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

— Warren Buffett, 1996

Benjamin Graham

"The investor's chief problem - and even his worst enemy - is likely to be himself."

— Benjamin Graham, Graham, Benjamin, "Security Analysis," New York: McGraw-Hill Companies, 1934

Paul Samuelson

"There is something in people; you might even call it a little bit of a gambling instinct… I tell people investing should be dull. It shouldn't be exciting. Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas."

— Paul Samuelson, "The Ultimate Guide to Indexing," Bloomberg Personal Finance, 1999

Jason Zweig

"The neural activity of someone whose investments are making money is indistinguishable from that of someone who is high on cocaine or morphine."

— Jason Zweig, Your Money & Your Brain, 2007

Introduction

What would you do if you never listened to another financial media pundit, watched another financial news show or spent another hour in front of your computer feverishly tracking the stock market? How would that make you feel? Anxious and nervous that you were missing out on something? Or relieved that you could spend your time doing what you really enjoy? More investors are discovering the solution to anxiety-free investing, learning the strategies that enable them to shift their focus away from the frenzy of Wall Street and put their attention on what they value most.

That's what this website is about—to show you, the investor, that you no longer have to lose any sleep worrying about your investments. It's actually possible to invest and truly relax. What is this groundbreaking way to invest? The truth is that it's not groundbreaking at all. Like most "secrets" or solutions, the answer has been around for a long time. It's not riveting or thrill-inducing and provides no emotional rush. It's not a quick fix. On the contrary, it's sound and prudent and offers a wise alternative to what is termed "active investing" in the financial investment world. What is it? It's passive investing with index funds.

This 12-Step Recovery Program for Active Investors will walk you through the land mines and pitfalls of active investing and show you a better way to invest. When you complete this 12-Step Program, you will understand the differences between active and passive investing and be fully aware of the emotional triggers that impact investment decisions. You will also obtain an enlightening education on science-based investing that may forever change the way you perceive how the stock market works. You will learn the hazards of speculation and the rewards of discipline. The best part is that you can learn to change your own investment behavior, which can lead to a more profitable and enjoyable life.

As you embark upon the 12 Steps, an important concept to understand is that most people tend to make investment decisions based on emotions. The challenge for all investors is to ignore emotional triggers that impede rational decisions. Emotions often override reason when it comes to investment decisions, leading to irrational and destructive behavior. The financial news media and Wall Street feed the fear, anxiety and other stressful emotions experienced by investors, resulting in less than favorable investment outcomes. This book will teach you how to hang on in the midst of turmoil and show you the destructive nature of active investing.

As you climb the 12 Steps illustrated in the following painting, you will abandon the gambling and speculative behaviors of the active investors located in the bottom right corner, ascend the stairs to claim your risk-appropriate portfolio (symbolized by the woman handing out colorful balls), and continue up to the balcony where individuals who have successfully completed their 12-Step Journey enjoy the tranquility of an investing state of mind I call, "Tradeless Nirvana."

The 12-Steps to Tradeless Nirvana
The 12-Steps to Tradeless Nirvana
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Active Versus Passive Investing

Active investing is a strategy investors use when trying to beat a market or appropriate benchmark. Active investors rely on speculation about short-term future market movements and ignore vast amounts of historical data. They commonly engage in picking stocks, times, managers, or investment styles. As later steps demonstrate, active investors who claim to outperform a market are in essence claiming to divine the future. When accurately measured, this is simply not possible. Surprisingly, the analytical techniques that active investors use are best described as qualitative or speculative, largely including predictions of future movements of the stock market based on too little information. Bottom line, these methods prove self-defeating for active investors and actually lead them to underperform the very markets they seek to beat.

The first step in any 12-Step Program focuses on recognizing and admitting a problem exists. In this case, this means identifying the behaviors that define an active investor.

These include:

  • Owning actively managed mutual funds
  • Picking individual stocks
  • Picking times to be in and out of the market
  • Picking a fund manager based on recent performance
  • Picking the next hot investment style
  • Disregarding high taxes, fees and commissions
  • Investing without considering risk
  • Investing without a clear understanding of the value of long-term historical data


There are sharp contrasts between the behaviors of passive investors and active investors. Passive investors don't try to pick stocks, times, managers, or styles. Instead, they buy and hold globally diversified portfolios of passively managed funds. The term "passive" translates into less trading of the fund's portfolio, more favorable tax consequences, and lower fees and expenses than actively managed funds.

