Active
investing is a strategy that investors use when trying to beat a market
or appropriate benchmark. Active investors commonly engage in picking
stocks, times, managers, or styles. As later steps demonstrate, active
investors who claim to outperform a market also claim the power to predict
the future. When accurately measured, this is simply not possible. Surprisingly,
the analytical techniques that active investors use can best be described
as qualitative or speculative. They include predictions of future sales
and earnings growth, and are often based on gut feelings and intuition.
On the other hand, the passive index investing approach is best described
as quantitative or scientific. Indexing techniques include statistical
analysis of risk and return data of 20 years or more, in addition
to extensive measurements of numerous performance criteria. Many indexes
are now based on 75 years of risk, return, and correlation data.
1.2.2
What Is Index Funds Investing?
As opposed to active
managers, investment managers of index funds are far less active in the
buying and selling of stocks, because they do not pick stocks or managers,
time markets, pick styles, or make attempts to forecast the future. As
previously mentioned, the analytical techniques that index funds managers
use are best described as quantitative or scientific.
Approximately 15% of all individual assets and 44%
of all institutional assets are currently invested in different index
funds. Many institutional funds are one hundred percent indexed. Even
Charles Schwab and Company recommends that investors put 80%
of their large cap assets into index funds. Mr. Schwab himself has 75%
of his mutual funds in index funds. Other indexing proponents include
Barclay's Global Investors, Dimensional Fund Advisors, The Vanguard Group,
Warren Buffet, Peter Lynch, numerous academic institutions, Economic Nobel
Laureates, and Index Funds Advisors (IFA). Insurance companies use a similar
approach to indexing when setting premiums for the risks taken by insuring
against thousands of different random events. Most of those premiums are
also invested in index funds while held in reserves for the inevitable
claim payment.
Most investors believe that index funds investing means investing in familiar
market indexes, such as the Standard and Poor's 500. S&P 500 funds
are structured with the aim to provide the same investment performance
as the S&P. By holding all the stocks in the same proportionate amounts
as the S&P index, the fund index represents about 86%
of the market value of all U.S. companies, mostly large blue chip stocks.
The problem is that market indexes, such as the S&P 500, were not
originally designed as investment vehicles.
Since the late 1980’s, index funds have expanded and are based on
more discrete customized indexes. Originally designed for very large pension
funds, institutional-style index funds are meant to capture various financial
risk factors or dimensions of the market. Exposure to a risk factor such
as company size or value constitutes a risk dimension of the market. Investors
have been compensated with higher returns for risk exposure to these risk
factors since 1929. These dimensions of the market can also be referred
to as indexes. Indexes are groups of stocks that have common risk and
return characteristics and comply to specific and clearly defined sets
of rules of ownership. These groups of stocks include companies from the
United States, foreign companies, and even emerging markets. There are
additional indexes within these markets, such as value, large value, small
growth, large growth, real estate securities, and many fixed-income investments,
such as short-term and long-term treasury bonds, municipal bonds, and
corporate bonds. Companies are purchased and held within the index when
they meet the index parameters. Stocks are sold when they move outside
of these parameters and no longer meet the index rules.
An example of an index fund is Dimensional Fund Advisors' (DFA) Micro-Cap
index fund, which invests in securities of U.S. companies whose size (market
capitalization) falls within the smallest 4% of the total market universe.
This includes all stocks traded on the New York Stock Exchange and the
American Stock Exchange, as well as those listed in the National Association
of Securities Dealers Automated Quotation Over-the-counter (NASDAQ OTC)
market. Another example would be DFA’s Small Cap Value Fund, which
invests in companies ranked in the lowest eight percent by size, as well
as the highest 25th percentile by book-to-market ratio (value).
DFA funds are now available to individual investors through a small qualified
group of registered investment advisors who have demonstrated their understanding
and commitment to the concepts described in this 12-Step Program.
The overwhelming majority of investors are active investors. Extensive
research by many academics and investment professionals has shown that
investors cannot beat a market in the long run with stock, time, manager,
or style picking. It is disconcerting that about seventy percent of all
institutional money invested in U.S. stocks is still actively managed.
1.2.3
Comparison Table
The table below summarizes
the differences between the two approaches to investing.
