IPO" phone calls and a recent WSJ article on zombie funds leads me to reflect on the fact that most investors are like Moby Dick's captain Ahab. Ahab was obsessed with catching the white whale, Moby Dick. An obsession that lead him down a path of his own destruction.

Many spend their money paying advisers to produce market beating returns and in the end don't do better than a simple buy and hold strategy. Then there are those who invest with the Madoff's of the world and end up losing much more than a good return.

They somehow believe that they can get instantly rich in the market, they spend money on  software systems or advisory services. They spend hours watching CNBC, and watching the market, and worry about whether they should own more gold or Facebook. 

Unfortunately, many drive themselves into an Ahabian obsession with finding the great return.  They ignore the fact that a simple buy and hold strategy of holding an index of the US stock market since 1973 would have earned 10.5% through 2010. Holding the US market since 1927 would have earned 9.8%. 

Two years ago I attended the Get Motivated seminar at HSBC Arena in Buffalo NY. It is more of a day of infomercials interspersed with motivational speakers. One of the pitches that day was a stock picking software system - just buy on the up arrows and sell on the down. The crowd swarmed to the sales desks by the thousands to purchase the system. They were never told about trading costs or  short term taxes, nor was there discussion about what to do when negative news on one of your stocks hits the market when you are out golfing. I just shook my head at the power of a great sales pitch and the desire of humans to get rich quick and easy.

Study after study shows that over the long run very few outperform the market on a consistent basis. Yet so many sail the seas trying to beat the market. In the end it is the brokers and advisers that sail the seas in their customer paid for yachts. 


 In fact when Harry Markopolos, author of the book No One Would Listen, tried to warn regulators in 2000 that the 15% sustained return promised by Madoff was impossible in the capital markets no one would listen. The point here is that Markopolos knew that those kind of consistent returns dont exist in the stock market. So why do so many continue to reach for returns that have never existed?  Probably because we believe in America that we can get rich overnight, that we can time the market, pick the winning stock. In the end, those tasks are nearly impossible to achieve. Therefore, most investors would do themselves a favor and just purchase a diversified portfolio of index funds that give them exposure to the US stock market, the global stock market and the bond market and relax while the Ahabs of the world make themselves crazy. 

The "Perfect Portfolio" - great advice from the Oblivious Investor

Below is a short section of a recent blog from one of my favorite financial bloggers: The Oblivious Investor (http://www.obliviousinvestor.com). It is about as perfect advice on portfolio structure that you can get.

Forget about Perfect

Even the idea that it’s possible to have a perfect portfolio is problematic. It can make people want to change their portfolios all the time based on the most recent convincing-sounding argument they’ve read. (I know this personally, because I used to struggle with it myself.) And it can keep people from focusing on other things — such as savings rateor retirement age — that are generally more important than asset allocation.

Instead of searching for a perfect portfolio, I’d suggest the following approach:

1. Work out a “good enough” portfolio.
2. Recognize that it will not be perfect and that there will always be well-reasoned portfolios/strategies that have outperformed you over any particular period you choose to examine.
3. Implement the portfolio anyway and move on with your life.

What Makes a “Good Enough” Portfolio?

As far as what makes a portfolio “good enough,” it’s not anything tricky:

• It should be diversified. (This does not necessarily require several mutual funds.)
• It should have a roughly appropriate asset allocation for your risk tolerance. (Consider limiting your stock allocation to twice your maximum tolerable loss.)
• It should have low costs.

Investing Insight from "How We Decide"

"The secret is there is no secret" this quote is from:
Lehrer, Jonah (2010-01-14). How We Decide (Kindle Locations 1088-1098). Houghton Mifflin Harcourt. Kindle Edition.

"How We Decide" by Jonah Lehrer is wonderful. If you have any interest on how the brain works I highly recommend this interesting and readable book.

