1.3.4 The Poor Accounting of Active Investors

Active investors, like casino gamblers, often do not account for their total return properly. Common mistakes include the exclusion of loads, commissions, taxes, and cash flows in and out of their portfolios. Another common error is quoting the returns of only the portion of their portfolios that performed well. Then there is the problem of hearing only from the winners and not hearing from the losers who seem to disappear into thin air. Since 1961, twenty-eight percent of mutual funds have vanished from the record. There is no accounting for their returns.

1.3.5 Stock Market Prices Are Random

The stock market moves with new information. News is unpredictable and random; therefore, the stock market moves in an unpredictable and random way. The Random Walk Theory describes the way stock prices change unpredictably as a result of unexpected information appearing in the market. This "random walk" of changing prices has created a misconception among investors that stock prices change randomly for no rational reason. The news is random and unpredictable by nature. Investors react to the news, thereby effecting stock prices.

The year 2000 marked the centennial of the Random Walk Theory of stock market prices. Many scholars have confirmed and refined the research of Louis Bachelier, the hapless unsung hero of financial economics. On March 29, 1900, Bachelier presented "The Theory Of Speculation" as a thesis before the faculty of sciences at the Academy of Paris. He anticipated what was to become standard fare in financial theory: the random walk of financial market prices. One hundred years since the theory's conception, the vast majority of investors are still not convinced that the markets are random.

In 1964, MIT professor Paul Cootner published a 500-page book of reprints of all research on the randomness of the market. The book was titled, "The Random Character of Stock Market Prices." It contained the first full text English translation of Bachelier's 1900 thesis.

1.3.6 Stock Markets are Efficient

The Efficient Market Theory explains the process of free and efficient financial markets. First, information about stocks is widely and inexpensively available to all investors. Second, all known and available information is already reflected in current stock prices. Third, the price of a stock agreed on by a buyer and a seller is the best estimate of the true value of that stock. Finally, stock prices change almost instantaneously as new unpredictable information appears in the market. All of these factors make it nearly impossible to capture returns in excess of a market return without taking greater than market levels of risk. As discussed in Step Eight: Riskese™, the only issue of concern is the relationship between risk, return, time, and correlation.

1.3.7 When Risk Capacity™ is Not Matched with Risk Exposure

Risk is the source of investment returns, yet investors want to avoid it. It serves investors well to learn about and embrace risk in accordance to their capacity level. Risk Capacity™ defines the risk level that is appropriate for a particular investor. Many investors invest in portfolios that are mismatched to their Risk Capacity™. A thorough analysis, such as the one in Step 10: Risk Capacity™, looks at an investor’s investment time horizon, net worth, income, investment knowledge, and attitude towards risk. With this analysis, an investor can then review investment choices and make a selection that matches personal Risk Capacity™.

An investment policy or portfolio is a statement of the Risk Capacity™ assessment and the resulting risk exposure, in the form of an asset allocation of indexes.

Most investors do not get around to fully assessing their Risk Capacity™ and find themselves without an investment policy for their short-term and long-term investing. Without this policy, they are easily persuaded to change their course. They lose out on the long-term returns that would result from subjecting their capital to risk.

1.3.8 The High Cost of Turnover

High turnover creates short-term capital gains in a mutual fund or a portfolio of individual stocks. In taxable accounts this can create an insurmountable barrier to beating an index. The average mutual fund turns over ninety percent of its stock each year. This high percentage forces the distribution of capital gains by the fund, which become tax liabilities for the fund’s shareholders. Active investors incur far greater federal and state taxes, since almost all of the capital gains are short-term and are taxed up to forty-six percent. On the other hand, index fund investors buy and hold, so they rarely incur capital gains. When they do, they are long-term gains that are taxed at twenty percent. New tax managed funds harvest losses to offset gains. By their passive nature, they have lower turnover rates. These tax-managed funds nearly eliminate federal and state taxes.

1.3.9 The Emotional Stress of Active Investing

In fact, trading patterns analyzed by a Dalbar study showed that most investors invariably buy high and sell low. The more an investor buys and sells mutual funds, the lower the expected return. All these findings were also true of bond fund investors. According to the study, a buy-and-hold strategy outperformed the average investor by more than three to one after ten years.

When the stock market performs well, as it did for most of the 1980's and '90's, investors are more prone to believing they can beat a market. When they get lucky and make a profitable investment call more than once, they are lured into thinking they are successful market forecasters. Unfortunately, this false sense of confidence leads them to the poorhouse.

