that you can’t check on its value every day, or even every year. You happily hold onto it, oblivious to the fact that its actual market value may have temporarily declined 20% on occasion. Ben Graham observed this effect when he noted that during the Depression, investors in obscure mortgage bonds that were not quot- ed in the newspaper held on to them. They eventually did well because they did not have to face their losses on a regular basis in the financial pages. On the other hand, holders of corporate bonds, which had sustained less actual decrease in value than the mortgage bonds, but who were supplied with frequent quotes, almost uniformly pan- icked and sold out. The other way to avoid myopic risk aversion is to hold enough cash so that you have a certain equanimity about market falls: “Yes, I have lost money, but not as much as my neighbors, and I have a bit of dry powder with which to take advantage of low prices.” At the end of the day, the intelligent investor knows that the viscer- al reaction to short-term losses is a profoundly destructive instinct. He learns to turn it to his advantage by regularly telling himself, each and every time his portfolio is hit, that low prices mean higher future returns. There Are No Great Companies This is really just another variant of “Dare to Be Dull.” It is relatively easy to make the great company/great stock mistake. Everyone wants to own the most glamorous growth companies, when in fact history teaches us that the dullest companies tend to have the highest returns. In the real world, superior growth is an illusion that evaporates faster than you can say “earnings surprise.” Yes, in retrospect it is possible to find a few companies like Wal-Mart and Microsoft that have pro- duced long-term sustained earnings increases, but the odds of your picking one of these winning lottery tickets ahead of time from the stock pages are slim. Instead, you should consider overweighting value stocks in your portfolio via some of the index funds we’ll describe in the last section. Unfortunately, we’ll find out in Chapter 13 that this isn’t always possi- ble, either for reasons of tax efficiency or because of your employment situation. But at a minimum, beware the siren song of the growth stock, particularly when people begin talking about a “new era” in investing. To quote my colleague Larry Swedroe, “There is nothing new in the markets, only the history you haven’t read.” Behavioral Therapy 185 Relish the Randomness Realize that almost all apparent stock market patterns are, in fact, just coincidence. If you dredge through enough data, you will find an abundance of stock selection criteria and market timing rules that would have made you wealthy. However, unless you possess a time machine, they are of no use. The experienced investor quickly learns that since most market behavior is random, what worked yesterday rarely works tomorrow. Accept the fact that stock market patterns are a chimera: the man in the moon, the face of your Aunt Tillie in the clouds scudding over- head. Ignore them. When dealing with the markets, the safest and most profitable assumption is that there are no patterns. While there are a few weak statistical predictors of stock and market returns, most of the financial world is totally chaotic. The sooner you realize that no system, guru, or pattern is of benefit, the better off you will be. Most importantly, ignore market strategists who use financial and economic data to forecast market direction. If we have learned any- thing over the past 70 years from the likes of Cowles, Fama, Graham, and Harvey, it’s that this is a fool’s errand. Barton Biggs’s job is to make Miss Cleo look good. Unify Your Mental Accounting I guarantee you that eachmonth, quarter, year,ordecade, you will have oneor two asset classes that you will kick yourself fornot owning more of.There will also beoneor two dogs you will wish you hadneverlaid eyes on.Certain asset classes, particularlyprecious metalsand emerg- ing markets stocks, arequite capableoflosing 50% to 75% of their value within a year or two. This isasitshould be. Do not allow the inevitable small pockets ofdisasterinyour portfolio to upset you. In order to obtain the full market return of any asset class, you must be willing to keep itafterits price has dramatically fallen.If you cannot hold onto the asset class mutts in your portfolio, you will fail.Theportfolio’sthe thing; ignorethep erformance ofits components as much as you can. Do not revel in your successes, and at least take note of the bad results. Your overall portfolio return is all that matters. At the end of each year, calculate it. 1 If your math skills aren’t up to the task, it’s well worth paying your accountant to do it. 186 The Four Pillars of Investing 1 Here’s how. If there are no additions to or withdrawals from you