A passively managed fund or index fund can be defined as a mutual or exchange traded fund with specific rules of ownership that are adhered to regardless of market conditions. An index fund's rules of construction clearly identify the type of companies suitable for its investment. Equity index funds would include groups of stocks with similar characteristics such as size, value and geographic location of company. This group of stocks may include companies from the United States, foreign countries or emerging markets. Additional indexes within these markets may include segments such as small value, large value, small growth, large growth, real estate, and fixed-income. Companies are purchased and held within the index fund when they meet the specific index parameters and are sold when they move outside of those parameters.

Figure 1-1 illustrates the different characteristics between active and passive investing. Introduced in the early 1970's, index funds investing has caught on, and for good reason. As the chart shows, index fund investors have fared better in returns and incurred lower taxes and turnover than active investors. They are also able to enjoy a relaxed state of mind.

Figure 1-1

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Emotions-Based Investing

The emotions of investors tend to match the wild gyrations of the market itself. Investors might feel euphoric when the market hits a new high and panic-stricken when the market has dropped like a rock. Who can blame these investors? The stock market can be a scary place when gut instinct overrides knowledge of the specific market dynamics at play, including fair prices, randomness, efficiency, and the benefits of diversification.

Behavioral Finance is a field that studies the connection between investors' emotions and their financial decisions. In The Little Book of Behavioral Investing: How Not to be Your Own Worst Enemy,1 author James Montier talks about the importance of planning ahead to protect us from the "behavioral biases that drag down investment returns." He highlights the need for investors to pre-commit to an investment strategy in order to avoid the pitfalls of emotional decisions.

In Your Money & Your Brain,2 financial writer Jason Zweig details evidence of the release of addiction related dopamine in our brains when we anticipate big wins. "The dopamine rush we get from long shots is why we play lotto, invest in IPOs, keep too much money in too few stocks, and invest with active portfolio managers instead of index funds," Zweig states. "Our brains are wired to force us into forecasting; it is a biological imperative. In fact, humans are born with what I've come to call ‘the prediction addiction.'" Several researchers working in neuroeconomics, including Harvard's Hans Breiter have identified a striking similarity between the brain's reaction to cocaine, morphine and the prediction of financial rewards.

Even wealthy individuals struggle with emotions management and investing discipline. A 2011 Barclay's study3 found that 41% of high net worth investors wished they had more self-control over their investing decisions. The study concluded that emotional trading can cost an investor about 20% in returns over a 10-year period. Investors who prevent themselves from over-trading through specific strategies are on average 12% wealthier than those who don't use self-control mechanisms. These self-control strategies include minimizing time spent checking on a portfolio or talking to someone prior to making a buy or sell decision.

Several behavioral biases that tend to affect investor decisions include the following:

  • Overconfidence: People mistakenly believe they can outperform the market.
  • Hindsight bias: Investors think past events were predictable and obvious and believe they should have known better. The truth is that news moves the markets, and past events could not have been predicted in advance.
  • Familiarity bias: Investors invest only in stocks they know, which provides a false sense of security. An example may be a "legacy" stock that's been passed down in a family through many generations. Regional or geographical bias also comes into play when investors choose stocks of companies headquartered in their state or region of residence, which can lead to undiversified investments.
  • Regret avoidance: Investors vow to never repeat the same decision if it resulted in a previous loss or missed gain, not understanding that the future cannot be predicted.
  • Self attribution bias: Investors tend to take full credit for investment gains and blame outside factors for losses, wrongly attributing success to personal skill or ability.
  • Extrapolation: Investors base decisions on recent events, assuming past market trends will repeat themselves.

These behavioral biases cause investors to believe they have control in areas where they actually have none. A disciplined investing approach involves the understanding of the factors we can and cannot control, planning ahead and not giving into emotions when making investment decisions.

Figure 1-2 depicts the roller coaster of emotions active investors experience. In the emotional cycle, they wait until they feel confident their selected investments are on a perceived upward trend; then they place their orders. But once prices fall, doubt sets in. When that turns to fear, they often sell the investment, resulting in a loss.

Figure 1-2

In contrast, Figure 1-3 shows the constant relaxed emotions that indexers enjoy by accepting market randomness and relying on investing science instead of making decisions based on emotions. Passive investors invest regardless of market conditions, because they understand short-term volatility is unpredictable. They know succumbing to gut instincts and emotions undermines long-term wealth accumulation. They also know that news about capitalism is positive on average—but involves some stomach-churning volatility, as many experienced in the downturn of 2008 through March 2009, and again to some degree in 2011.