In the quote below he summarizes how the brain effects investing decisions: the dopamines in your primal/reactive/lizard brain want to see patterns in the world. This usually spells disaster for investors:

"The lesson here is that it's silly to try to beat the market with your brain. Dopamine neurons weren't designed to deal with the random oscillations of Wall Street. When you spend lots of money on investment-management fees, or sink your savings into the latest hot mutual fund, or pursue unrealistic growth goals, you are slavishly following your primitive reward circuits. Unfortunately, the same circuits that are so good at tracking juice rewards and radar blips will fail completely in these utterly unpredictable situations. That's why, over the long run, a randomly selected stock portfolio will beat the expensive experts with their fancy computer models. And why the vast majority of mutual funds in any given year will underperform the S&P 500. Even those funds that do manage to beat the market rarely do so for long. Their models work haphazardly; their successes are inconsistent. Since the market is a random walk with an upward slope, the best solution is to pick a low-cost index fund and wait. Patiently. Don't fixate on what might have been or obsess over someone else's profits. The investor who does nothing to his stock portfolio—who doesn't buy or sell a single stock—outperforms the average "active" investor by nearly 10 percent. Wall Street has always searched for the secret algorithm of financial success, but the secret is, there is no secret. The world is more random than we can imagine. That's what our emotions cant understand."

Book Review: "Are you a Stock or a Bond"

 "Moshe Milevsky's book can be looked at as 2 books. Book 1 is how to save for retirement. He argues that you are the CEO of YOU Inc. and that you need to manage your lifes balance sheet. He argues that if you have a job that is very stable and offers a good defined benefit plan (the old classic - when you retire your employer will pay you a constant payment in retirement) , that plan is like owning a safe bond. You can then invest more heavily in stocks. Conversely, if you make your money in a  volatile industry or in a field that is effected by the stock market then you should save more in bonds - this serves as a hedge or insurance against a bad stock market on your (YOU Inc.'s) balance sheet.
Part 2 of the book, in my opinion, is great. He develops a decision model for retirees to protect their life's savings. He recommends that a person break their retirement into 3 types of funds: Lifetime annuities, some sort of limited time period guaranteed annuity payment, and an investment account. The model he presents takes into account a retires spending needs along with estate planning desires to develop a probability of success strategy that limits downside risk of running out of money while in retrement. Something that, as we are living longer, needs to be an important part of the retirement planning process.

I Bonds: Limited to $10,000/yr, But Great Safe Savings Option

In an environment where earning a good return in a safe, savings vehicle is very difficult, I Bonds offer a wonderful and safe option - provided that you dont need the funds within a year. Think of the I bond as a 12 month CD.

Below is an excerpt from a 3/10/2012 WSJ article by Ruth Simon:

"I Savings Bonds, issued by the U.S. Treasury, offer one of the best deals for savers, though in small doses. Unlike a typical supersafe investment, the interest rate on I Bonds has two parts: a fixed rate that lasts for the life of the bond and a variable inflation rate that is adjusted twice a year based on changes in the consumer-price index. Currently, the fixed rate is 0% and the inflation rate is 3.06%, meaning investors receive a 3.06% yield.


"With I bonds, you are at least guaranteed to keep pace with inflation," notes Mel Lindauer, co-author of "The Bogleheads' Guide to Investing," a resource for fee-wary investors. I Bonds also have several tax advantages. Among them: They are exempt from state and local taxes, and interest income is tax-deferred.


One downside is that investments are limited to $10,000 per person per year, though you can also receive a tax refund of up to $5,000 in the form of an I Bond. The bonds generally can't be redeemed in the first 12 months, so they are best used as part of a multiyear emergency fund. Between years one and five, you will pay the last three months' interest as a penalty for cashing in early. After five years, the bonds can be cashed in without penalty."

Below is information from http://www.treasurydirect.gov/

I Savings Bonds In Depth

As of January 1, 2012, paper savings bonds are no longer sold at financial institutions.  This action supports Treasury’s goal to increase the number of electronic transactions with citizens and businesses. See the press release.

I Bonds are a low-risk, liquid savings product. While you own them they earn interest and protect you from inflation.  Once sold and redeemed solely as a paper security, they’re now also available in electronic form and in paper form through your IRS tax refund. As a TreasuryDirect account holder, you can buy, manage, and redeem I Bonds online.

A new program called SmartExchange^SM allows TreasuryDirect account owners to convert their Series E, EE, and I paper savings bonds to electronic securities in a special Conversion Linked Account within their online account.

Buying I Bonds through TreasuryDirect:

• Sold at face value; you pay $50 for a $50 bond.
• Purchased in amounts of $25 or more, to the penny.
• $10,000 maximum purchase in one calendar year.
• Issued electronically to your designated account.

Buying Paper I Bonds:

• Available only through your IRS tax refund
• Sold at face value; i.e., you pay $50 for a $50 bond.
• Purchased in denominations of $50, $75, $100, $200, $500, $1,000, and $5,000.
• $5,000 maximum purchase in one calendar year.
• Issued as paper bond certificates.

