The Only Guide to a Winning Investment Strategy You'll Ever Need: The Way Smart Money Preserves Wealth Today

The Only Guide to a Winning Investment Strategy You'll Ever Need: The Way Smart Money Preserves Wealth Today

by Larry E. Swedroe
     
 

Investment professional Larry E. Swedroe describes the crucial difference between "active" and "passive" mutual funds, and tells you how you can win the investment game through long-term investments in such indexes as the S&P 500 instead of through the active buying and selling of stocks.

A revised and updated edition of an investment classic, The Only

See more details below

Overview

Investment professional Larry E. Swedroe describes the crucial difference between "active" and "passive" mutual funds, and tells you how you can win the investment game through long-term investments in such indexes as the S&P 500 instead of through the active buying and selling of stocks.

A revised and updated edition of an investment classic, The Only Guide to a Winning Investment Strategy You'll Ever Need remains clear, understandable, and effective. This edition contains a new chapter comparing index funds, ETFs, and passive asset class funds, an expanded section on portfolio care and maintenance, the addition of Swedroe's 15 Rules of Prudent Investing, and much more.

In clear language, Swedroe shows how the newer index mutual funds out-earn, out-perform, and out-compound the older funds, and how to select a balance "passive" portfolio for the long hail that will repay you many times over. This indispensable book also provides you with valuable information about:

- The efficiency of markets today
- The five factors that determine expected returns of a balanced equity and fixed income portfolio
- Important facts about volatility, return, and risk
- Six steps to building a diversified portfolio using Modern Portfolio Theory
- Implementing the winning strategy
- and more.

Read More

Product Details

ISBN-13:
9781429972956
Publisher:
St. Martin's Press
Publication date:
01/01/2005
Sold by:
Macmillan
Format:
NOOK Book
Pages:
352
Sales rank:
1,075,183
File size:
1 MB

Read an Excerpt

The Only Guide to a Winning Investment Strategy You'll Ever Need

The New 2005 Edition


By Larry E. Swedroe

St. Martin's Press

Copyright © 2005 Larry E. Swedroe
All rights reserved.
ISBN: 978-1-4299-7295-6



CHAPTER 1

Why Individual Investors Play the Loser's Game


The most costly of all follies is to believe in the palpably not true.

— H.L. Mencken


It is undesirable to believe a proposition when there is no ground whatever for supposing it true.

— Bertrand Russell


For of all sad words of tongue or pen / The saddest are these: "It might have been."

— Whittier, "Maud Muller"


Galileo was an Italian astronomer who lived in the sixteenth and seventeenth centuries. He spent the last eight years of his life under house arrest, ordered by the church for committing the "crime" of believing in and teaching the doctrines of Copernicus. Galileo's conflict with the church arose because he was fighting the accepted church doctrine that the Earth was the center of the universe. Ptolemy, a Greek astronomer, had proposed this theory in the second century. It went unchallenged until 1530 when Copernicus published his major work, On the Revolution of Celestial Spheres, which stated that the Earth rotated around the Sun rather than the other way around.

History is filled with people clinging to the infallibility of an idea even when there is an overwhelming body of evidence to suggest that the idea has no basis in reality — particularly when a powerful establishment finds it in its interest to resist change. In Galileo's case, the establishment was the church. In the case of the belief in active management, the establishment is comprised of Wall Street, most of the mutual-fund industry, and the publications that cover the financial markets. All of them would make far less money if investors were fully aware of the failure of active management.

Most investors, investment advisors, and portfolio managers engage in active management of their investment portfolios. They try to select individual stocks they believe will outperform the market. They also try to time their investment decisions by increasing their stock investments when they believe the market will rise and decreasing them when they believe the market will fall. These investors, advisors, and portfolio managers attempt to beat the market through active management strategies despite an overwhelming body of academic evidence that has demonstrated that the vast majority of returns of a diversified portfolio of securities is explained by investment policy (asset allocation). The evidence is that only a very small percent of returns is explained by active management — individual stock selection (attempts to find mispriced securities) and timing the market decisions (shifting assets into and out of the market or between asset classes). For example, a study of the ten-year performance (period ending March 31, 1998) of ninety-four balanced mutual funds and the five-year performance of fifty-nine pension plans found that about 100 percent of the level of returns is explained by asset allocation. The conclusion was that, on average, active management added no value above the level of return that could be expected from passive management.

Asset allocation is the process of determining what percentage of your assets are allocated, or dedicated, to various specific asset classes. An asset class is a group of assets with similar risk characteristics. Asset classes can be as broad as fixed income or equities. Alternatively, they can be more narrowly defined. Fixed income can be divided into short term and long term. Equities can be divided into such categories as small companies and large companies. They can also be split into categories such as growth companies or value companies (a term we will fully explore later). They can even be more narrowly defined into such categories as small-value and large-value companies. Adding the broad category of domestic versus international, one ends up with such categories as U.S. small value and international large value. As was stated earlier, academic research has determined that investor decisions about the allocation of assets among available asset classes (what is referred to as investment policy) are by far the major determinant of the risk and the returns of a diversified portfolio of securities.