Figure 1-3

Passive investors also engage in periodic rebalancing and are rewarded in the long term for their discipline. Figure 1-4 depicts the disciplined emotions and approach of "Rebalancers" who sell a portion of their funds that have grown beyond their target allocation and buy more of other funds to restore their target allocation. This is actually the opposite behavior of active investors, because rebalancers will sell a portion of their portfolio after it has gone up and buy more of those investments that have declined in order to maintain a specific asset allocation. This strategy seems counterintuitive and can be emotionally difficult to implement. Annual rebalancing requires discipline and ensures that a portfolio will remain diversified in volatile markets. This discipline also enables passive investors to better fulfill the age-old investing axiom: "buy low, sell high."

Figure 1-4

The impact of emotions on investor performance is a subject of much analysis. An annual study called the Quantitative Analysis of Investor Behavior (QAIB),4 which has been conducted by Dalbar since 1994, measures the impact of investor decisions to buy, sell and switch into and out of mutual funds. Each year, the study has shown the average mutual fund investor earns significantly less than the mutual funds over the same time period. In fact, the report issued in April 2012 carried this headline: "Investor Irrationality on Display." The study further concluded, "One of the most startling and ongoing facts is that at no point in time have average investors remained invested for sufficiently long periods to derive the benefits of the investment markets."

The Dalbar study further addresses the problems with investor behavior by stating, "The gross underperformance of the average investor in 2011 clearly displays what has been the case for twenty-five years: Irrational decisions lead to inferior returns." The previous year's Dalbar study states, "As this report has shown for the 17th time in as many years, mutual fund investors consistently underperform the relevant index." The report also shows that most of this loss in performance is due to psychological factors that translate into poor timing of their buys and sells (investor behavior).5

Figure 1-5 illustrates the results of the 2013 Dalbar study, a comparison of the returns of an average equity fund investor to the returns of the market from 1993 through 2012. Permitting their decisions to be driven by short-term volatility, the average equity fund investor earned returns of only 4.25%, while the S&P 500 returned 8.22%. An investment of $100,000 made in 1993 grew to $229,891 over the 20-year period for an average equity fund investor, while the same amount invested in the S&P 500 grew to $485,190. Even better, an investor who owned an all-equity, small value tilted, globally diversified index portfolio would have grown a $100,000 investment to $673,978. Clearly, investor behavior can have a far more negative impact on investments than investors realize.

Figure 1-5

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Active Investors Lose

In the June 2002 issue of Money Magazine,6 Jason Zweig described a study conducted by Indiana University Professor of Finance Charles Trzcinka, illustrated in Figure 1-6. The study used a similar technique to Dalbar by showing the difference between the annualized returns of the average mutual fund (time-weighted returns) and those of the average mutual fund investor (dollar-weighted returns). As the chart indicates, the average active fund advertised a 5.7% time-weighted annualized return from 1998 to 2001. The average fund investor, however, only earned a 1.0% annualized return. This discrepancy in returns arises because funds often obtain large returns when there are fewer dollars and shareholders invested in the fund, and fund declines often occur after a large inflow of investors chase those large returns. Once word of a fund's success spreads, investors swarm to the fund. When it inevitably declines, the fund is much larger than when it began, and it loses far more wealth for investors than it had previously gained.

Figure 1-6

Active investors also pay higher expenses, taxes and fees. When taxes and inflation are considered, I estimate that the average mutual fund investor lost a 3.3% annualized return over the 4-year period. The average mutual fund reported annualized returns of 1.4%, a 4.7% gap between the return reported by the mutual fund and the return to the investor after inflation and taxes. The disparity between the fund returns and those that are actually earned by average active investors confirms the benefits of passive investing and emotions management.

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Index Funds Investing

While active investors seek to outperform the markets, buyers and rebalancers of index funds seek to capture the returns of the entire market in a lower-cost and tax-efficient manner. Index funds investors select passive funds that track defined asset class indexes. Regardless of market conditions, they stay the course and do not make investment decisions based on emotions. Since the global markets have delivered the returns of capitalism at a generous 9.5% annualized return over the last 85 years, a wise investment strategy is to hold and rebalance a portfolio that is globally diversified across many asset classes or indexes.

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Matching Risk Capacity with Risk Exposure

Stock market returns are compensation for bearing risk. Higher expected returns require higher risk. Therefore, investors should take on as much risk as they have the capacity to hold—their risk capacity. One of the most effective ways to determine risk capacity is to examine five distinct dimensions: an investor's time horizon and liquidity needs, investment knowledge, attitude toward risk, net income, and net worth. This is explained more fully in Steps 10 and 11.

