Human behavior flows from three main sources:
desire, emotion, and knowledge.
Some people think you can’t go wrong buying stocks, at least in the long run. Others think that stocks are like a trip to Vegas, where most people return home with less money than they came with. Both are wrong. The stock market is more nuanced than these simplistic caricatures. Historically, investors have, on average, made a lot of money, but there is no guarantee how future investors will do.
Table 10-1 shows the average annual returns from short-term Treasury bills, long-term Treasury bonds, and the stocks included in the S&P 500 index. The standard deviation is a measure of the volatility of the annual returns about the historical average. The table uses a peculiar starting year (1926) simply because that’s as far back as these data go.
The average annual return on the stocks in the S&P 500 has been 12 percent, which is not only positive but much higher than the average returns from Treasury bills or bonds. An investment of $10,000 is worth $931,000 after forty years if it earns a 12 percent annual return, but only worth $103,000 with a 6 percent return.
Stocks have also been volatile, with an annual standard deviation twice that of Treasury bonds. Figure 10-1 confirms visually what the standard deviation tells us numerically—the stock market fluctuates a lot from year to year. Stock returns also seem random in that there is no evident pattern.
As Figure 10-1 shows, the stock market often rises or falls more than 20 percent in a year. Stock prices also fluctuate wildly month to month, week to week, and even daily. On October 19, 1987, stock prices fell by more than 20 percent in a single day, sending many investors to the sidelines, convinced that the stock market is too risky. That was a costly overreaction. The market bounced back and investors who have been invested in stocks since October 19, 1987, have done much better than have those who left the market.
A financial author once wrote:
An exhaustive computer survey, conducted a few years ago at the University of Chicago, showed that the average annual profit (before taxes) on any New York Stock Exchange investment held for one month or longer—regardless of what the company was, when the shares were purchased or when they were sold—was 9.3 percent.
The 9.3 number would now be 12 percent, but that’s not the biggest problem with this claim. The stock market doesn’t go straight up and all stocks don’t do equally well. The return depends on the stock and when it is bought and sold.
Figure 10-2 shows the daily prices of two popular stocks, Apple and Washington Mutual Saving Bank (commonly known as WaMu) between 1983 and 2003. In March 1983, WaMu was $14 a share and Apple was $42. The zig-zags in Figure 10-2 show that both stocks fluctuated greatly over the next twenty years, with Apple going above $140 in 2000 and below $20 in 2003. Meanwhile, WaMu was above $40 in 2003, triple its value twenty years earlier.
We hope to do to this industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs and Lowe’s-Home Depot did to their industry. And I think if we’ve done our job, five years from now you’re not going to call us a bank.
He was right. Five years later, people didn’t call WaMu a bank. They called it bankrupt. In fact, the biggest bank bankruptcy ever.
WaMu’s growth was fueled by loans to people who other banks considered too risky, and its downfall came from losses on these subprime loans and then a run on the bank as nervous depositors withdrew $16.7 billion over a ten-day period. The federal government took control of WaMu and sold what was left of the wreckage to JPMorgan Chase for $1.9 billion.
Meanwhile, Figure 10-3 shows that Apple jumped and slumped, hitting $190 in 2008 and falling below $80 in 2009. Apple topped $700 in September 2012 and dropped below $400 seven months later. Wheee! (Apple did a 7-for-1 stock split in January 2014 and traded for around $100 a share in 2016, which is equivalent to $700 before the split.)
The stock market can be like riding a roller coaster, sometimes exhilarating, other times terrifying. Some investors find these roller-coaster rides so gut wrenching that they avoid stocks altogether. I know a woman who keeps her money in a safe in her kitchen. She doesn’t want to worry about the stock market crashing, and she doesn’t feel that money is real unless she can hold it in her hands. Personally, paper money doesn’t seem all that real to me.
For other investors, uncertainty is the main attraction. Investing is a game—much like poker—that blends skill and luck, and it can be played against professionals with the results reported in the daily newspaper and on the internet. It is a game worth playing, and it is a game worth winning.
Many investors buy stocks through mutual funds. Mutual funds issue shares, like other corporations, but instead of using the shareholders’ money to build factories and office buildings, they buy stocks and bonds. There are thousands of mutual funds catering to the specialized and varied tastes of investors. There is a fund for baptized Lutherans, one for airline pilots, and another for cemetery owners. One fund buys only aviation stocks; another buys stock in gold-mining companies. One fund invests in Australian securities; one in Ohio businesses. Others do not invest in alcohol, tobacco, gambling, or munitions stocks. The Vice Fund does the opposite, specializing in sinful industries.