portfolio, simply divide the end value by the beginning value and subtract 1.0. For example, if you start- ed the year with $10,500 and ended with $12,000, your return was (12,000/10,500) Ϫ Don’t Become a Whale Wealthy investors should realize that they are the cash cows of the investment industry and that most of the exclusive investment vehicles available to them—separate accounts, hedge funds, limited partner- ships, and the like—are designed to bleed them with commissions, transactional costs, and other fees. “Whales” are eagerly courted with impressive descriptions of sophisticated research, trading, and tax strategies. Don’t be fooled. Remember that the largest investment pools in the nation—the pension funds—are unable to beat the mar- ket, so it is unlikely that the investor with $10 million or even $1 bil- lion will be able to do so. My advice to the very wealthy? Swallow your pride and make that 800 call to a mutual fund specializing in low-cost index funds. Most fund families offer a premium level of service for those with seven-fig- ure portfolios. This is probably not exclusive enough for your tastes but should keep you clear of most of the unwashed masses and earn you returns higher than those of your high-rent-district neighbors. CHAPTERS 7 AND 8 SUMMARY 1. Avoid the thundering herd. If you don’t, you’ll get trampled and dirty. The conventional wisdom is usually wrong. 2. Avoid overconfidence. You are most likely trading with investors who are more knowledgeable, faster, and better equipped than you. It is ludicrous to imagine that you can win this game by reading a newsletter or using a few simple selection strategies and trading rules. 3. Don’t be overly impressed with an asset’s performance over the past five or ten years. More likely than not, last decade’s loser will do quite well in the next. 4. Exciting investments are usually a bad deal. Seeking entertain- ment from your investments is liable to lead you to the poor- house. Behavioral Therapy 187 1.0 ϭ 0.143 ϭ 14.3%. If you had inflows or outflows during the year, this must be adjusted for. (This is the mistake made by the Beardstown Ladies, who did not make this correction.) This is done by first calculating the net inflow. In the above example, if you added $1,000 and then took out $700 during the year, your net inflow was $300. You subtract half of this, or $150, from the top of the fraction, and add one-half to the bottom. So, (12,000 Ϫ 150)/(10,500 ϩ 150) ϭ 1.113; your return was 11.3%. If you had a net outflow of $300, then you do the reverse—add to the top, subtract from the bot- tom. So, (12,000 ϩ 150)/(10,500 Ϫ 150) ϭ 1.174; your return was 17.4%. 5. Try not to worry too much about short-term losses. Focus instead on avoiding poor long-term returns by diversifying as much as you can. 6. The market tends to overvalue growth stocks, resulting in low returns. Good companies are not necessarily good stocks. 7. Beware of forecasts made on the basis of historical patterns. These are usually the results of chance and are not likely to recur. 8. Focus on your whole portfolio, not the component parts. Calculate the whole portfolio’s return each year. 9.If you are very wealthy, realize that your broker will likely do his best to bleed you with vehicles featuring excessive expenses and risks. 188 The Four Pillars of Investing P ILLAR F OUR The Business of Investing The Carny Barkers Unless you are going to be trading stock and bond certificates with your friends, you will be forced to confront the colossus that bestrides the modern American scene: the financial industry. And make no mis- take about it, you are engaged in a brutal zero-sum contest with it— every penny of commissions, fees, and transactional costs it extracts is irretrievably lost to you. Each leg of this industry—the brokerage houses, mutual funds, and press—will get its own chapter. Their operations and strategies are somewhat different, but their ultimate goal is the same: to transfer as much of your wealth to their ledger books as they can. The brokerage industry is the most dangerous and rapacious, but also the easiest to deal with, since it can be bypassed completely. You will have to deal with the fund industry, and we’ll discuss the lay of the land in this vital area. More than seven decades ago, journalist Frederick Allen observed that those writing the nation’s advertising copy wielded more power than those writing its history. Ninety-nine percent of what you read in and hear from the financial media is advertising cloaked as jour- nalism. In our modern society, it is impossible to avoid newspapers, maga- zines, the Internet, and television. You will need to understand how the financial media works and how it plays a central role in the sur- vival of the brokerage and fund industries. This page intentionally left blank 9 Your Broker Is Not Your