Table 1-1
1.2.4 Beating a Market
We reference the phrase “
beating a market” throughout this 12-step Program. This is defined
as the attempt to obtain a higher net return on investments from a portfolio
of stocks, bonds, or mutual funds than from a relevant and investable index
or benchmark. The net return includes adjustments for all commissions, loads,
fees, expenses, risks, and federal and state taxes. It is calculated over
a reasonable period of at least five years, but preferably over 20 years.
The net return of an active investor’s stock portfolio can then be
paralleled to the index fund of a comparable index. The index may consist
of the entire stock market or a more specific index, such as small capitalization
value stocks. No investor over or underperforms an index. They simply invest
in something other than the index. Since the index is the only source of
long-term risk and return data, why would an investor subject hard earned
savings to anything other than the index?
The most basic tenet of all investing is that exposure of your money to
a higher level of risk should be rewarded with a higher expected return.
In contrast, lower levels of risk should correlate to a lower expected return.
One of the problems with measuring the performance of stock market investing
is the lack of a standardized system of benchmarks from which to measure
performance. This lack of benchmarking is the black hole
of investing. If there is no definitive benchmark, it is impossible to determine
if exposure to risk has been properly rewarded. In other words, has the
active investor really beaten a market with repeatable skill, or can it
just be attributed to luck?
1.2.5
Risk
There are many terms
used by investment professionals and academics in their quest to define
risk. These include markets, benchmarks, asset classes, styles, style
boxes, investment objectives, risk factors, market dimensions, market
segments, categories, market averages, buckets of stocks, rules of ownership,
slices of the market, industry classifications, and indexes such as Dow
Jones Indexes, Standard and Poor's Indexes, Russell Indexes, Wilshire
Indexes, Morgan Stanley Capital Indexes, Wired Index, and many more. Diversification
and measures of volatility, such as standard deviation, are also used
to describe risk. Every one of these is an attempt to identify common
risk and return characteristics among groups of stocks included in that
classification. To reduce confusion, market or index will often be substituted
for these terms.
An appropriate challenge
to the investment industry is a call to action to develop an SEC-approved
standard to measure the risk of various investments. The three-factor
model proposed by Eugene Fama and Kenneth French in 1992 would be an excellent
starting point. This model is discussed later in Step 8: Riskese™.
1.3
Problems
1.3.1
Active Investors are Everywhere
About 85%
of investors are active investors. The most popular strategies in attempting
to beat a market include stock, time, manager, and style picking. Steps
3, 4, 5, and 6 describe these strategies and explain the futility of all
these methods.
Stock pickers try to pick winning stocks rather than diversify their portfolio.
Market timers, or time pickers, try to make money by timing the markets.
They think they can strategically pick specific times to get in and out
of a market, believing this approach is more profitable than a buy-and-hold
strategy. Time
picking also refers to the purchase or sale of individual stocks.
Manager pickers buy stock portfolios or mutual funds managed by the money
managers who seem to have the best recent performance record.
Style pickers identify which style, such as large growth or small value,
is the next style to perform above and beyond the others.
The majority of individuals in the U.S. who are currently invested in
stock mutual funds holds shares of an actively managed mutual fund. However,
according to data from Strategic Insight, about three out of every five
dollars invested in stock funds in 2001 were invested in index funds -
nearly 60% of stock fund cash flow. This means more investors are understanding
the benefits of indexing.
1.3.2
Active Investors are Gamblers
Active
Investor
Active investors believe they are in control. They delude themselves that they have a special understanding
of the market, a superior edge over less knowledgeable investors, making them immune to disaster. The truth is that all investors can
access the same information as professional money managers through the
Internet and many other sources. Still, many investors believe they are
smarter and more sophisticated than the average investor. Those under
this illusion fail to realize how much investment performance depends
on luck. Most of them eventually pay dearly for this mistake.
Active investing in
the stock market is a lot like casino gambling. Take a look at the numerous
comparisons in the various news articles below. (Note the references to
addiction.)
Las Vegas Review-Journal;
June 29, 1998, SOS: STUCK ON STOCKS. "By far, the most gambling
performed in the world is performed in the stock markets," said
Paul Ashe, president of the National Council on Problem Gambling. "More
money is lost in the stock market than in legal and illegal casino gambling
combined," said Marvin Steinberg, a Connecticut psychologist who
specializes in treating compulsive investment gamblers.
