The Smartest Way to Invest - Clue: It's Not With the Wizards of Wall Street

INTRODUCTION

Burton G. Malkiel

According to Jeremy Siegel, the stock market has produced annual returns of about 9% since the start of the 20th century. These returns include dividends and capital gains on the securities purchased. Unfortunately, however, the average investor has failed to earn close to the market return.

There are two reasons for that. The first reason is that investors tend to put money into the stock market when everyone is optimistic and when exuberance has led to market peaks. For example, during the 12 months ending in March of 2000, at the peak of the market, more new money went into equity mutual funds than during any preceding period. However, when the market was reaching troughs during the autumns of 2002 and 2008, periods of great pessimism, individuals were making significant withdrawals from their equity investments.

When a mutual fund advertises that it has earned a 9% rate of return over some preceding period, the assumption is that an investor buys at the beginning of the period, reinvests dividends, and sells at the end of the period. But investors don’t behave that way. They tend to sell at market lows and buy at market highs. A study by Dalbar Associates suggests that the average investor may earn as much as 5 percentage points less than the average mutual fund return because of this timing penalty. As Pogo used to say, “We have met the enemy and he is us.” Destructive investment behavior is the enemy of investment success.

The second reason why investor returns tend to be substantially below market returns is that investors tend to put their money into the kinds of equity mutual funds that have recently had good performance. For example, the large inflows into such funds during the first quarter of 2000 went entirely into high tech “growth funds.” So-called “value funds” experienced large fund outflows. Within the next two years, the overpriced growth funds fell sharply in value. Some high tech funds lost 75% of their market value or more. Even during the sharp market declines in the first two years of the 2000s, so-called value funds suffered only minor declines. This selection penalty exacerbates the timing penalty described above. Probably the most important lesson investors can learn is to avoid herd behavior and avoid the destructive tendencies that tend to ruin our investment returns.

Even if investors adopt a tried and tested buy and hold strategy and do not move in and out of the stock market during periods of euphoria and extreme pessimism, they still may fail to achieve the market return. The reason is that they tend to buy the high-cost investment funds that are heavily advertised by the financial community. The average equity mutual fund run by professional stock pickers charges an expense ratio of about one percent per year. Moreover, professional investment advisers charge an additional one percent to help the investor select “the best” portfolio managers. Brokers will often sell so-called “wrap” accounts to individuals where all costs are wrapped into one fee and charge the investor as much as three percentage points a year. Just as returns compound over time, so do costs. And investors may find that over time as much as half of their investment returns have been eviscerated by investment costs.

This is especially true with respect to long-term retirement plans such as 401(k)s and individual retirement accounts (IRAs). Collectively, almost 50 million American families have savings of close to 10 trillion dollars in IRAs. More than 75 million families have employer-based retirement plans. In 2015 the Council of Economic Advisers did a study of the combined costs of high expenses and conflicted economic advice resulting from the incentives of financial advisers to steer savers into products or investment strategies that provide larger payments to the adviser but are not in the best interests of the saver. Their remarkable conclusion was that the estimated annual cost of conflicted and high-priced investment advice is about $17 billion a year. It is in this context that Richard Evans provides his solution to growing your retirement nest egg in his wise book, The Smartest Way to Invest.

Evans is convinced that as investors we engage in self-destructive behavior because we incorrectly believe we can predict the future and can identify superior portfolio managers in advance. Neither is true. His solution is to propose comfortably diversified portfolios (a set of “One-Decision funds”) designed to ride out the inevitable market storms and a substantial cash reserve to cope with emergencies. So Evans concludes that the time-tested investment strategy of buy-and-hold can provide “a cognitive Pepto-Bismol.” When corrections come, you won’t be surprised because you must expect corrections. When turbulence arises in markets, don’t try to do something, just stand there.

A main point of this easy-to-read and helpful book is that people make investing mistakes because they are uncomfortable with their investments. If investors can be convinced that they are prepared for whatever the markets throw at them, they will be better able to avoid the high cost of reacting to large market swings. As our behavioral coach, Evans reminds us that the long-run trend of growing world economies is intact. And Warren Buffett echoes that sentiment, declaring that nobody has ever profited by having a long-run negative view of the U.S. stock market. With few exceptions, in equity markets around the world, Newton’s law of gravity works in reverse: What goes down eventually comes back up.

Broad diversification can give investors the comfort they require. Richard Evans’ recommendations for diversification are expressed clearly and forcefully. Don’t just buy large-company stocks such as those included in the Standard & Poor’s 500-stock index; include smaller companies as well. Don’t just buy U.S. stocks; buy those in international markets as well, including those from the rapidly growing emerging markets. Don’t just buy equities; buy bonds as well to provide an anchor for your portfolio during times of turmoil. Broad diversification provides the only free lunch that is available in our financial markets.

What I like especially about this book is its reliance on low-cost index funds as the recommended building blocks for portfolios that are suitable for all investors. I have believed in index funds all my professional life, and I am now more convinced than ever that they should form the core of all portfolios. Buying an index fund does not mean that you are settling for average—that you are accepting mediocrity. Index investing is superior investing. The one thing that is absolutely certain about investing is that the higher the fee paid to the purveyor of the investment instrument, the less there will be for the investor. As Jack Bogle, founder of the Vanguard Group, has said, “In investing you get what you don’t pay for.” And the data from years of experience with index investing reveal conclusively that index funds produce superior returns to high-cost, actively-managed funds.

The clear logic behind the empirical results is irrefutable. All the stocks in any national market are held by someone. Thus, if some investors are holding a selected group of stocks that do better than average, it must follow that some of the investors are holding the stocks that do worse than average. Investing has to be a zero-sum game. For every winner there will be a loser.

But in the presence of costs, the game becomes a negative-sum game, or in the words of Charles Ellis, “a loser’s game.” The index investor will achieve the market return with essentially zero cost (index funds and exchange-traded index funds are available at costs that are today as low as 3/100 of one percent). Actively managed funds, where the investment manager attempts to purchase those stocks he or she believes will outperform the market, charge about 1% per year as a management fee. Thus, it follows that as a group, actively-managed funds must underperform index funds by their difference in costs. And empirical evidence suggests that actively-managed funds do produce net returns that are inferior to index funds by approximately the difference in their costs. Moreover, actively-managed funds tend to realize taxable capital gains each year. Passively managed index funds do not trade from security to security and are therefore tax efficient, making the gap in after-tax returns even larger.

At the start of every year, press stories proudly declare that the current year will be the “year of the stock picker,” buttressing their claim with quotes from well-known “active” portfolio managers. While they may admit that the last several years have favored passive or indexed investing, they insist that all this is about to change. The current year is likely to demonstrate the advantages of stock picking and active portfolio management. Unfortunately, after the year is concluded, the results fail to support the optimism of the professional portfolio managers. In year after year two-thirds or more of professionally managed equity mutual funds fail to beat index funds that hold similar sets of securities. And those portfolio managers who do happen to outperform the index in a particular year are usually not the same as those who beat the averages in the next year. There is little or no persistence in equity mutual fund superior performance.

Morningstar, the company that analyzes and reports on mutual fund performance, did a study...