Chapter 10.

Bogle, John C., John Bogle on Investing. John Bogle on Investing. McGraw-Hill, 2001. McGraw-Hill, 2001.

Morningstar Principia Pro Plus, April 2001.

Nocera, Joseph, A Piece of the Action. A Piece of the Action. Simon and Schuster, 1994. Simon and Schuster, 1994.

Pressler, Gabriel, "Buying Unloved Funds Could Yield Lovable Returns." Morningstar Fund Investor, Morningstar Fund Investor, January 2001. January 2001.

Zweig, Jason, Unpublished speech.

Chapter 11.

Anonymous, "Confessions of a Former Mutual Funds Reporter." Fortune Fortune, April 26, 1999.

Bogle, John C., Common Sense on Mutual Funds. Common Sense on Mutual Funds. Wiley, 1999. Wiley, 1999.

Quinn, Jane B., "When Business Writing Becomes Soft p.o.r.n." Columbia Journalism Review, Columbia Journalism Review, March/April 1998. March/April 1998.

Nocera, Joseph, A Piece of the Action. A Piece of the Action. Simon and Schuster, 1994. Simon and Schuster, 1994.

Chapter 12.

Cooley, Phillip L., Hubbard, Carl M., and Walz, Daniel T., "Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable." American a.s.sociation of Individual Investors Journal, American a.s.sociation of Individual Investors Journal, February 1998. February 1998.

Chapter 13.

Gibson, Roger C., a.s.set Allocation. a.s.set Allocation. McGraw-Hill, 2000. McGraw-Hill, 2000.

Chapter 14.

Edleson, Michael E., Value Averaging. Value Averaging. International Publis.h.i.+ng, 1993. International Publis.h.i.+ng, 1993.

Schwed, Fred Jr., Where Are the Customer's Yachts? Where Are the Customer's Yachts? Wiley, 1940. Wiley, 1940.

2010 Postscript

What Have We Learned from the Meltdown?

In the two years between the publications of my first finance book, The Intelligent a.s.set Allocator The Intelligent a.s.set Allocator, in 2000, and this volume in 2002, the investment world turned upside down as the bubble in tech stocks burst, taking much of the rest of the market with it.

In the subsequent eight years, another full market cycle took place. A ma.s.sive rise in liquidity and credit inflated the value of nearly all a.s.sets-not only of stocks and bonds of all descriptions, but also of houses, commercial real estate, and commodities. This bubble then led to the second-worst collapse in U.S. market history.

As the dust settles, current market valuations for stocks are not radically different from what they were in 2002, and thus the expected returns listed on page 72 are not, with two exceptions, in serious need of modification. Those two a.s.set cla.s.ses, REITs and precious metals stocks-particularly the latter-have seen their valuations climb to the point where they are unlikely to deliver the salutary results that they have in the past.

What, then, have we learned since 2002? For the most part, the recent turmoil has reinforced the themes emphasized in this book: * Costs still matter.* Diversification still works.* Risk tolerance should still not be overestimated.* The current investment conventional wisdom should still be avoided.

Nevertheless, a few things really are different this time: * Short-term interest rates are very low; money market funds and Treasury bills now offer near-zero yields.* Exchange-traded funds (ETFs) have begun to eclipse traditional open-end mutual funds.* The most frequently traded and highest-quality corporate and munic.i.p.al bonds proved to be remarkably illiquid in the teeth of the crisis, probably even more so than during the Great Depression. (In plain English, just when you most needed to sell them to raise cash for living expenses or to scoop up stocks on the cheap, you could not do so without taking a significant haircut.) We'll discuss each of these in turn.

Eternal Truths Costs still matter, and the performance of active managers does not persist. Duh. The laws of arithmetic continue to apply: since professional investors are are the market, in the aggregate they must receive the market return the market, in the aggregate they must receive the market return minus expenses minus expenses. I'm not going to bore you with the ma.s.s of mutual fund statistics and academic studies on the inadequacies of active management that has acc.u.mulated since 2002. I cannot, alas, resist relating the sad story of Bill Miller.

As skipper of the Legg Mason Value Trust, Mr. Miller beat the S&P 500 each and every year each and every year between 1991 and 2005, yet in the subsequent three years, his fund did so poorly that it almost completely wiped out the previous fifteen years' worth of stellar performance. From the beginning of his tenure as manager in 1991 to the end of 2008, he beat the S&P 500 by only a small margin: an 8.50% annualized return versus 7.93% for this index. As you can guess, only his lucky few early investors ever got those returns. between 1991 and 2005, yet in the subsequent three years, his fund did so poorly that it almost completely wiped out the previous fifteen years' worth of stellar performance. From the beginning of his tenure as manager in 1991 to the end of 2008, he beat the S&P 500 by only a small margin: an 8.50% annualized return versus 7.93% for this index. As you can guess, only his lucky few early investors ever got those returns.1 The vast majority of his fundholders, suckered in by his blistering previous results, arrived too late to the party, got taken over a cliff, and lagged even the badly battered S&P 500 by over 15% per year between 2006 and 2008. And, oh yes, I almost forgot: for the privilege of accompanying Mr. Miller on this doomed runaway train, Legg Mason charged the pa.s.sengers a 1.7% management fee. Worse, this 1.7% fee did The vast majority of his fundholders, suckered in by his blistering previous results, arrived too late to the party, got taken over a cliff, and lagged even the badly battered S&P 500 by over 15% per year between 2006 and 2008. And, oh yes, I almost forgot: for the privilege of accompanying Mr. Miller on this doomed runaway train, Legg Mason charged the pa.s.sengers a 1.7% management fee. Worse, this 1.7% fee did not not include the considerable transactional costs incurred by the trading in his ever-more-bloated fund. include the considerable transactional costs incurred by the trading in his ever-more-bloated fund.