Buddy A broker with a clientele full of contented customers was—and is—a broker who will soon be looking for a new job. Brokers need trades to make money. Joseph Nocera, from A Piece Of The Action 191 Imagine for a moment that you’re a businessman who’s been assigned by your company to a small country in eastern Europe. Let’s call it Churnovia. (It neighbors Randomovia, which you heard about earlier.) Although you find the climate, culture, and cuisine to your liking, you do wonder about the nation’s legal system. After all, Churnovia has only recently emerged from the shadow of the former Soviet Union, and legal concepts such as property and contractual obligation are not as well developed as they should be. One day, you feel a belly pain and, by the time you are rushed to the hospital, you are in agony. You are whisked into surgery where your appendix is removed. You seem to recover rapidly and are quick- ly discharged home. But your spouse notices something curious while you’re asleep: your abdomen seems to be ticking. Sure enough, you go into a quiet room and are able to detect a faint, regular noise ema- nating from your midsection. You return to your surgeon and report this unusual observation. After replacing the stethoscope into his white coat, he nonchalantly replies, “Oh yes, it’s not unusual for bellies to tick after a bout of appendicitis.” You are not impressed, and your concern increases as your pain gradually returns, this time accompanied by high fever. Your faith in Churnovian medicine shaken, you fly home, where doctors remove a wristwatch surrounded by a sack of infected tissue. This time, your recovery is not as rapid, and you are confined to the hospital for many weeks of antibiotic therapy. It is months before you can return to work. You begin to wonder about legal recourse and consult an expert in international law. His report is not sanguine. “You see, there’s a big difference between Churnovian and American medicine. For starters, doctors there have no firm educational requirements. You don’t even have to go to medical school. Some, in fact, have never completed high school. All you have to do is cram for a multiple-choice exam, which you can take as many times as you need in order to pass. And as soon as you pass, you can hang out a shingle. What’s worse, Churnovian doctors owe no professional duty to their patients. They can easily get away with performing unnecessary surgeries for financial gain. Also, when things go wrong, they aren’t held to a particularly high standard. And here’s the pièce de résistance: upon entering the hospital you signed an agreement to submit all disputes to an arbitration board whose structure is mandated by the Churnovian Medical Association. I’m sorry, but I’d be a fool to take your case.” Sound farfetched? It isn’t. Once you step inside the office of a retail brokerage firm, you might as well be in Churnovia. Consider: • There are no educational requirements for brokers (or, as they’re known in the business, registered reps). No mandatory courses in finance, economics, law, or even a high-school diploma are nec- essary to enter the field. Simply pass the pathetically simple Series 7 exam, and you’re on your way to a profitable career. In fact, having gotten this far in the book, you know far more about the capital markets than the average broker. I have yet to meet any brokers who are aware that small-growth stocks have low returns, or who are familiar with the most basic principles of portfolio the- ory. I have never met a broker who was aware of the corrosive effect of portfolio turnover on performance. And I have yet to encounter one who is able to use the Gordon Equation to esti- mate returns. •B rokers have no fiduciary responsibility toward their clients. Although the legal definition of “fiduciary” is complex, this basi- cally means the obligation to always put the client’s interests first. Doctors, lawyers, bankers, and accountants all owe their clients fiduciary responsibility. Not so stockbrokers. (Investment advisors do.) • There are few other professions where the service provider’s interest is so different from the client’s. Not even HMO medicine contrasts the welfare of providers and consumers as starkly. While you seek to minimize turnover, fees, and commissions, it’s in your broker’s best interest to maximize these expenses. A hoary old broker adage expresses this objective perfectly: “My job is to slowly transfer the client’s assets to my own name.” 192 The Four Pillars of Investing • Almost all brokerage houses have you agree, at the time of open- ing your account, to resolve any future legal disputes via arbitration before the New York Stock Exchange, Inc. or NASD Regulation, Inc., in other words, the brokers’ own trade groups. In the following pages, we’ll survey the sorry story of the brokerage industry and