Many people are drawn to mutual funds by their advertised expertise, reasoning that just as they pay a doctor for medical services and a lawyer for legal assistance, so they should pay a professional for investment management. They choose a fund with an outstanding record and if this fund’s subsequent performance is disappointing, they switch to another fund that has been more successful.
Management fees depend on the number of assets managed, and the top-performing funds are swamped by investors looking to share in the success. This investor chase for successful funds encourages funds to trade feverishly, looking for the quick profits that will lure more investors (and management fees).
Like his mentor, Benjamin Graham, Warren Buffett has been critical of the hyperkinetic activity of institutional investors who speculate about short-term price fluctuations instead of focusing on long-term investment values. In a Berkshire annual report, Buffett wrote that “the term ‘institutional investor’ is becoming one of those self-contradictions called an oxymoron, comparable to ‘jumbo shrimp,’ ‘lady mud wrestler’ and ‘inexpensive lawyer.’” I would add that “value investor” is not an oxymoron, and that value investors should be leery of hyperactive mutual funds.
Mutual funds can be bought through fund salespeople, insurance agents, stockbrokers, or directly from the fund itself. No matter which route is used, the fund may levy a sales charge, called a load fee. For a “full load” fund, the load is generally between 5 percent and 8.5 percent, split between the salesperson and the fund itself. Funds that sell directly to investors are generally “low loads,” with a fee of 3 percent or less, all of which goes to the fund. Funds that don’t charge load fees are called no-loads.
In addition, SEC Rule 12b-1 allows mutual funds to charge an annual fee—often, one percent or more—to cover marketing expenses (including sales commissions). To discourage early redemptions, funds with substantial 12b-1 fees may impose early redemption fees to ensure that investors either pay several years of 12b-1 fees or a substantial redemption fee. David Swensen, Yale’s extraordinary portfolio manager, has said, “Shame on the SEC for allowing 12b-1 fees, shame on the directors for approving them, and shame on the mutual funds for assessing them.”
How do they get away with it? It’s our fault. The Security and Exchange Commission requires mutual funds to show all of their charges in a standard table in the prospectus, including estimates of how these fees affect a $1,000 investment over periods of one to ten years. Unfortunately, the table is not mandatory reading. A former director of the SEC’s investment management division estimated that fewer than 10 percent of mutual fund investors ever open the prospectus.
Many mutual fund salespeople capitalize on short-term froth in the stock market by focusing their sales pitch on recently successful funds, giving the misleading impression that future investors are assured of a similarly spectacular performance. We fall for their babble because our dreams of easy riches make us gullible. Mutual fund families play this game, too, promoting funds that have had recent successes and not mentioning disappointments. Many in the industry suspect that some fund families have hundreds of disparate funds and keep creating new funds to ensure that they will have successes that can be promoted heavily.
Mutual funds have considerable latitude in reporting past results and some of them play sneaky games. For example, if two funds merge, the manager can choose which of the two performance records to attribute to the combined fund. For instance, if Fund A has earned 10 percent a year and Fund B has lost 10 percent, the manager can merge B into A and continue to report the fund’s return as 10 percent a year. John Bogle, founder of the Vanguard Group, strongly criticized this practice, observing sarcastically that “we are able to get rid of our poor performing funds by merging them into sister funds with lustrous records, and the record of the ‘turkey’ simply vanishes into thin air.” In 1993 Lipper Analytical Services reported that the annual return for diversified U.S. stock funds that stayed in business for the entire twenty-year period from 1973 to 1992 was 11.8 percent, compared to 11.4 percent for the S&P 500. However, 40 percent of the funds in business in the 1970s had disappeared by 1992. When the performance of these vanished funds is taken into account, the annual return for all diversified stock funds over this period dropped by more than a percentage point, to 10.5 percent.
While advertisements may be misleading and salespeople deceptive, the Securities and Exchange Commission requires a more complete and accurate disclosure in a mutual fund’s prospectus. One of the best ways to see through the hype is to read it carefully. Not nearly enough people do.
Study after study has found that, before expenses, mutual funds do as well, on average, as monkeys throwing darts. After expenses, two out of three funds do worse than the market. Professionally managed mutual funds charge an unconscionable amount for this inferior performance. As David Swensen wrote, “Overwhelmingly, mutual funds extract enormous sums from investors in exchange for providing a shocking disservice.”
No problem. Even if two-thirds of the funds do worse than the market, just invest in the one-third that beat the market. Right? As one market observer put it, “The problem of picking a mutual fund seems to be simplicity itself: The investor should select whichever fund will give him the largest percentage return, year after year.” Sure enough, investors pour money into recently successful mutual funds, paying big load fees in the belief that past performance ensures future success.
