Saturday, August 6, 2011

Aiming for Average

There are very few instances in life where I aim for average. I most certainly do not want to be an average North American bodyweight. I don't want my pharmacy to provide average service. And when I was in school, I was not satisfied with average grades. But there is one area where not only do I want to be average, but it makes absolute sense. Sadly, because there is so much money and marketing behind convincing the "average" citizen to perform well above average in this regard, my outcome is likely to be anything but average, if you catch my drift.

I speak of course of investing. Anyone who invests in mutual funds for their retirement either on their own or more likely through an investment advisor, needs to read this post. And since the source of my inspiration is "The Little Book of Common Sense Investing" by John Bogle, it follows that they should read it as well.

The aim of most investors and the pitch made to them by their financial advisors is to "beat the market". But if you do enough reading you will learn that it is next to impossible to do just that. I have written before on passive index investing and its advantages so I refer you to an earlier post on the topic here.

What I want to do here is to highlight a few key points in Mr. Bogle's book that really jumped out at me. Even though the author is preaching to the converted when I read this book I still found it fascinating mostly because he insists on doing something of which I'm a big fan: backing up his assertions with data. Someone new to the beautiful simplicity of index investing will likely be quite skeptical because their investment advisors have always told them different. And these are individuals we should be able to intrinsically trust, right? Sadly, most investment advisors are either woefully uneducated OR they are making recommendations that mostly serve to benefit them. A good test to see if you have a good advisor is to ask him or her if they recommend index funds. If they say no, go find someone else. And the excerpts from Mr. Bogle's book below will help convince you why. If they don't, take the book out from the library. It's a quick read but it will change the way you save for retirement and while you'll be aiming to do "just as good" as the market, you'll end up trouncing the Joneses.

On buying funds based on past performance, an issue I've also addressed previously here.
1. "In short, selecting mutual funds on the basis of short-term performance is all too likely to be hazardous duty, and it is almost always destined to produce returns that fall far short of those achieved by the stock market, itself so easily achievable through an index fund."
2. Quoting Nassim Nicholas Taleb, author of Fooled by Randomness. "Toss a coin; heads and the manager will make $10 000 over the year, tails and he will lose $10 000. We run the contest for the first year for 10 000 managers. At the end of the year, we expect 5 000 managers to be up $10 000 each, and 5 000 to be down $10 000. Now we run the game a second year. Again, we can expect 2 500 managers to be up two years in a row; another year, 1 250; a fourth one, 625; a fifth, 313. We have now, simply in a fair game, 313 managers who made money for five years in a row. And in 10 years, just 10 of the original 10 000 managers. Out of pure luck...a population entirely composed of bad managers will produce a small amount of great track records.
3. Quoting Ted Aronson, partner at money management firm Aronson+Johnson+Ortiz: "It takes between 20 and 800 years of monitoring performance to statistically PROVE that a money manager is skillful, not lucky. To be 95% can easily take nearly a millennium. Investors need to know how the money management business really works. It's a stacked deck. The game is unfair.
4. Quoting author Jason Zweig: "Buying funds based purely on their past performance is one of the stupidest things an investor can do." (To understand why this is so true, read my post linked at the beginning of this section, or do some reading on "reversion to the mean".)

On whether advisors add any value in choosing winning mutual funds:
1. A recent study by a research team led by two Harvard Business School professors concluded that, between 1996 and 2002 alone, "the underperformance of advisor-sold funds relative to funds purchased directly by investors cost investors approximately $9-billion per year."
2. Here's a real knockout punch from the same study listed in #1. "The study's conclusion: the weighted average return of equity funds held by investors who relied on advisers (EXCLUDING all charges paid up front or at the time of redemption [these are known as front-end or back-end loads, quite common in funds sold by advisors and would make the returns look even worse]) averaged just 2.9% per year compared with 6.6% earned by investors who took charge of their own affairs.

As an aside here, that percentage difference initially looks small. But let's assume for a minute that someone starts investing $10000 per year at age 25 and retires at 65. One individual trusts his advisor and invests in the funds they choose. They other goes it alone. Here is the difference in the value of their portfolios at age 65.
Advisor-assisted: $740 000
Self-directed: $1.8 million
So you essentially paid that advisor $1.06 million over 40 years to give you lousy returns. That's $26 000 a year. Not a shabby salary for him and the fund company but a real kick in the pants for you.

The last quote I leave you with is from the book discussing a unique study initiated by the New York Times in 1993.
"The editors asked five respected advisers how they would invest $50 000 in a tax-free retirement account holding mutual fund shares for an investor who had a time horizon of at least 20 years. The comparative standard would be the returns earned by Vanguard 500 Index Fund...By 2000, 7 years later, the Times reported their accomplishments. The hypothetical $50000 portfolios run by the advisers had turned in a profit, on average, of $88 500, ranging from $62000-$105000
...not one of these advisers was able to outpace the results of the Vanguard 500 Index Fund...$138 750. That is, the average adviser produced a paper profit on his portfolio of recommended funds that was about 40% less than the profit on the index fund...In mid-2000, the Times abruptly terminated the contest without notice."

Still not convinced? In my own experience, my simple portfolio of index funds purchased monthly and rebalanced annually that takes 5 minutes of effort every month has outpaced the recommendations of the adviser I fired 4 years ago by at least 5-10% in annual return. And when I went to setup an RESP for our newest addition I was confronted with the same old story by the in-house "adviser" (who has no more education than that offered by the bank and had less sophisticated knowledge about investments than myself). She was totally incredulous that I was using index funds and wanted me to switch to a Comfort portfolio, probably the worst form of mutual funds known as a Fund of Funds. That is, the fund itself holds various other funds sold by that company so you get hammered by the overarching fees of the fund itself and the hidden fees in the embedded funds. I politely declined and then she went on about its great past performance (which is pretty rich given that it was started at the nadir of the last stock market recession, so sure it looks damn good).

And finally, as a little thought experiment. What if I took the advice of MOST retail investment advisers to which most average individuals have access and purchased funds in my portfolio that have the best past performance? Starting in 2004, I'll identify the top 10 funds in each year for each of my portfolio asset classes, that is: Canadian Equity, US Equity, International Equity, Fixed Income. I'll then see where those funds rank in the subsequent year in terms of performance. My hypothesis is that they will show a stark and significant reversion to the mean. I will also run a hypothetical portfolio on Globeinvestor Gold to determine what would actually happen if I invested $10000, equally weighted into each asset class, each year and held the investments until present day. Stay tuned for the results.

1 comment:

Anonymous said...

I'm on the edge of my seat.
But really, I am glad that I am sleeping with my financial advisor. Otherwise, I would still be stuck with that horrible fund I bought into when I started working 6 years ago.