The media continues to foster and encourage the high emotions of active investing. Many ads lead investors to believe they can beat a market through stock picking and time picking. In a September 1999 advertisement from Ameritrade (Online Broker), an image of a scowling young woman was displayed. Her quote read as follows: "I don't want to just beat the market. I want to wrestle its scrawny little body to the ground and make it beg for mercy." It goes on to say, "Ready to take on the market? The sooner you do, the sooner you can show that lily-livered stock market who's boss." Finally, it ends with, "Believe in yourself."

1.3.10 1,500 Investors Can Be Wrong

The lack of investor education has generated a lot of recent interest. Most school systems have not incorporated an educational program for investing. The average investor is unprepared to make decisions about investing hard-earned money. Investors usually receive their education in bits and pieces from advertisements, television, magazines, newspapers, or books. These sources are created by an industry that generates huge margin interest, fees, and commissions from the trading of active investors. Most of the promotion and education provided by the investment industry encourages investors to gamble in the stock market.

Money Magazine and the Vanguard Group conducted a study in 1997, which randomly selected 1,555 investors from across the United States, and asked them twenty basic questions on investing. The investors received a sixty-seven percent, or an "F" grade! In a 2000 update of the survey, the average score dropped to only thirty-seven percent correct answers. Why do investors continue to invest in something they do not understand?

1.4

Solution

1.4.1 Active Investors Anonymous

A 1998 PriceWaterhouseCoopers study on the first 25 Years of Indexing, concludes, "even as better information on indexing becomes available, emotional factors may continue to constrain the growth of indexing. Many institutional fund managers feel driven to beat the market, even while recognizing the arguments in favor of indexing."

I am Mark Hebner, president of Index Funds Advisors (IFA), a registered investment advisory firm. Years ago I learned some painful lessons when I sold my previous business and turned the profits over to active managers. I woke up one morning crestfallen, realizing that my decision to do so had cost me $30 million in lost opportunity. After thoroughly researching the science of passive investing and index funds, I came to the conclusion that I needed to withdraw all of my investments from several stockbrokers and place them in index funds. I concluded that a 12-Step recovery program for active investors was critically needed. Today, I am passionate about educating investors about the benefits of index funds.

1.4.2 The History of 12-Step Recovery Programs

The concept of a 12-Step Recovery Program originated in 1935 and today is used to treat more than thirty addictions, including gambling, alcohol, overeating, drugs, and sex. Millions of people rely on such programs.

In the early 1930’s an American alcoholic named Rowland H. (only the last initial is used to keep him anonymous) traveled to Switzerland to undergo treatment from the world renowned Dr. Carl Jung. After a couple unsuccessful trips, Dr. Jung told Rowland that he needed a "profound spiritual experience" to enable him to stop his drinking. In other words, he needed to find a higher power. Other patients with these experiences had overcome their addictions and changed their behaviors.

The 12-Step Program is partially based on the replacement of an addiction with a higher power, whatever that may be for a person. As investors become more familiar with the Nobel Prize winning stock market research outlined in this book, many may experience investing epiphanies and transform their thinking and investment behaviors. Many “Stockaholics™” are already beginning to see the light.

Rex Sinquefield, a director at DFA, attended the University of Chicago in the 1970s. He said, "Every time one of my professors talked about efficient markets, I thought I was looking at Moses coming down from the mountain, and I took that seriously." DFA is now known as the “mecca” of indexing. Maybe Sinquefield had his profound spiritual experience there in the classroom.

I had my epiphany when I heard Professor Eugene Fama of the University of Chicago, and a Director of Research at DFA discuss the Three Factor Model at a financial conference. After reviewing Step 2, which describes the research of Fama, French, and many others, readers will know why.

1.4.3 The Big Book on Investing

When the founder of Alcoholics Anonymous, Bill W., needed a vehicle to carry his message to millions of alcoholics, a book was the only affordable method. So, he wrote Alcoholics Anonymous in 1938. That book has become affectionately known as “The Big Book.” Coincidentally, 1938 was the same year that Alfred Cowles created what was later to become the Standard & Poor’s 500. (Cowles did not know that his creation would go on to become the first index used to establish an index fund by Rex Sinquefield.)

This book is a modified 12-step Program designed to educate investors on how to overcome the emotional desires to actively invest. Some refer to it as the “Big Book on Investing.” In 1938, Bill W. was limited to books as an affordable method of communication. But, today we have the Internet. It’s a medium I take full advantage of in my mission to lead investors to a highly efficient, tax-managed, low-cost and risk appropriate portfolio.

