You know how much I like to goad financial experts, journalists, financial planners, and others who seem targeted at turning your money into their money, don't you? :-) (If you don't, see here, here, here, here, and here.)
So when I saw this article from Smart Money about how a monkey can pick stocks as well as many mutual fund managers, I had to post on it. Here's the overview:
It's a commonly used explanation of probability and randomness: Take 1,000 chimpanzees, have them flip coins 10 times in a row, and some of them are bound to get heads all 10 times. We consider those chimps lucky.
Take the same idea and apply it to stock-picking. Only now, the primates in question are mutual-fund managers. With so many out there actively running portfolios, some are bound to pick winners. Most of us would call the ones that do talented, but not William Bernstein. The author and investment adviser puts the fortunate managers' performance on par with that of the coin-flipping simians.
Ok, enough for the fun part. Let's get down to business and see what this guy has to say:
Despite endless warnings from financial experts and the fine-print in prospectuses, Bernstein says, investors continue to make the costly mistake of presuming that a fund's past performance is indicative of future returns. It's not. That's why Bernstein, who runs Efficient Frontier, a boutique money-management firm in North Bend, Ore., with $140 million in assets, always favors index funds for long-term investments. While some managers will outperform the market over any given period, he concedes, very rarely do those same managers continue to do so indefinitely.
"Forty to 50 years of data show that it's all due to luck," he says. "The studies show that if you take successful money managers that have done well in the past [and] track them, you see they don't outperform the market."
Bernstein points out that funds that tracks various indexes, whether bonds, domestic equities or foreign stocks, also have the advantages of lower fees and greater tax efficiency. That's generally not the case with actively managed portfolios that involve more turnover of holdings.
The rest of the piece is an interview with Bernstein. Here are my favorite parts of it:
- Indexes will beat three-quarters of active managers. If you look at a global portfolio, if you actively manage each of 10 asset classes, chances are you'll lose. To win in one asset class, you can be lucky and beat the index. But if you're an investor, you need to beat the benchmark in at least seven or eight of the asset classes if you're investing in 10 to 15 asset classes. The chances of doing that are close to zero.
- Sure, I can show you data on hedge funds and mutual funds that mutual-fund managers have beaten the market. So say there is proof you can beat the market. But that's like saying you didn't wear your seat belt and you didn't have an accident, so you don't need a seat belt. So much of life is due to chance. Mutual-fund managers and hedge-fund managers behave like outperformance isn't due to chance. If it's due to luck, it won't repeat. If it's due to skill, it will repeat. Forty to 50 years of data show that it's all due to luck. The studies show that if you take successful money managers that have done well in the past [and] track them, you see they don't outperform the market.
- One of the studies looked in given five-year periods at what were the best mutual funds, and tracked how they did going forward. In each and every case they underperformed the Wilshire 5000 Index. In a couple of examples they did better than the average mutual fund, and in a couple of examples they did worse than the average mutual fund. So they did average. But the average mutual fund is terrible. You're also paying transactional expenses, the hidden costs of doing transactions. The average mutual fund gets the market return minus their expenses. You're much better off getting market return. As John Bogle says, it's simple arithmetic. You keep expenses down by investing passively.
- I agree with Bogle that bond allocation should be appropriate for your age. If you're 50 years old, you should have 50-50 in bonds and stocks.... The next question would be what do you invest in bonds and stocks? Bonds should be corporate Treasurys, somewhere between one- and five-year duration. The Vanguard Short-Term Bond Index fund (VBISX) is a superb fund. It doesn't get any more cheap or efficient than that.
- With stocks, I say domestic with a value tilt. You should have some small stocks in there, like one of Vanguard's small index funds. And for large stocks, an S&P 500 index fund. And then as far as foreign funds go, Vanguard has a total foreign stock fund, and a Pacific and European fund if you want to break it down. One thing about Vanguard is that it doesn't have a good foreign value fund. That's the one case I'd recommend an ETF. Barclays has an ETF that's the value half of the EAFE index. You want to have value exposure.
- One overarching concept that I think is useful is how much noise there is in finance. You could take the dumbest, most inept, incompetent money manager, and without a great deal of luck he can beat the market over 10 years. If you're a terrible money manager you can beat the market. On other hand, you can be the best money manager, have the best information, the best discipline, and with a little bit of bad luck you can underperform the market for 10 or 15 years. When you see someone beat the market, it's probably because of dumb luck.
And here's the best quote of all:
"If I had to grade these, the average Vanguard index fund is an A. The average ETF is an A-. The average mutual fund is a C. And a managed brokerage account is an F."
Of course I like this piece because 1) it gives the experts a hard time, 2) I invest in mostly index funds, so I believe what he's saying, and 3) I invest mostly with Vanguard because they have among the lowest fees out there (if not the lowest).
What do you think?
if you read the intelligent investor, Graham states several times that people invest like they are a hurd of cattle. They invest on emotion, trend, and popularity and not simply with the numbers.
Why pay mutual fund managers 1% + when index funds only cost around .10 to .25 %?
Posted by: YoungMiser | October 03, 2005 at 09:04 AM
Chimpanzees are not monkeys. They are great apes. (Feeling pedantic this morning.)
Posted by: robert the red | October 03, 2005 at 10:02 AM
If we are going to drum on about the bias and self-interest inherent in financial advisors (which is a debatable position, in my opinion) we might as well also call out the bias in financial advice magazines and (dare I say) websites. They have a self interested reason to believe that the individual is best served by managing their portfolio by consulting their publications.
Ultimately I think a hybrid solutions works. Many people realize value from a financial planner, but they also need a modicum of research to keep the business relationship honest. While a monkey may pick stocks pretty well, no monkey I know of will proactively suggest ways to think about steps you can take to retire early. These things aren't impossible to do without a planner, but with the right planner success rates are improved.
Posted by: Duane Gran | October 03, 2005 at 01:50 PM
Duane --
1. I didn't realize I was "drumming on". You sound like my wife. ;-)
2. Yes, I have a certain point-of-view (or bias if you prefer) -- we all do. We like certain things and don't like others. The reason I advocate what I do on this point is: a) I have known a lot of people who have been taken by "financial planners" and b) the methods and tips I have suggested here have worked for me. I am debt free and have a substantial net worth.
3. I think there are times when a REAL financial planner is needed. That's why I wrote this piece: http://www.freemoneyfinance.com/2005/07/how_to_choose_a.html . In addition, I detailed the criteria I'd use as to when I would and wouldn't use a planner here: http://www.freemoneyfinance.com/2005/09/fmf_speaks_my_t.html .
4. Don't pre-judge monkeys. They are often more on target than financial bloggers like myself. ;-)
FMF
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