Considering that one academic study after another has demonstrated that well over 90 percent of returns are determined by asset-allocation decisions, one has to wonder exactly why individual investors and the majority of professional money managers spend virtually all of their time trying to pick stocks and time the market. We will shortly examine the causes of this peculiar behavior.

If you had a heart condition and your doctor offered you a choice between two drugs, an old drug with say a 5 percent chance of success or a new drug with a 95 percent chance of success, which would you choose? What would you say if I told you that you can get the 95 percent solution for your investments, and that this solution is the result of over fifty years of academic research, which culminated in the awarding of the 1990 Nobel Prize in economics to three of the main contributors to the body of work known as MPT? What would you say if I told you that you could increase returns and reduce risk at the same time? Would you be surprised if I told you that the solution did not require a degree in financial economics and that it was based on a commonsense approach that every investor could understand? However, given the availability of the 95 percent solution, we are confronted with the enigma that the majority of investors choose the 5 percent solution, active portfolio management. I believe that there are several cultural phenomena contributing to this peculiar behavior.


The Black Hole of Knowledge

Most Americans, having taken a biology course in high school, know more about amoebas than they do about investing. Despite its obvious importance to every individual, our education system almost totally ignores the field of finance and investments. This is true unless you go to an undergraduate business school or pursue an M.B.A. in finance. My daughter is a senior in an excellent high school, and she is graduating very close to the top of her class. Having taken a biology course, she can tell you all you would ever need to know about amoebas. She could not, however, tell you the first thing about how financial markets work.

Just as nature abhors a vacuum, Wall Street rushes in to fill the void. Investors, lacking the protection of knowledge, are susceptible to all the advertising, hype, and sales pressure that the investment establishment is capable of putting out. The problem with this hype is that, in general, the only people who are actually enriched are part of the investment establishment itself. As you will discover, the vast majority of investment firms, mutual funds, and individual investors consistently underperform the Standard & Poor (S&P) 500 Index. This index is made up of the stocks of five hundred of the largest U.S. companies (hence the name "S&P 500"). It is often considered a proxy for the market itself. It is, therefore, the most often used benchmark against which the performance of active managers is judged.

One well-known Wall Street advisor, Robert Stovall, when asked about Wall Street's underperformance, responded: "It's just not true that you can't beat the market. Every year about one-third of the fund managers do it." He then quickly added, "Of course, each year it is a different group." Amazing! How is the average investor to know which group of fund managers will succeed? The lack of persistence of outperformance is one reason why mutual funds have been created to mimic the performance of the S&P 500 Index and other indices as well. For obvious reasons, such funds are called index funds.


Hard WorkShouldProduce Superior Results

A second factor in this behavioral dilemma is the great faith in the Protestant work ethic. To quote my exboss, an otherwise intelligent and rational man: "Diligence, hard work, research, and intelligence just have to pay off in superior results. How can no management be better than professional management?" The problem with this thought process is that while these statements are correct generalizations, efforts to beat the market are an exception to the rule. If hard work and diligence always produce superior results, how do you account for the failure of the vast majority of professional money managers (in all likelihood all bright, intelligent, capable, hardworking individuals) to beat the market year in and year out? In the face of all this evidence, they continue to give it the old college try. The lesson: Never confuse efforts with results. As you will see, hard work is unlikely to produce superior results because the markets are efficient.


Behavioral Finance

When the vast majority of active managers underperform their respective indexes, why do individual investors continue to place the vast majority of their funds with active managers? Richard Thaler, an economist at the University of Chicago, an advocate of "behavioral finance," attributed this behavior to overconfidence. "If you ask people a question like, How do you rate your ability to get along with people? Ninety percent think they're above average. Ninety percent of all investors also think that they're above average at picking money managers."

Prof. Richard Thaler and Robert J. Shiller, an economics professor at Yale, noted that "individual investors and money managers persist in their belief that they are endowed with more and better information than others and that they can profit by picking stocks. While sobering experiences sometimes help those who delude themselves, the tendency to overconfidence is apparently just one of the limitations of the human mind." This insight helps explain why individual investors think they can identify the few active managers who will beat their respective benchmarks.

There are other behavioral reasons why investors choose active managers. For example, many investors feel that by not selecting an actively managed fund they give up the chance of being above average, and the vast majority think they can at least do better than that. When asked whether fund managers were also over-confident, Thaler responded: "All fund managers think they're above-average money managers. Active fund managers can't believe that markets are efficient. Otherwise they would have no reason for existing."

Individuals also like to be able to blame active managers when they underperform yet be able to take credit for choosing the active managers who happen to outperform the market. Another explanation for choosing actively managed funds is that people often feel a sense of loss of control if they invest in passive investment vehicles. Individuals fail to understand that passive investors have total control over the most important determinant of risk and returns — the asset-allocation decision. Once an investor turns over control to an active manager, they actually lose control as the active manager is now at the helm, making decisions on market timing and asset selection.