Unfortunately, funds with above-average records in the past are no more likely to do well in the future than are funds with below-average records. This is why the president of Morningstar, an independent mutual fund rating service, once said that rating mutual funds on their annual performance was “the dumbest thing imaginable.” Nonetheless, they started doing just that the next year. There is always a market for dumb things.
Mutual funds are not the only professionally managed portfolios whose performance has been disappointing. Money managers as a whole underperform the market after management fees and other expenses, and there is little consistency in their performance—knowing which managers have done well in the past is little help in predicting which will do well in the future. As this evidence accumulated in the late 1960s, many realized that if most professionals do worse than the market indexes, the way to beat most investment professionals is to buy the indexes and keep costs down. Instead of trying to pick stocks that might beat a market index, an index fund buys the stocks in the index.
In 1971 Wells Fargo Investment Advisors started an index fund for pension funds and other institutional investors and soon grew to become one of the largest single investors in the stock market; its annual management fees are as low as 0.05 percent. John Bogle wrote his senior thesis at Princeton on the failure of mutual funds to beat the S&P 500 and concluded that the way to beat most mutual funds was to buy the stocks in the S&P 500. Bogle founded Vanguard in 1975 and, a year later, introduced the first index fund open to small investors. Vanguard now has more than 200 funds managing more than $2 trillion in assets. Its index funds routinely beat two-thirds of the managed funds.
Many reputable firms offer index funds that essentially own all the stocks in a stock market index. One of the most popular is the Vanguard 500 Index Fund, which contains the 500 stocks in the S&P 500. Because Vanguard does not pay people to pick stocks, the expenses are tiny—about 0.16 percent annually, or $16 on a $10,000 investment. That’s less than the cost of making one trade a year; for example, selling Amazon to buy Google.
For an even broader portfolio, the iShares Core S&P Total U.S. Stock Market ETF covers 90 percent of all U.S. stocks, with an expense ratio of 0.03 percent, and the Vanguard Total World Stock holds more than 98 percent of all the stocks traded anywhere in the world, with annual expenses of 0.17 percent.
Index portfolios do not beat the market. They are the market. But they won’t do worse than the market, either, and that is comforting for some investors.
Many wise, seasoned, and admired investors—including Dave Swensen and Burton Malkiel—recommend investing in index funds. Even Warren Buffett, one of the gods of value investors, wrote in his 2013 Letter to Berkshire Shareholders that he wants the money he leaves to his heirs to be invested in an index fund:
My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s 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.
Oddly enough, Buffett did not recommend investing in his own company, Berkshire.
John Bogle’s core argument is correct:
In the stock market, some investors do better and some worse, but their aggregate returns equal the market’s returns, minus the costs of investing. After all, they are the market. So if a fund matches the market’s gross return and does so at a cost much lower than the average fund, it will always beat the average fund over time.
Bogle is comparing index funds to other mutual funds, but the same argument applies to all investing. If some investors index the market, the average return (before expenses) for all other investors must equal the index. If the index investors have lower fees and other expenses, they will, on average, do better than investors who do not index.
A reasonable response to the evidence that stock prices are hard to predict and that human emotions can lead us astray is to be passive. Instead of trying to pick the best stocks or the best time to buy stocks, buy all stocks and hold them all the time. Indexing is easy and cheap, and can shelter us from our emotions run amok.
Suppose, however, that the performance of those who do not index is not utterly and completely random. Suppose that there is a strategy—value investing—that is successful but not widely followed, perhaps because it is hard to control desire and emotion, two of Plato’s three pillars of human behavior. If so, while the average investor gets an average result, those who have the discipline to be value investors do better than other investors. If so, they must do better than the average investor and may do better than indexing.
There is truth and wisdom in the advice that ordinary investors should park their money in an index fund. Unchecked human emotions can lead us to trade too much, to trust hot tips, to chase trends, to be caught up in speculative bubbles and fearful panics. Indexing protects us from ourselves. Investors who cannot control their desires and emotions should put their savings in a low-cost index fund (I love Vanguard, too) and leave it alone. They will sleep better and do better than they would being led around by desire and emotion.
Yes, indexing protects us from human foibles and follies that can lead us into making bad investment decisions. On the other hand, if we recognize these human imperfections and are not seduced by them, we may be able to take advantage of the fact that human errors and animal spirits create potentially profitable opportunities. That is the essence of value investing. Wishful thinking, fads, trend chasing, fear, greed, and other human emotions can cause Mr. Market’s prices to surge above or collapse below intrinsic values, allowing value investors to buy stocks cheaply and sell stocks profitably.
Those investors who can be true value investors, putting aside wishful thinking, greed, fear, and other destructive human tendencies, can do better than indexing.