how its interests and yours are diametrically opposed. The Betrayal of Charlie Merrill By any measure, Charles Edward Merrill was a spirited visionary. Yet he certainly did not fit the stereotype. Self-aggrandizing and overly fond of carousing, strong drink, and other men’s wives, he nearly sin- gle-handedly pioneered the financial services industry in the period surrounding World War II. The rise and fall of his dream—the broker- age company as public fiduciary—is a story worth telling. Born in 1885, Merrill entered the brokerage business after dropping out of Amherst and quickly built a successful investment banking and retail brokerage firm. Merrill was repulsed by the corrupt financial cli- mate of the late 1920s, with its bucket shops and overt stock manipula- tion, and strove to be different. Wall Street then was the ultimate insid- er’s poker game in which the investing public invariably played the sucker. The 1929 crash produced a wave of popular revulsion against the brokerage industry and resulted in the passage of the Securities Acts of 1933 and 1934, and the Glass-Steagall Act, which still shape the finan- cial industry today. But for decades before this, Charlie Merrill knew there was something wrong, and he wanted to fix it. In 1939 he got his chance, accepting the leadership of a new firm: the merged Merrill, Lynch & Co. and E.A. Pierce and Cassatt, later renamed Merrill Lynch. Merrill undertook the job with relish and made it his mission to restore public confidence in the brokerage industry—in short, to “bring Wall Street to Main Street.” This was a tough row to hoe, and his methods were nothing short of revolutionary. First and foremost, he paid his brokers by salary, not commissions. Since the first “stock jobbers” began plying their trade in the coffeehouses of London’s Change Alley in the late seventeenth century, brokers had made their living by “churning” their clients—encouraging them to trade exces- sively in order to generate fat fees. Merrill wanted to send a messagetothe investing publicthat his bro- kers were different from thecommission-hungry rogues ofhiscompeti- tors. Bycontrast, hissalaried employees would act as theobjective, dis- interested stewardsof thep ublic’s capital.Hewould not charge for col- lecting dividends, as did other “wirehouses”(as brokerage firms, which Your Broker is Not Your Buddy 193 communicated over private phone lines, were known).Commissions would bethe minimum allowedbythe exchange. Although high by today’s standards, a Merrill customerwould get rates offered onlythe biggest clients at other firms. A Merrill brokerwould always disclose the company’s interest in aparticular stock,something that was not requiredby law and unheard of elsewhere in the industry (and rarely doneeven today). Hot tips were replacedbyanalytic research. Merrill’s revolution succeeded. By the time he passed away in 1956, Merrill Lynch had grown into the nation’s largest wirehouse, with 122 offices, 5,800 employees, and 440,000 customers. Yet Merrill died an unhappy man. First and foremost, although Merrill Lynch had made the mass mar- ket transition, the rest of Wall Street had not yet made it to Main Street. It gave the old man no satisfaction to be the leader of a failed, back- ward industry. But more importantly, the rest of Wall Street continued to treat the client as it always had: not as an object of respect, worthy of the most effective and efficient investment product, but instead as a “revenue center.” Worse was still to come. Donald Regan (who laterbecameTreasury Secretary) took over the reins at Merrill in 1968.The markets were buoyantthat year.Then,asnow, tech stocks wereall the rageand trad- ing volume was high,atleast bythe standardsof the day. Brokersat other firms, all ofwhomworked on acommissionbasis, were making money like it was going out of style. But there was no joy at Merrill, wherethe brokers weresalaried. Defections mounted,and within a shorttimeafter assuming power,R eganwas forced to join the rest of the industryand allowhistroops a piece of thecommission action. Thus was Merrill’s legacy betrayed, along with its clients. In the short run, Regan had saved the company; the defections stopped and prof- itability returned. Trading volume at Merrill skyrocketed as it became just like everyone else. At the same time, the company ceased treating its clients’ interests as a sacred trust and turned them into cash cows to be methodically milked for commissions. This was the end of the trail for the modern retail brokerage firm as a socially useful enterprise. It fell to others, notably Ned Johnson at Fidelity and Jack Bogle at Vanguard, to later champion inexpensive access to the markets for the average investor. We’ll examine that story—the rise of the mutual fund industry—in the next chapter. Stockbroking’s Seamy Underside Few industries are as opaque to serious study as retail brokerage. The most basic data pertaining to broker background and performance, 194 The Four Pillars of Investing [...]