Playing the Market

Another reason Americans choose the 5 percent solution, curiously almost in opposition to the work ethic reason, is that they love to gamble. Americans love lotteries, Las Vegas, wagering on sporting events, and so on. That is why you hear the term "play the market." Serious investors never play the market; they invest in the market. Serious investors do not care that a passive strategy (buy and hold the market) is boring. They do not look for markets to provide them with excitement. Instead, they look for markets to produce returns commensurate with the amount of risk taken. Serious investors follow the advice of Girolamo Cardano, a sixteenth-century physician, mathematician, and quintessential Renaissance man, who said: "The greatest advantage from gambling comes from not playing at all."


The Gambler's Fallacy

Investors also fall prey to what is known as the gambler's fallacy, the idea that winners ride "hot streaks." Of course, there is no proof of that idea, either in gambling or investing. As proof that selecting mutual funds that beat the market is not the winner's game, Mark Hulbert, publisher of the Hulbert Financial Digest, a newsletter that tracks the performance of investment newsletters, put together a portfolio of "market beaters." He chose managers who had managed to beat the market in the preceding year. That portfolio earned a 99 percent return over the next fifteen years. Not a bad return, except for the fact that a portfolio of "market losers," those funds that lagged the market in the previous year, returned 350 percent over the same period. In contrast to these seemingly impressive returns, the stock market as a whole rose about 600 percent over the same period. Belief in "hot streaks" leads to the mistake of confusing luck and skill.


The Cocktail Party Syndrome

Finally, many investors choose the 5 percent solution so that they will have a great cocktail party story to tell, boasting about their great investments. Of course, you never hear about investments that did not turn out well.

There is a winning strategy to outfox the loser's game of trying to select individual "undervalued" securities or trying to time the market. It is the same strategy that is the winner's game in tennis: choose not to play the loser's game.

CHAPTER 2

Active Portfolio Management Is a Loser's Game


The value of an idea has nothing to do with the sincerity of the person expressing it.

— Oscar Wilde


An idea is not responsible for the people who believe in it.

— Don Marquis


All great ideas are controversial, or have been at one time.

— George Seldes


No matter how thin you slice it, it's still baloney.

— Alfred E. Smith


For better or worse, then, the US economy probably has to regard the death of equities as a near-permanent condition.

BusinessWeek, August 13, 1979, with the

Dow Jones Industrial Average (DJIA) at 875.26


In building their investment portfolios most investors pursue one or more of the following alternative strategies:

• They select individual stocks based on their own research, advice from a broker, or on a "hot tip" from a friend.

• They choose mutual funds based upon their past performance, particularly chasing the hot money managers.

• They rely on the recommendations of trade publications such as Forbes, Money, SmartMoney, Worth, and the Wall Street Journal.

• They rely on the advice gleaned from newsletters to which they subscribe or "market gurus" who appear on CNBC and elsewhere, including the Internet.

• They rely on fund ratings by such services as Morningstar, which rates funds using a star system similar to the one used by film critics.


We will explore each of these strategies in this chapter, plus some additional insights regarding the weaknesses inherent in an active management approach.


Individual Stock Selection


Bull market: An upward movement in prices causing an investor to mistake himself for a financial genius.

— Anonymous


Investors attribute successes to their own brilliance, and they attribute failures to bad luck. If you keep doing that, at the end of the day you think you're a genius.

— Nicholas Barberis


Brad Barber, Professor of finance at the University of California, Davis, and Terrance Odean, Associate Professor of finance at the University of California, Davis, studied the performance of individual investors by examining over one hundred thousand trades covering the period 1987–93. Their conclusion: Individual investors aren't as bad at stock picking as many people think. They're worse! The study found that stocks individual investors buy trail the overall market and stocks they sell beat the market after the sale. The longer the time span the study covered, the more their performance trailed the market. Investors shot themselves in the foot with their trades even before taking into account the transaction fees and taxes they paid for the privilege of "playing the market." These costs would further depress trading performance. The authors concluded: Individuals shouldn't be trying to pick stocks. They further stated that investors probably don't realize just how badly they are doing. Since they were trading in a rising market, their portfolios generally showed gains. Unfortunately, the time and money they spent trying to pick stocks cut into their profits instead of enhancing them.

In another study Barber and Odean found that the more investors traded, the worse the results (except, of course, for the wallets of their brokers). The conclusion we can draw is that there is an inverse correlation between confidence and performance — the more confident one is in his/her ability to either identify mispriced securities or time the market, the worse the results. In studying men versus women, they found that although the stock selections of women do not outperform those of men, women produce higher net returns due to lower turnover (lower trading costs). Also, married men outperform single men. The obvious explanation is that single men do not have the benefit of their spouse's sage counsel to temper their own overconfidence. It appears that a common characteristic of human behavior is that, on average, men have confidence in skills they don't have while women simply know better.


(Continues...)

Excerpted from The Only Guide to a Winning Investment Strategy You'll Ever Need by Larry E. Swedroe. Copyright © 2005 Larry E. Swedroe. Excerpted by permission of St. Martin's Press.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Read More

Customer Reviews

Average Review:

Write a Review

and post it to your social network

     

Most Helpful Customer Reviews

See all customer reviews >