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.

FRUGAL FRUGAL FRUGAL - a lesson from: The Millionaire Next Door

The 3 words that describe the affluent in America: FRUGAL FRUGAL FRUGAL.

The millionaire next door is someone who budgets - they know what they spend money on.
Asked why someone who is a millionaire needs to budget, the answer is:

"They become millionaires by budgeting and controlling expenses, and they maintain their affluent status the same way"

The average millionaire achieved their wealth through a combination of hard work and careful money management. They live below their means. They work on making themselves capitalists - meaning they save and invest and start earning more and more of their wealth from investment earnings rather than business income.

7 Traits of Millionares

Although the book is over 15 years old, The Millionaire Next Door provides wonderful financial guidance. Here are the 7 common denominators of millionaires - 80% of whom are first generation rich:

1. They live well below their means.
2. They allocate their time, energy, and money efficiently, in ways conducive to building wealth.
3.They believe that financial independence is more important than displaying high social status.
4. Their parents did not provide economic outpatient care.
5.Their adult children are economically self-sufficient.
6. They are proficient in targeting market opportunities.
7. They chose the right occupation.

The millionaire next door is usually a business person who has lived in the same city all their adult life, owns a business, married once, lives next door to people with a fraction of their wealth,  is a compulsive save and investor, and has made the money on their own.

Becoming a millionaire is the result of hard work, perseverance, planning, and most of all, self discipline.

An Investing Lesson Christmas Card from AWM

Dear Readers: I hope this Christmas season is filled with joy and peace for you and your families.

Below is short newsletter in which I have excerpted a couple recent articles that highlight the investing lessons I have emphasized to most of you.

December 2011:

We are bombarded daily with the current difficulties of the stock market. Combine that with low interest rates on bonds, CD’s and savings accounts, no wonder investors are fearful. Fortunately, time honored principles still prevail. Those principles are:

1. Have a plan - invest in a mix of asset classes that is suitable to your risk tolerance and time horizon.
2. Use Index funds to fill your asset class needs.
3. Stay the course. Don’t panic and try to move in and out of the market.

This first excerpt highlights the need for a plan and staying the course, it is from James P. O'Shaughnessy, the author of the best selling What Works on Wall Street:

"Consistency is the hallmark of great investors and it is what separates them from everyone else. If you use even a mediocre strategy consistently, you'll beat almost all investors who jump in and out of the market, change tactics in midstream and forever second-guess their decisions.

Look at the S&P 500. It is a simple strategy that buys large- capitalization stocks. Yet this one-factor, rather mediocre strategy still manages to beat 70% of all actively managed funds because it never leaves its strategy. Realistically consider your risk tolerance, plan your path and then stick to it. You may have fewer stories to tell at parties, but you'll be among the most successful long-term investors. Successful investing isn't alchemy; it's a simple matter of consistently using time-tested strategies and letting compounding work its magic."

Excerpted from James P. O'Shaughnessy's "Advisors Bookshelf" column in December 9 edition of Investment News.

This second excerpt is from a Dec. 16th Reuters story, it highlights the benefits of investing with simple index funds:

Dec 16 (Reuters) .... fund managers who pick and choose their stocks, rather than passively follow an index, are having a year to forget. Only 27 percent of large-cap managers are beating their benchmarks year-to-date, according to new research from Bank of America Merril Lynch . Growth managers, in particular, aren't earning their paychecks, with only 12 percent outperforming their indices.

Indeed, if anything, active managers seem to be getting worse. Last year, Standard & Poor's SPIVA scorecard - which measures active funds against their benchmarks - revealed that 34.3 percent of large-cap managers beat the S&P 500 for 2010.

Which begs the question: What's going on? "It's a very tough environment for active managers right now," says Srikant Dash, managing director of S&P Indices who founded the SPIVA scorecard almost a decade ago. "There seems to be limited opportunity to find winners."

Active-versus-passive investing used to be a lively debate for market wonks. On one side of the argument, index proponents like Vanguard Group founder Jack Bogle say pairing low fees with market-mirroring returns is the most reliable way to build your portfolio. On the other side, there are star managers like Legg Mason's Bill Miller, who famously beat the S&P 500 with his picks for 15 years in a row. Recently, though, the contest has turned into a bit of a rout - and even Bill Miller is exiting his flagship fund (but remaining chairman), after trailing the index for four of the last five years.

Some reasons for the mismatch are evergreen, like the higher fees that actively-managed funds must overcome. Active large-cap funds currently have an average expense ratio of 1.28 percent, versus 0.68 percent for similar index funds, according to the Chicago-based fund research firm Morningstar. ..... On the average, though, realize that expecting your active fund manager to beat the market over the long-term - especially during an era of economic Black Swans - is a risky bet. "If you want to go active in your quest to beat the market, there's nothing necessarily wrong with that," says Dash. "Just be aware of the risk: That the majority of active managers fail to outperform their benchmarks. It's remarkably consistent."

Finally, below is a chart from an investors 401K account which I advise on. He called me and asked whether he needed to change his portfolio allocation. He was no longer with the employer and stopped contributing in 2009 when he left the company. He said to me “Mike, you told me to stay the course, I have not moved out of the 80% stock portfolio.”

 I looked up his account and below is what I found. This man, who invested $11,466 over a few years, then did nothing, earned 16.8% through the worst market since the depression. Yes, he temporarily lost market value in 08 and 09, but he had an investment plan, he used index funds and he stayed the course.*

for ALL FUNDS from 03/31/2004 through 12/19/2011

Your cumulative personal rate of return during this period: 217.1%  (Annualized Return: 16.1%)

Total net investments made during this period: $11,465.97

The above lesson may seem like simple unsophisticated strategy. Sometimes we tend to over think things, especially when it comes to the stock market. The sophistication comes with the discipline to invest according to your risk tolerance, staying the course, and using cost efficient index funds.