1.4.4 Top Investors Agree

Warren Buffet stated in a February 1996 investment letter to his Berkshire Hathaway shareholders: “…the best way to own common stocks is through index funds….” In his 1997 letter he writes: “Let me add a few thoughts about your own investments. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.” In February 2003 he gave this advice to investors in his shareholder letter: “…those index funds that are very low cost (such as Vanguard’s) are investor friendly by definition and are the best selection for most of those who wish to own equities. And, his February 2004 letter states: “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, low-expense way. An index fund that they never touched would have done the job. Instead many investors have had experiences ranging from mediocre to disastrous.”

Even though some professionals outperform a market, it is a different group of professionals that do so each year. A consistent methodology to identify them in advance has yet to be discovered.

Benjamin Graham, the father of fundamental stock analysis, and a man revered by Warren Buffet, also relinquished the idea that investors can expect to beat a market. Shortly before his death in 1976, he was interviewed by Charles Ellis and said: “I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago when [the Security Analysis by] Graham and Dodd was first published; but the situation has changed.... [Today] I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost.... I’m on the side of the ‘efficient’ market school of thought.”

Several other questions and answers from this interview are shown below:

"In the light of your 60-odd years of experience in Wall Street what is your overall view of common stocks?

Common stocks have one important characteristics and one important speculative characteristic. Their investment value and average market price tend to increase irregularly but persistently over the decades, as their net worth builds up through the reinvestment of undistributed earnings--incidentally, with no clear-cut plus or minus response to inflation. However, most of the time common stocks are subject to irrational and excessive price fluctuations in both directions, as the consequence of the ingrained tendency of most people to speculate or gamble--i.e., to give way to hope, fear and greed."

Can the average manager of institutional funds obtain better results than the Dow Jones Industrial Average or the Standard & Poor's Index over the years?

No. In effect, that would mean that the stock market experts as a whole could beat themselves--a logical contradiction.

Do you think, therefore, that the average institutional client should be content with the DJIA results or the equivalent?

Yes. Not only that, but I think they should require approximately such results over, say, a moving five-year average period as a condition for paying standard management fees to advisors and the like.

What about the objection made against so-called index funds that different investors have different requirements?

At bottom that is only a convenient cliche or alibi to justify the mediocre record of the past. All investors want good results from their investments, and are entitled to them to the extent that they are actually obtainable. I see no reason why they should be content with results inferior to those of an indexed fund or pay standard fees for such inferior results.

Source: “A Conversation with Benjamin Graham.” Financial Analysts Journal, vol. 32, no. 5 (September/ October 1976.):20–23.

1.4.5 Index Funds Investors Win

Investors in index funds usually win over active investors over long periods of time. The path to recovery for active investors begins with understanding the following steps outlined in this book.

About 85% of investors engage in active investing. This 12-Step Program comprehensively addresses the emotional hurdles an active investor needs to clear. The first step of every 12-Step recovery program is admitting to the existence of a problem. My hope is that this first step has helped you recognize active investing behavior, and realize that harmful behaviors can be changed.

In Step 2, Nobel Prize winners and other academics are discussed. These legendary individuals have committed most of their lives to researching the stock market in order to develop the ideas that today determine how trillions of dollars are invested. Once these capital market ideas are understood, the investor can start ignoring stock pickers, market timers, last year’s winners, Wall Street strategists, technical analysts, and investment media gurus who attempt to make stock market predictions. I trust that you will be inspired to see the stock market in a whole new light.

Questions will appear at the end of each step to affirm your understanding of the information presented in each particular step. When you think you are sure of the correct answer for a question, click the "Answer" button to check.

1. Investment managers of index funds engage in:

1. analytical techniques best described as science.
2. market timing.
3. manager picking.
4. analytical techniques best described as speculation.
5. stock picking.
   
   

2. A Dalbar Study showed that the average investor earned 3.90% per year over a 20-year period while the S&P 500 gained:

1. 1.9%
2. 19.2%
3. 11.93%
4. 5.7%
5. 6.9%

3. PriceWaterhouseCoopers found that one of the largest hurdles keeping investors from index funds is:

1. The high management fees of index funds.
2. The emotional drive, desire, or need to beat a market.
3. The below the market performance of index funds.
4. The difficulty in finding an active manager.
5. The high taxes generated by index funds.
   

4. In his 1997 letter to shareholders, Warren Buffet stated that "… the best way to own common stocks is:

1. To own Berkshire Hathaway" (his company).
2. To have your broker pick 10 Growth Stocks."
3. To look at the track record of last year's top 10 funds."
4. To buy at the bottom of the market and sell at the top."
5. To own an index fund that charges minimal fees."
   

5. When 1,555 investors were given a test of 20 basic questions in 2000 regarding investing, the average score was:

1. one hundred percent correct
2. ninety-five percent correct
3. sixty percent correct
4. thirty-seven percent correct
5. zero percent correct