If you redeem I Bonds within the first 5 years, you'll forfeit the 3 most recent months' interest; after 5 years, you won't be penalized.

My Thoughts:

Lets assume that you buy $10,000 of I bonds and redeem after 1 year and forfeit 3 months of interest, your return will still be 75% of the inflation rate (CPI), after 2 years 87.5% 0f CPI, after 3 years 92% of CPI.  

If you invest today and earn the current stated rate of 3.06%  for the next 1 year (this adjusts every 6 months, so unlike a CD your rate will fluctuate). You then withdraw the funds after the 1 year waiting period. Your return will be approximately 75% of 3.06%, or 2.30%. Comapre this to current 1 year CD rates of  slightly over 1%.

Active vs. Indexing: Excellent WSJ Article

In a column in todays WSJ,  Karen Damato points out that in 2011 80% of active stock fund managers did not beat their respective benchmarks. But, so far in 2012, 64% are beating their benchmarks. She asks are they suddenly smarter?

Not necessarily; she points out that generally they are not suddenly smarter but rather the stocks that they are investing in are in favor. She writes:

"John Cochrane, a finance professor at the University of Chicago Booth School of Business, says investors are misguided if they think fund managers add—or subtract—value based on how savvy they are at picking individual stocks.

Managers typically have a strategy that favors certain kinds of stocks, such as those with rapid earnings growth or very low prices relative to earnings or rising dividends. Stocks with a common trait tend to rise or fall in market favor together. So the performance of a fund versus a benchmark can be better viewed in terms of the various factors a manager overweights or underweights, Mr. Cochrane says."

At the end of the day investors need to ask a couple questions:

1. If I am actively managing a portfolio, am I comparing the performance to the correct benchmark?

2. Am I earning a benchmark beating return for the fees I am paying?

What most will find is that it is a better long term solution to invest with low cost index funds.

For the complete article:

http://online.wsj.com/article/SB10001424052970203824904577215381237716676.html?mod=ITP_thejournalreport_0

Warren Buffet, Peter Lynch, David Swensen: Investing Advice

"If professionals do indeed have the game rigged in their favor, we should see evidence of that in terms of better performance. Yet consistent professional outperformance is nowhere to be found. It doesn't matter whether you look at institutional investors, pension plans or hedge funds, the evidence is the same.

If the evidence isn't enough, perhaps you should consider the advice from three legendary investors."

Peter Lynch
"[Investors] think of the so-called professionals as having all the advantages. That is total crap. ... They'd be better off in an index fund."

Warren Buffett
"Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals."

David Swensen
"Unless an investor has access to "incredibly high-qualified professionals," they "should be 100 percent passive -- that includes almost all individual investors and most institutional investors."

The above is pulled from larry Swedroe's CBS Moneywatch column on 2/13/2012.

For the full column: 

http://www.cbsnews.com/8301-505123_162-57374574/is-investing-rigged-to-favor-pros/?utm_source=twitterfeed&utm_medium=twitter&utm_campaign=Feed%3A+LarrySwedroeMoneywatch+%28CBS+Moneywatch+-+Larry+Swedroe%29&utm_content=Google+International

3 Pieces of Investing Advice from AWM

1. There is always a correlation between risk and return - a high expected return always means that there is a greater possibility of a loss.
Generally, when you hear of an investment return that is better than yours it is because that investment is riskier. Never compare your returns in a vacuum.
So, the next time your neighbor is bragging about some great investment return, ask them if they know the amount of risk they are taking. In fact, ask them if the return relative to the risk is efficient.
I often have people show me a "great" return, but when evaluated relative to the risk it is not that great.
An investors return should only be compared to the risk they are taking.

2. Portfolios are commodities. That means most advisers, banks, mutual fund families, brokers who recommend a certain allocation are all very similar. That is because they are all using similar software - "Portfolio optimization" software which allows somebody to enter into a computer the historic risk/return statistics of different stock/bond classes and find what combination gave the best risk/return outcome. Outcomes differ a little based on the data entered, but generally the Principle's 60% stock portfolio is similar to the Merrill Lynch 60% which is similar to the Smith Barney 60% etc.
I have created my own portfolios and my 60% is close to everyone else's.
which leads to point 3.