* This is used to demonstrate a point, this man started saving in 2004, performance returns will be different for others depending on when and how money was invested.

Your Age and How Much Saved: A Quick Calculation

Your Capital To Income Ratio is a quick tool to help you determine whether you are on track with your retirement savings. My experience, as a practicing financial planner, is that most people are not saving enough to maintain their standard of living in retirement.

This post is copied from "The White Coat Investor"  blog: http://whitecoatinvestor.com/

"The Capital to Income Ratio is the most important ratio discussed in Charles Farrell’s Your Money Ratios.  It’s the ratio of your retirement stash divided by your current income.  If your income has recently increased significantly, average your last four years of income.  If you have a sporadically working spouse, don’t count his or her income.  If your spouse works, use both incomes, and average your ages.  The chart below can be used to see if you’re “on track” for retirement.

Age	Capital to Income Ratio
25	0.1
30	0.6
35	1.4
40	2.4
45	3.7
50	5.2
55	7.1
60	9.4
65	12

Per Mr. Farrell’s calculations, maintaining these ratios will allow you to retire on 60% of your income (plus social security) at age 65.

For example, a 45 year old doctor making $200,000 a year should have $740,000 in retirement/savings accounts.  Try calculating your ratio out and see how you’re doing.  I’m right on track, which is reassuring, since I don’t actually need my investments to provide 60% of my current income as discussed here

He provides two other charts in his book, which he labels the “silver medal” chart and the “bronze medal” chart, which allow for you to retire on 50% of your income at age 65 and at age 70 respectively.  Chart out your ratio on these charts and see where you stack up:

Age	60% at 65	50% at 65	50% at 70
25	0.1	0.1	0.1
30	0.6	0.5	0.45
35	1.4	1.25	1
40	2.4	2	1.6
45	3.7	3.1	2.5
50	5.2	4.5	3.5
55	7.1	6.1	4.8
60	9.4	8.1	6.5
65	12	10	8.2
70			10

Using these charts you can see what you’re on track for. If you’re way ahead of where you need to be, early retirement might be an option for you. If you’re behind, better start saving more."

Invest Consistently: Sound Advice.

Sound advice from James P. O'Shaughnessy, the author of the best selling What Works on Wall Street:

"Consistency is the hallmark of great investors and it is what separates them from everyone else. If you use even a mediocre strategy consistently, you'll beat almost all investors who jump in and out of the market, change tactics in midstream and forever second-guess their decisions.

Look at the S&P 500. It is a simple strategy that buys large- capitalization stocks. Yet this one-factor, rather mediocre strategy still manages to beat 70% of all actively managed funds because it never leaves its strategy. Realistically consider your risk tolerance, plan your path and then stick to it. You may have fewer stories to tell at parties, but you'll be among the most successful long-term investors. Successful investing isn't alchemy; it's a simple matter of consistently using time-tested strategies and letting compounding work its magic."

Excerpted from James P. O'Shaughnessy's "Advisors Bookshelf" column in December 9 edition of Investment News.

Hayek, spontaneous order and index funds

If I can use a picture of Salma to get one to click on this post and read a little about Friedrich's ideas, I have achieved a small victory in educating the masses. 


This is a re-post in a new package.

"in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process… will hardly ever be fully known or measurable."

The above quote is from the 1972 Nobel prize lecture of Austrian economist Friedrich Hayek who wrote brilliant works that explained the errors of fascism and socialism. He taught that the modern economy has too many variables for one person, or organization, to efficiently allocate its resources. Hayek argued that the price system does a better job of allocating resources than a government controlled system. Hayek's observations are part of his reflections on spontaneous order - which is the idea that order comes out of chaos when many self interested individuals are involved. This idea is played out in many areas. A recent example of spontaneous order is the open architecture software - Linux, which is written by programmers from all over the world who, in their spare time, add to the code. Linux now operates some of the fastest computers in the world and is the operating systems that runs many devices that we use in our daily life.

So how does this apply to investing?

The investing world is divided by those that believe they can predict economic and investment trends - the active managers, they believe they can predict which stocks to pick for your portfolio or mutual fund. Then there are those that believe that the stock market is too complex to make those decisions accurately on a consistent basis (the indexers). The indexers argue that the collective wisdom of all the investors in the world will average out to the best answer. The indexers, one could say, are Hayekian in their thinking. They would argue that if Wal Mart makes up 2% of the stock market, then an individual investor should own 2% of Wal Mart.

What is the collective wisdom of all investors in the investing world? Answer: index funds.

What is the record of index funds? Answer: Over time, they outperform active managers. Yes, year to year some active managers outperform the average. But it is not the same ones on a regular basis.

Spontaneous order seems to play out in stock funds. It explains why index funds outperform active managers. The collective wisdom of the many results in better investment performance than that of one or a few.

What does this mean for the average investor. It means that the best course of action has been to hold a well diversified, risk appropriate portfolio of the global stock and bond market, fund it with index funds, and rebalance annually.

For an analogous column, see Russ Roberts's 2004 Business Week column : "The Bagel and the Index Fund,"

http://www.businessweek.com/bwdaily/dnflash/jan2004/nf20040120_6180.htm

I recommend Russ Roberts's podcast: Econtalk, his blog: Cafe Hayek, and his books: "The Choice", "The invisible Heart", and "The Price of Everything."

Roberts is a professor of Economics at George Mason University

In another related article, see Jason Zweig's January 8, 2011 Wall Street Journal Column, in which he also cites Hayek in his explanation on why forecasters rarely get forecasts correct:

http://online.wsj.com/article/SB10001424052748703675904576064320900295678.html?mod=ITP_businessandfinan