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 Published
Monday, July 16, 2007
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This
Not the same game as the '60s
by Stephen Butler
'Don't confuse brains with a bull market."
I was reminded of that aphorism the other day when an acquaintance
mentioned that they had a friend who was offering to manage their
401(k) money with monthly moves between cash and equity funds.
This self-styled "advisor" was suggesting that they
move everything out of international funds for the moment until
"international funds became more reasonably priced ... possibly
in a month or so."
The anecdote reminded me of the phenomenon in the 1960s when
rising markets lead to an influx of people parading onto stock
brokerage firms seeking jobs as brokers.
The book, "Winning the Loser's Game" by Charles D.
Ellis, is full of sound investment advice. It offers the perfect
antidote for any of us who may feel like we have the financial
markets figured out after the dramatic rise of the past four years.
Ellis looks at investment management from a height of 30,000
feet. His book starts by building the case that "this time
it's different." He points out that today's investment climate
is entirely different from the '60s.
Back then, individual amateur investors competed against each
other to take advantage of "market inefficiencies" which
were created by amateurs who influenced stock prices for reasons
that were irrational.
Today, institutional investors (mutual funds and pensions) dominate
the market. These institutions all use the same sophisticated
analytical research. The playing field has been leveled.
In this rarefied atmosphere, few single institutions have demonstrated
long-term superiority or an ability to beat overall market returns.
Long term, their results tend to be equal to market returns minus
whatever transaction costs and management fees they charge.
Managing market risk is the primary objective of investment management.
The highest level of market risk would be represented by ownership
of a single stock. Pick any familiar stock. It is easy to remember
times when the price has fluctuated by as much as 20 percent or
more within a single year.
We remove this market risk by diversifying across a variety of
investment types or styles. The entire market has dropped by 20
percent only about once every 20 years.
When we have market risk under control, the next step is to determine
what level of risk we want to assume.
Ellis contends that there is no substitute for a written investment
policy. The level of risk will be largely determined by our time
frame.
The long-term experience in investing is never surprising. An
average 10 percent annual return is reasonably predictable over
any rolling 10-year period.
The short-term experience, by comparison, is always surprising.
A written investment policy forces us to contemplate the timeframe,
and it is there as a reminder when some short-term surprise threatens
to freak us out and take us off course.
If we get a little greedy, and find ourselves tempted by specific
industry funds, we might dial in an investment mix that would
increase risk statistically by 20 percent over the average market
risk.
On paper, this would lead to market returns of 1.4 percent per
year, more than average market returns. Over 30 years, this extra
1.4 percent would lead to 25 percent more money in the end. As
enticing as this might seem, no sizable institutional investor
has ever achieved that incremental return over any sustained period
of time.
For a better mousetrap, the average investor can typically increase
returns by at least 1.4 percent per year just by reducing investment
fees. This approach doesn't demand an increase in risk and the
desired result of a 1.4 percent annual increase is guaranteed.
Why? Because the average mutual fund charges 1.5 percent while
index funds charge as little as 0.12 percent.
Moreover, someone who wanted to reduce portfolio risk by 30 percent
could invest 35 percent of their money in bond funds. This mix
would only cost them an estimated 1 percent per year in returns.
But, if you've saved that much in fees, you're back to net market
returns with 30 percent less risk.
Successful investing starts with a clear assessment of the timeframe
and comfort level for accepting risk. A long timeframe makes the
job easy. A short timeframe, by comparison, brings the temptations
of the "Loser's Game" too close for comfort.
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