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Value of a Passive Advisor

Passive advisors play an integral role in emotions management. Knowledgeable, passive advisors help maximize investor success because they provide the critical discipline needed to combat emotional, reflex reactions like pulling out of the market the way so many did in late 2008, early 2009, or in 2011. Passive advisors not only help to manage an investor's emotions, they serve as fiduciary stewards of their clients' wealth.

Figure 1-7 is a compilation of 18 studies which depict varying levels of investor success with or without passive advisors. It shows that the average fund investor without a passive advisor (blue bars) captured only an average of 50% of fund returns. Indexers without passive advisors (purple bars) were more successful at capturing fund returns than average fund investors, due to a less active approach. However, they also failed to capture the full returns of the index funds they owned. The average passive investor captured only an average of 83% of a fund's return, according to the studies. This is likely explained by a failure to rebalance asset allocations during market turbulence, a delay of investing when cash is available, or even the inability to stay invested during rocky markets.

Figure 1-7

In sharp contrast, the Morningstar Indexes Yearbook states individuals who invested in Dimensional Fund Advisors (DFA) funds and used passive advisors (green bar) captured all of the fund returns and then some—109% of the fund returns.

A 2005 Morningstar report says, "Consider the success Dimensional Fund Advisors (DFA) has had in selling its funds through advisors who undergo training on the merits of passive investing and in portfolio construction theory. Consider that over the past decade the dollar-weighted return of all index funds was just 82% of the time-weighted return investors could have gotten with those funds. Yet, the figures for DFA are much better. In fact, the dollar-weighted returns of DFA funds over the past 10 years are actually higher than their time-weighted returns, suggesting advisors who use DFA encourage very smart behavior among their clients, even buying more out-of-favor segments of the market and riding them up, rather than buying at the peak and riding the trend down, which is usually the case with fund investors."7 The findings of this Morningstar report are shown in Figure 1-8.

Figure 1-8

Knowledgeable passive advisors help their clients stay invested and rebalance through market turbulence. Such behavior enables these investors to maximize their ability to capture returns and provides justification for the right passive advisor. Many investors are lured into do-it-yourself indexing through exchange traded funds (ETFs). This is a step in the right direction, but without a passive advisor, these investors have not experienced the full value of advised indexing. Quality passive advisors offer valuable services, such as rebalancing, tax loss harvesting, a glide path strategy, and other wealth management tools that are rarely properly applied by do-it-yourself investors. Step 12 provides more information on these topics.

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The Ulysses Pact

Homer's legendary story about Ulysses (Greek name Odysseus) tying himself to the mast to avoid destruction can be aptly applied to investing. Ulysses was able to hear the beautiful siren songs without being led to his demise, because he made an agreement with his seafaring crew as they approached the sirens. He ordered them to plug their ears with wax and keep him tied to the mast despite his protests and cries. Under no circumstance were they to untie him. Ulysses desperately tried to break free upon hearing the sirens, but the men kept their promise, and the entire crew sailed safely through danger. They all worked together to strategically prevent their own ruin.

The Siren Songs of Investing
The Siren Songs of Investing

The lure and noise of financial media often drive the behaviors and decisions of investors. A Ulysses Pact is like an investment policy statement, a proactive and strategic agreement that is made between a client and advisor in advance of any market turmoil or uncertainty. An advisor can guide clients through the murky or turbulent waters and ensure they don't jump ship in response to the noise by signing a Ulysses Pact. This pact allows an investor to agree up front that under no circumstance will he act on emotions that can lead to irrational and wealth-destroying decisions. It can serve as a promise to one's self to follow a passive advisor's counsel to hold on and not buy or sell as a reflexive reaction to the short-term movements of the market. This encourages a client to hold on and understand that the free market will set prices for a positive expected return, so that the storm will pass.

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Legendary Investors Agree on Index Funds

Renowned investor Warren Buffett is an advocate of index investing and has recommended it to his shareholders in three annual reports. "Over [the past] 35 years, American business has delivered terrific results. It should therefore have been easy for investors to earn juicy returns: All they had to do was piggyback corporate America in a diversified, lower-expense way. An index fund they never touched would have done the job. Instead, many investors have had experiences ranging from mediocre to disastrous," Buffett said in his 2004 letter to shareholders. Buffett not only advocates index funds, he's betting on them.

