Efficient Markets: Markets are not perfect but neither are really smart guys

Next time you think you, your mutual fund, your broker, your stock picking software can beat the market; scan the graphic below and read this short excerpt from Business Week July 16-21, 2013, "The Hedge Fund Myth"

"Hedge funds are built on the idea that a smarter guy (and they are almost all guys; only 16.8 percent of managers are women) with a better computer can make miracles possible by uncovering inefficiencies in the market or predicting the future. In pure dollar terms, there are more resources, advanced degrees, and computing firepower devoted to chasing this elusive goal than almost any other endeavor, and that may include fighting wars. Yet traders face the immutable fact that every second, each megabyte of information, blog post, one-line rumor, revenue estimate, or new product order from China has already been taken into account by the efficient market and reflected in a security’s price. This means that trying to gain what traders call an “edge,” at least legitimately, is almost impossible. As the financial incentives on Wall Street have become enormous, so have the competition and pressure to gain an advantage at any cost."

Full Article: http://www.businessweek.com/articles/2013-07-11/why-hedge-funds-glory-days-may-be-gone-for-good#p2

What if You Paid Your Doctor Like You Pay Your Financial Adviser?

There would be moral outrage if we lived in a world where doctors didn't directly charge patients, but earned all their income from the pharmacy companies for the prescription drugs they prescribed. We would ask "how can the doctor be objective?"

Reality: We live in a world where the vast majority of financial advisors dont directly charge the client a penny, but receive commissions and fees from the investments and insurance products they sell clients. This is how brokers and many fee based advisors earn their fees. There is no moral outrage, no cry of "how can they be objective?"

This year the UK, Netherlands, and Australia have made commissions in financial products illegal, see Jason Zweig's WSJ blog:

http://blogs.wsj.com/moneybeat/2013/06/21/the-intelligent-investor-going-dutch-could-fee-hurdles-come-down-everywhere/

A fee only advisor charges a client directly. The charge is generally based on time spent or on the amount of money managed. The client receives an invoice and pays directly or may pay directly from the investment portfolio.

Ask your advisor how they get paid and then ask whether they can be objective in their advice.

Full Disclosure: AWM is a fee only advisor.

Advice to those attempting to manage their own stock portfolio.

A short quote from  Satyajit Das's excellent book:  Extreme Money: Masters of the Universe and the Cult of Risk.  Excellent advice for those who attempt to own individual stocks and manage their own stock portfolios.

"Bernard Baruch, the famous financier and investor, once offered the following guide to investment success:
If you are ready and able to give up everything else, to study the whole history and background of the market and all the principal companies whose stocks are on the board as carefully as a medical student studies anatomy, to glue your nose at the tape at the opening of every day of the year and never take it off till night; if you can do all that and in addition you have the cool nerves of a great gambler, the sixth sense of a kind of clairvoyant, and the courage of a lion, you have a chance."

Das, Satyajit (2011-08-04). Extreme Money: Masters of the Universe and the Cult of Risk (p. 98). Pearson Education. Kindle Edition.

You Don't Need To Invest In Hedge Funds To Have Investing Success

This chart shows the return of a simple portfolio that holds 60% in a simple S&P 500 index fund and 40% in a global bond index fund vs. the returns of the hedge fund industry over the last 10 years.

What this tells you is that it is hard to beat the market. Hedge funds hire some of the sharpest minds on Wall Street and charge a fee of 2% per year plus 20% of the return they make. If they can't beat the market, what makes you think that you can, or your broker, or the neighbor who tells you he is making money hand over foot?

The lesson for most investors is to hold stocks that look very much like that of the overall stock market (the S&P 500 or a Total Market index fund will do) + a portion of bonds that look like the overall bond market. Hold these in a proportion that is right for your risk tolerance, minimize taxes (holding a stock index does this very efficiently), keep fees low (index funds do this better than any other funds) and you will have a high probability of outperforming the average investor over time.

Gatsby and Investor Behavior

"Gatsby believed in the green light, the orgiastic future that year by year recedes before us. It eluded us then, but that's no matter - tomorrow we will run faster, stretch out our arms farther.... And one fine morning-- So we beat on, boats against the current, borne back ceaselessly into the past."

The above quote from the final page of F. Scott Fitzgerald's The Great Gatsby is a beautifully written description of the American psyche. It can also be read as an insight to investor behavior as it relates to the stock market. That is because we believe in the endless possibilities that the market can bring to us. Our dream is the hope that a person can choose the right investment and get rich. This hope has been ingrained in our American DNA through literature, movies and television. 

Wall St can be the place of fortunes and when its not, it can destroy financial lives if we take risks we dont understand or cannot afford. Yet we keep going back and we continue to believe that if we pick the right stock, mutual fund or adviser we can achieve the elusive - consistent market beating returns that will result in easy financial wealth.

We believe in the dream and ignore the academic research that says: over time, an investor has a very low probability of beating the market; and that holding a portfolio of simple index funds, that represent the overall market, outperforms almost all other strategies. Yet "we beat on, boats against the current"  trying to beat the market. Unfortunately, there are really no shortcuts. That is the tragedy of Gatsby. He tried to achieve his dream through shortcuts. It cost him his life. 

There are no shortcuts when it comes to investing success. Occasionally, some get lucky and get rich on a small investment. Those are the rare exception. The secret to successful investing is a disciplined commitment to saving, managing our get rich quick emotions by holding a risk appropriate, well diversified portfolio of various asset classes, rebalancing, and keeping costs low through the use of index funds.

PBS Frontline (4/23/2013) - Powerful evidence in support of indexing

"The evidence is overwhelming. Year after year, actively managed mutual funds fail to beat index funds. Studies have born this out repeatedly over various periods in bull and bear markets"

The quote is from the April 23, 2013 PBS Frontline documentary on the 401K industry, link below:

http://www.pbs.org/wgbh/pages/frontline/retirement-gamble/

It is one hour and it is excellent - especially the last 1/2 hour which focuses on fees and index funds.

Bad Investor Behavior: A Graph

This simple graph, produced by BlackRock, shows mutual fund money flows (blue bars) vs. the return of the S&P 500 (US Market). 

The graph demonstrates how investors pull money out of the market when stocks are low and buy into the market when the stock market is high. Investors do the opposite of buy low and sell high. It is no wonder the average investor underperforms the market. Investors act on fear and not rational analysis.

Ideally inflows would have been up in 2002 and 2009/2010.