Northern New
Jersey Record: February 2, 1998, High-Risk Investments Online
Internet Trading Can Be Addictive and Costly. Dan Gaffney liked
the odds. A $1,200 wager, a $150,000 score. He came so close to winning,
too. But somehow, he lost. And it didn’t feel like losing $1,200. It
felt like $150,000 had just slipped through his fingers.
ABC NEWS, February
1, 1999; The Craving to Buy and Sell; Online Trading Becoming
Addiction for Some
San Francisco
Business Times; Options junkies get treatment as chronic gamblers
www.800gambler.org
January 25, 1999, Stock Market Gambling and The Addiction Of The
Millennium
The San Francisco
Chronicle, August 16, 1999, Losing Your Shirt For Day Traders.
For those risk-loving hunters of the stock market, gambling is the essence
of their trade
Fidelity
Outlook, Summer 1999; Cover Story, The New Psychology of Investing;
Obsessive, Compulsive, and so far Successful
Forbes,
September 13, 1999: Addicted to the Click, How my on-line trading
frenzy ended in a lingerie department in Paris
San
Francisco Examiner; Wrapped up in risk; Compulsion to gamble
can blind even the best investors to bets gone bad
Paul Samuelson, Nobel Laureate, MIT Economist
"My guess is that indexing will have a larger role if you call
me ten years from now than it does now. But it will still be a minority
mode of investing. Why? There is something in people; you might
even call it a little bit of a gambling instinct. They want to be
interested in the process of investing, and it's traditionally been
difficult to get too jazzed up about indexing. I tell people [investing]
should be dull. It shouldn't be exciting. Investing should be more
like watching paint dry or watching grass grow," he says. "If
you want excitement, take $800 and go to Las Vegas." - Paul
Samuelson, Nobel Laureate, MIT Economist, The
Guide to Ultimate Indexing:To make the most of a growing array of index investments, you
need to look beyond the obvious.By
Daniel McGinn, September 1999
The active investor's addiction to beating the odds is often as strong
as any other addiction. Like gambling, active investing can be extraordinarily
exciting for investors who get carried away by the adrenaline of winning.
Of course, it can create significant agony for those who experience
the losing side of risk. One of the biggest mistakes made by the active
investor is believing there is skill involved when the stock market
proves profitable. Many of today’s day traders are learning this the
hard way. There are now approximately 15 million online trading accounts
in the United States. Stories of mounting losses are becoming more
prevalent as the odds of playing the markets take their toll on this
new breed of investors. Just like casino gambling, there are more
tales about the winners than the losers, but the stories rarely give
an accurate accounting of true net profit.
The
title speaks for itself. by James Cramer, 2002
New studies in the field of neuroeconomics confirm the release of
dopamine when presented with the opportunity of a surging stock. This
validates and confirms the addictive nature of Stockaholics™.
The powerful allure of monetary reward leads to the overwhelming urge
to trade stocks or funds. It has now been shown through brain imaging
studies that the circuits that switch on at the prospect of big profits
are the same as the ones that lead to the addictive nature of cocaine,
casino gambling, alcohol, chocolate, and sex, just to name a few. The
brain images below tell the story.
In
the October
2002 issue of Money Magazine, the highly respected journalist
Jason Zweig writes a ground-breaking article about the new evidence
of the release of addiction related dopamine in our brains. He declares,
"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." He goes on to say that, "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." Zweig
reports that there are several researchers working on nueroeconomics
at this time. At Harvard, Hans Breiter is leading a project and
has stated that they have discovered a "striking" similarity
between the brain's reaction to cocaine, morphine, and the prediction
of financial rewards. Please take the time to read Jason's new book on this subject, Your Money & Your Brain. Also see Center for Neuroeconomic Studies Duke University.
Followup on above video: Tim Sykes, 25, ran a top-ranked, short-bias fund called Cilantro Fund Partners, which he founded in 2003 in his senior year at Tulane University in New Orleans. After suffering a roughly 35% loss over two years, on October 1, 2007, Timothy closed his hedge fund.