3. What are you paying? Especially if the adviser is charging you fee's of 1%. Calculate the hourly rate on 1%. If you have a retirement portfolio of $500,000 and some adviser is charging 1% (a common fee),  that is $5,000/year. If that adviser spends 10 hours/year really focusing on your portfolio you are paying $500/hour. Nice. Even nicer when all the academic evidence says that your adviser has almost no chance to outperform an index portfolio over time. If they do outperform whatever benchmark, then they either are lucky or taking more risk than the benchmark.

An adviser should:

1. Know what your investment needs are and what your tolerance for risk is.
2. Help you allocate into a suitable portfolio.
3. Help minimize your costs.
4. Hold your hand and keep you from doing irrational things when the markets are bad.

"The Big Investment Lie"

This is a blog post copied from one of my favorite blogs: 

http://whitecoatinvestor.com/

Don’t Invest in Hedge Funds (until you’ve read this book)

Posted on February 1, 2012 by White Coat Investor

Michael Edesess’s book The Big Investment Lie is now 5 years old.  I’m afraid that far too few investors have read it.  At this time of so much discontent with Wall Street, it’s time to pull it down off the shelf for another look.  Mr. Edesess provides an insider’s look at Wall Street and its huge disconnect with Main Street.  With a brand-new PhD  in mathematics in hand, he was hired by a brokerage firm.  Due to this degree, he was able to rub shoulders with the financial academics and see the evidence of what worked in finance and what didn’t first hand. Then, he realized The Big Investment Lie.  Here’s his explanation:

    Within a few short months I realized something was askew.  The academic findings were clear and undeniable, but the firm–and the whole industry–paid no real attention to them.  It was as if theoretical physicists knew the laws of thermodynamics, but engineers spent their time trying to construct perpetual motion machines–and were paid very handsomely for it….The message of this book is not new.  It has been written many times before–though, it seems, not forcefully enough.  If the book is imbued with a sense of outrage, it is because nothing else has worked.  The lie perpetrated by the investment world to sell its services at exorbitantly high prices still works all too well.

So, what is the lie?  It is this:

Most professional investment help, no matter how seemingly respectable, is in truth hazardous to your financial health.

Michael Edesess

He then divides the book into three appropriately titled sections- How Much You Pay, How Little You Get, and How You Are Sold.  He goes far above and beyond even Jack Bogle’s criticisms of the industry.  You see the usual skewering of active mutual fund managers, but you also get well-written chapters on hedge funds, derivatives, business ethics, and on how institutional investors get fooled too.  He also gets in to behavior finance and discusses how investors delude themselves with “The Lie”.

The discussion of hedge funds throughout the book is particularly good.  I quote again:

Now we come at last to the crowning achievement of the fee-charging business, the piece de resistance, the masters of the fee-charging universe-hedge funds….In 2004, those fees totaled $70 billion on an estimated $1 trillion in hedge fund assets–an average fee rate of 7 percent.  While not all hedge funds have large ups and downs, the ones that acquire the big names, essentially carrying the whole hedge fund business in the public mystique, do experience large ups and downs.  They get famous for the ups and draw huge amounts of investment capital and then are usually not noticed so much for the downs.  But the hedge fund managers make out very well on them.

Where are the investors’ yachts?  Indeed, where are the investors’ flotillas?  Hedge fund management is not just a license to steal; it is a license to steal literally billions.  The hedge fund management business has created more billionaires than you can shake a stick at.  In 2004, according to Alpha magazine, a magazine published by Institutional Investor, the average cash take-home pay for each of the top twenty-five hedge fund managers was $251 million.  Yes, you read that right.  It doesn’t take long to become a billionaire at that rate.  And where does the money come from?  It comes literally straight out of the investors’ accounts.

He does a great analysis of perhaps the best known hedge fund manager, George Soros.  His Quantum Fund grew from $6 Million in 1969 to $5.5 Billion in 1999 when he closed it.  Much of that, of course, is new capital contributed by investors seeking great returns.  So how much did Soros get for that work?  His personal fortune was estimated at $7.2 billion, not including the $4 billion he’s given away.  So $11 Billion for the manager on a fund that was only $5 Billion at its largest!  Keep in mind there are 10,000 other hedge funds out there that have come and gone.  If this is how the most well-known/successful hedge fund did, how are the unlucky ones doing?