... explain how the product being pushed, the Gateway Incentive Variable Annuity, pays the salesman a 4% upfront commission plus a 1% “trail” fee each year The ad urges the magazine’s investment-professional readers to “Find out more about the annuity that keeps paying and paying and paying ” A great deal, no doubt, for the salesman But not for the person buying one of these beauties, who, after first paying... company that at all times maintains an inventory of the stock or bond, to allow for smooth trading In many cases, the broker is acting as an “agent,” which means that he and his company are not the market makers Instead of getting the spread, they trade with the market maker and collect a commission for this service But frequently the broker acts as “principal,” meaning that his firm is, in fact, the. .. accounts A total of 179,820 trades were executed in 2,506 accounts over the course of seven years On average, that meant 76 trades per account, or about 11 per year At an average of $150 per trade, this amounts to $1,650 per year Since the median account size was approximately $40,000, that’s 4% skimmed off the top annually Thirty years ago, trading was expensive and the average account usually did... small, inbred one At its center are the corporate officers who dole out financial information about their companies to the analysts Not only Your Broker is Not Your Buddy 197 are all of the analysts getting their information from the same place, but their access to it is exquisitely dependent on the good will of the company If analysts are too critical of the companies they are covering, that vital... Morningstar Inc., April 2001.) funds) and those that have none (no-load funds) for each of the nine Morningstar categories The average load fund return is 0.48% per year less than that of the average no-load fund This is mostly accounted for by the 12b-1 fees added into the fund expenses What are 12b-1 fees? They are an additional level of expense allowed by the SEC in order to pay for advertising The theory... anesthesia Like all human beings placed in morally dubious positions, brokers are capable of rationalizing the damage to their clients’ portfolios in a multitude of ways They provide valuable advice and discipline They are able to beat the market They provide moral comfort and personal advice during difficult times in the market Anything but face the awful truth: that their clients would be far better off without... less happy: he was now faced with the impossible 208 The Four Pillars of Investing job of attempting to invest a mountain of cash rapidly in a small corner of the market, a setup for incurring huge market impact costs, which we discussed in Chapter 3 Fortunately, his pain was eased by a high salary and the knowledge that as a newly minted superstar manager, he could demand even higher compensation,... sophistication and expertise On the top rungs are the institutional money managers and brokerage house industry analysts; they are well- 200 The Four Pillars of Investing acquainted with the basics of modern finance My experience is that many of these wirehouse aristocrats actually invest their personal portfolios in index funds Unless you are a large client (or, as you would be known in the trade, a “whale”),... sold by insurance agents, financial planners, and brokers for retirement accounts, where Neither Is Your Mutual Fund 205 the tax deferral is unnecessary Consider a recent advertisement from Kemper Annuities & Life in Financial Planning magazine, a trade publication for investment advisors: Now an annuity that keeps paying, and paying and paying and paying and paying and paying The advertisement... techniques All brokerage houses spend an enormous amount of money on teaching their trainees and registered reps what they really need to know—how to approach clients, pitch ideas, and close sales One journalist, after spending several days at the training facilities of Merrill Lynch and Prudential-Bache, observed that most of the trainees had no financial background at all (Or, as one used car salesman/broker . brokersare capableofrationalizing the damagetotheir clients’ portfolios in a multitudeofways. They provide valuableadvice and discipline. They areableto beat the market. They provide moral comfortand. a small, inbred one. At its center are the corporate officers who dole out financial information about their companies to the analysts. Not only 196 The Four Pillars of Investing are all of the analysts. ignore market strategists who use financial and economic data to forecast market direction. If we have learned any- thing over the past 70 years from the likes of Cowles, Fama, Graham, and Harvey,