1.3.3
Active Investors Lose
In the June
2002 edition of Money Magazine, once again Jason Zweig gets to
the bottom of what investors really earn. He describes the difference
between the returns that mutual funds report and the actual returns
of the average investor in those funds. Active investors chase hot
funds. As a consequence, they end up with less than one fifth the
funds' annual returns. When inflation and our estimate of taxes are
deducted, it is not a pretty picture for active investors. See right.
Figure
1-1
Table 1-2 illustrates
some of the details of this unique study. The large gap between the
funds' and shareholders' returns was a shock to even the researchers.
The reason for this gap is attributed to active investors who followed
the destructive behavioral patterns that Dalbar Research had been describing
since 1994. These patterns include waiting for funds to have a good
year or two followed by pouring in a flood of cash just before the
fund reaches its peak. Then they ride the fund to near bottom and sell.
One encouraging exception was the Dimensional Fund Advisors (DFA) institutional
index funds. DFA investors are limited to either large institutional investors
or individuals who have been educated by specially trained investment
advisors. Because the shareholders of these funds buy and hold diversified
portfolios at all times, they ride out the market gyrations and end up
obtaining market rates of returns. The table below shows the worst big
funds ranked by how investors performed relative to the funds and five
DFA funds listed in the article.
Table 1-2
In one example from the study, the Firsthand Technology Value fund racked up an impressive annualized return of 16% from 1998 to 2001. However, the investor return over this period was a devastating 31.6% loss. In total it was estimated that investors lost $1.9 Billion in this fund over this period, while the fund reported time-weighted returns of 16%. The head of fund marketing for Firsthand stated, "... people lost a lot of money because they took oversized bets in technology at the wrong time." A careful analysis of the chart below will reveal the tragedy of active investors behavior.
Figure 1-A
A study released by Dalbar in 2006
came up with similar results, but over a much longer period. The study
indicated that during the 20 years from 1986 to 2005, the average stock
fund investor earned returns of only 3.9% per year, while the S&P 500 returned 11.93%.
On an inflation adjusted return, the average equity fund investor earned
$19,625 on a $100,000 investment made in 1986, while the inflation adjusted
return of the S&P 500 would have been $400,938 or 20 times greater,
as shown in Figure 1.2 and Figure 1.3.
Dalbar previously
conducted similar studies in 1994 and 1998. The 1998 study found that
the return of the S&P 500 was five and a half times greater than what
the average investor earned. All three studies showed that the average
fund investor earned much lower returns than the S&P 500 or the average
mutual fund. Clearly, investor behavior can have a far more negative impact
on investment performance than investors realize.
Some investors can benefit from enlisting an investment educator or mentor
who will focus on changing their investing behavior, encourage long-term
investing, and discourage the gambling practices of trying to beat a market.
The fund tracking service Morningstar started disclosing these "investor
returns" in 2006. On the Data Definition page of their web
site, they state that "Morningstar investor returns (also known
as dollar-weighted returns) measure how the typical investor in
that fund fared over time, incorporating the impact of cash inflows
and outflows from purchases and sales. In contrast to total returns,
investor returns account for all cash flows into and out of the
fund to measure how the average investor performed over time. Investor
return is calculated in a similar manner as internal rate of return.
Investor return measures the compound growth rate in the value of
all dollars invested in the fund over the evaluation period. Investor
return is the growth rate that will link the beginning total net
assets plus all intermediate cash flows to the ending total net
assets."
Now that Morningstar is tracking such
data, investors bad behavior is finally quantified, as well the
advantages of using a passive advisor who helps reduce investor
error. In the Morningstar
Indexes Yearbook: 2005, they analyzed how the average index
investor did on their own versus those that are guided by an advisor
using asset class index-type funds from Dimensional Fund Advisors.
Here is what they had to say:
"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 [see Table 1-3].
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."
Table 1-3
The emotions of active investors go up and down like a roller coaster,
leading them to negative returns on average, after expenses and taxes
are deducted. The lessons in this 12-Step Program should allow investors
to resist the behaviors that have caused them such despair and poor results
in the past.
Figure 1-4
As a contrast, passive investors invest whenever they have the money to invest and regardless of market conditions, as seen below.