This book makes Jack Bogle’s tirades against Wall Street seem tame by comparison.  But if you enjoyed Bogle’s revelations from the inside of the industry, you’ll love The Big Investment Lie.  He concludes the book with the Ten New Commandments for Smart Investing, which shouldn’t be big news to regular followers of this blog:

Ten New Commandments for Smart Investing

1. Follow a wealth-building strategy, not a gambling strategy.
2. Stop searching for the Holy Grail: Give up the futile quest to beat the market
3. Stop believing that past investment performance predicts future performance
4. Don’t be duped by the false claims of investment managers and advisors
5. Fire managers and advisors who charge more than barebones fees
6. Don’t pay anyone to pick stocks for you; There’s no reward for the cost and risk
7. Avoid hedge funds like the plague
8. Know the risks of investing; Take only the risk you are comfortable with
9. Keep fees and taxes as low as possible; They can swamp your investment returns
10. Invest only in true low-cost index funds

There you have it, straight from the horse’s mouth.  If you’d like to read more, pick up a copy of The Big Investment Lie at Amazon or your local library

Fama Speaks on EconTalk: a little excerpt

This weeks guest on the podcast Econtalk is Eugene Fama, one of the giants of academic finance, specifically stock market behavior. Fama is a professor at the University of Chicago.

Below is a partial transcript of the interview. I have highlighted the relevant lessons for investors – specifically the strong evidence supporting the use of index funds.

  Fama (Guest): Ken French and I just published a paper called "Luck Versus Skill in Mutual Fund Performance," and basically looked at performance of the whole mutual fund industry--in the aggregate, together, and fund by fund, and try to distinguish to what extent returns are due to luck versus skill. And the evidence basically says the tests it's skill in the extreme. But you've got skill in both extremes. That's something people have trouble accepting. But it comes down to a simple proposition, which is that active management in trying to pick stocks has to be a zero sum game, because the winners have to win at the expense of losers. And that's kind of a difficult concept. But it shows up when you look at the cross section of mutual fund returns, in other words the returns for all funds over very long periods of time. What you find is, if you give them back all their costs, there are people in the left tail that look too extreme and there are people in the right tail that look too extreme, and the right tail and left tail basically offset each other. If you look at the industry as a whole; the industry basically holds a market portfolio. That's all before costs. If you look at returns to investors then there is no evidence that anybody surely has information sufficient to cover their cost

Russ: Which says that for any individual investing, certainly someone like me, that is, who doesn't spend any time or very much time at all looking--in my case no time, but let's suppose even a little time--trying to look at what would be a good investment. The implication is to go with index mutual funds because actively managed funds can't outperform. Guest: Well, no, it's more subtle than that. What's more subtle about it is, even if you spent time, you are unlikely to be able to pick the funds that will be successful because so much of what happens is due to chance. Russ: So, for me the lesson is: buy index mutual funds because the transaction costs of those are the smallest, and since very few actively managed funds can generate returns with any expectation other than chance to overcome those higher costs, I can make more money with an index fund. Guest: Right. Now, it's very counterintuitive, because we look at the whole history of every fund's returns, and sort them, and really the ones in the right tail are really extreme. Russ: Some great ones.Guest: They beat their benchmarks by 3-6% a year. Nevertheless, only 3% of them do about as well as you would expect by chance. Now what's subtle there is that by chance, with 3000-plus funds, you expect lots of them to do extremely well over their whole lifetime. So, these are the people that books get written about. Russ: Because they look smart. Guest: What this basically says is that there is a pretty good chance they are just lucky. And they had sustained periods of luck--which you expect in a big sample of funds. Russ: Of course, they don't see it that way. Guest: No, of course not. Russ: A friend of mine who is a hedge fund manager--before I made this call I asked him what he would ask you, and he said, well, his assessment is that efficient markets explain some tiny proportion of volatility of stock prices but there's still plenty of opportunity for a person to make money before markets adjust. And of course in doing so, make that adjustment actually happen and bring markets to equilibrium. Somebody has to provide the information or act on the information that is at least public and maybe only semi-public. What's your reaction to that comment? Guest: That's the standard comment from an active manager. It's not true. Merton Miller always liked to emphasize that you could have full adjustment to information without trading. If all the information were available at very low cost, prices could adjust without any trading taking place. Just bid-ask prices. So, it's not true that somebody has to do it. But the issue is--this goes back to a famous paper by Grossman and Stiglitz--the issue really is what is the cost of the information? And I have a very simple model in mind. In my mind, information is available, available at very low cost, then the cost function gets very steep. Basically goes off to infinity very quickly. Russ: And therefore? Guest: And therefore prices are very efficient because the information that's available is costless.