The June 2008 issue of Fortune8 Magazine reported that Buffett wagered a million dollars that an S&P 500 index fund's ensuing 10-year returns would beat those of five hedge funds chosen by a prominent New York-based asset management firm. Passing the 6-year point on December 31, 2013, the Vanguard fund picked by Buffett is up by 43.8%, while five hedge funds have gained only 12.5%. Since this is highly unlikely to reverse over the next four years, our money is on the Oracle of Omaha.

Many highly respected financial experts affirm Buffett's high regard for index funds. For its "Core and Explore" program, Charles Schwab and Company recommended investors put a large portion of their large-cap assets in index funds. In his book, Charles Schwab's Guide to Financial Independence, Schwab revealed, "Most of the mutual fund investments I have are index funds, approximately 75%."9

Benjamin Graham, influential economist and mentor to Warren Buffett, spent most of his professional life analyzing companies for stock market bargains. However, shortly before his death, Graham rejected his long-held belief that investors could expect to beat the market through individual stock analysis. Graham was visionary in his early description of what is now known as a value index fund when he stated, "The thing that I have been emphasizing in my own work for the last few years has been the group approach. To try to buy groups of stocks [index funds] that meet some simple criterion for being undervalued—regardless of the industry and with very little attention to the individual company."10

Tradeless Nirvana
Tradeless Nirvana

Noteworthy institutional investors also advocate index funds investing. David Swensen, Chief Financial Officer of the highly successful Yale Endowment Fund and author of Unconventional Success: A Fundamental Approach to Personal Investment11 and Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment,12 has been particularly outspoken about the downfalls of active investing and the merits of index investing for individual and institutional investors alike. In an August 2011 opinion piece which appeared in the New York Times, Swensen blasted active investing and its facilitators, including mutual fund companies, retail brokers and advisors, citing that market volatility causes ill-advised investors to behave "in a perverse fashion, selling low after having bought high." He asks, "What should be done? First, individual investors should take control of their financial destinies, educate themselves, avoid sales pitches, and invest in a well-diversified portfolio of low-cost index funds."13

So what is the lesson here? In a nutshell, when you fully embrace a new way of investing, you can substantially reduce the stress and anxiety commonly experienced by active investors. You will be calmer, relaxed and more centered in the midst of the noise and frenzy of media pundits and Wall Street. Your unwavering commitment to your investment plan will allow you to let go of unnecessary worry and enable you to focus on what truly matters to you most. You will not only be rewarded emotionally, you will also improve your probability of investment success. Why would you want to do anything else?

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Footnotes:
  • 1James Montier, The Little Book of Behavioral Investing: How Not to Be Your Own Worst Enemy (Hoboken: John Wiley & Sons, Inc., 2010).
  • 2Jason Zweig, Your Money and Your Brain (NY: Simon & Schuster, 2007).
  • 3 Dr. Ian Ayres, Dr. Peter Ayton, Dr. Greg B. Davies, Dr. Barbara Fasolo, Professor Thorsten Hens, Sheena Iyenger, Dr. Annie Koh, Dr. Neil Stewart, Rory Sutherland, and Dr. Chun Xia, "Risk and Rules: The Role of Control in Financial Decision Making," Barclays Wealth Insights, vol. 13 (2011).
  • 4Dalbar, Inc., "2012 Quantitative Analysis of Investor Behavior," (2012).
  • 5Dalbar, Inc., "2011 Quantitative Analysis of Investor Behavior," (2011).
  • 6Jason Zweig, “What Fund Investors Really Need to Know,” Money Magazine, June 2002.
  • 7Sanjay Arya, John Coumarianos, Pat Dorsey, Russel Kinnel, Don Phillips, Tricia Rothschild, "Morningstar Indexes Yearbook," Morningstar, Inc., vol. 2 (2005).
  • 8Carol J. Loomis, "Buffet's Big Bet," Fortune, June 23, 2008.
  • 9Charles Schwab, Charles Schwab's Guide to Financial Independence: Simple Solutions for Busy People (New York: Three Rivers Press, 1998).
  • 10Hartman L. Butler Jr., "An Hour with Mr. Graham," March 1976.
  • 11David Swensen, Unconventional Success: A Fundamental Approach to Personal Investment (New York: Free Press, 2005).
  • 12Swensen, Pioneering Portfolio Management: An Unconventional Approach to Institutional Investment.
  • 13David Swensen, "The Mutual Fund Merry-go-Round," New York Times (New York, NY), Aug. 13, 2011.
step 1jason zweigdalbarmoney magazineactive investorsindex fundsinvestingrisk exposurerisk capacitypassive advisordimensional fund advisorsulysses pactodysseussiren songswarren buffetfortune magazinebenjamin grahamdavid swensen

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