The trajectory of the Legg Mason Value Trust-a small number of early investors earning initially high returns, inevitably triggering a stampede of gullible performance-chasers into the fund, who then got nailed when its performance returned not so gently to earth-gets repeated with a depressing regularity. (If this story sounds vaguely familiar, then you might reread the sad tale of Robert Sanborn on pages 8485.) The moral remains the same: performance comes and goes, but expenses are forever.

[image]

Diversification still works in the long run in the long run. That, of course, is not what you're hearing these days, and for good reason. Consider the returns of the following a.s.set cla.s.ses during the great bear market of 20072009: [image]

During the most recent market turmoil, there was simply no place to hide; all stocks got hammered, and the further investors strayed from the good old S&P 500, the more they lost.

Next, let's look at the bear market of 20002002. Here, diversification seemed to work a bit better. The madness of the preceding 1990s was confined largely to tech stocks and to the largest growth companies, which investors saw as the new wired world's primary beneficiaries. During the 1990s bubble, everything else languished. Real estate? Obsolete in the New Economy. Small banking, manufacturing, and retail concerns? Doomed as well. Consequently, only tech and large-cap growth stocks, which were most heavily represented in the S&P 500 and the EAFE, and which had run up ridiculously in the previous five years, collapsed. REITs and U.S. small-cap value stocks, which had languished in the 1990s, actually made money between the broad market top of 2000 and the bottom in 2002.

[image]

Now, the punch line: consider how these a.s.set cla.s.ses fared over the full decade of the 2000s: [image]

During the past decade, the further you diversified away from a traditional portfolio of large-cap stocks, the better you did. And mark this well: the period covered by this last table is probably within shouting distance of the worst decade any person is likely to encounter during his or her investing career, encompa.s.sing not one, but two of the biggest market collapses in U.S. history.

Investment wisdom begins with the realization that long-term returns are the only ones that matter, and that over the long term, diversification protects your portfolio. Logically, you should care little that many days, or even years, along the way your portfolio suffers significant losses. Logic, unfortunately, is the hardest-won investment discipline.

In other words, it is how well diversification works over the decades, and not over the days, months, or even years, that matters most. If you still doubt the value of diversification, just ask j.a.panese investors, who have lost 1.9% per year for the past two decades for the past two decades, while everyone else earned decent, and in many cases more than decent, returns.

I doubt that U.S. stock returns over the next two decades will look anything like j.a.pan's over the last two. But why take the risk? Because we cannot predict the future, we diversify. This is the only free lunch there is in investing; sample as many plates from the all-you-can-eat table of the world's capital markets as you can.

[image]

If the 20072009 market collapse served any useful purpose, it was to reinforce the notion that high returns come attached to ferocious risk. Put more simply, if you expect high returns, you should also expect to suffer serious losses from time to time. As I explained in Chapter 4 Chapter 4, it is one thing to train for a crash landing in a flight simulator; the real thing is something else entirely. In the same way, no matter how good your math skills and no matter how complete your knowledge of market history, nothing comes close to helplessly watching a large chunk of your net worth disappear into thin air.

Most investors' allocations have become a good deal more conservative since 2008, and a significant minority has sworn off equities for good (or at least until the next bubble). For those who are nearing retirement, this is not necessarily a bad thing. But for young investors, who I hope are still aggressively saving for retirement, the opposite conclusion should be drawn. In Chapter 2 Chapter 2, I noted that bear markets were the friends of the young, allowing them to acc.u.mulate stocks cheaply, and indeed, those who followed the dollar cost averaging technique, or, even better, the value averaging method, described in Chapter 14 Chapter 14 wound up with near triple-digit returns on the stock purchases made in late 2008 and early 2009. wound up with near triple-digit returns on the stock purchases made in late 2008 and early 2009.

[image]

The conventional financial wisdom is almost always wrong. The Internet didn't change everything-at least not in the world of investments-and along with it, bricks, mortar, and real estate didn't become obsolete either. After the collapse of the tech bubble, real estate did indeed turn around, but it didn't, as its new enthusiasts predicted, climb forever. The business cycle wasn't abolished, and the newfangled derivatives didn't quite eliminate risk.

The word these days? The economies of the old, developed Western nations are entering a "new normal" of slower economic growth, and stocks and bonds in the United States, Europe, and j.a.pan will languish along with them. The place to be? Emerging markets, of course, with their blistering economies.

This line of reasoning has more than a few flaws. First of all, it turns out that, on average, the stocks of nations with rapidly growing economies have lower lower returns than those of more mature, developed nations. For example, since 1993, China has had one of the world's highest economic growth rates-at times exceeding 10% per year-yet between 1993 and 2008, its stock market returns than those of more mature, developed nations. For example, since 1993, China has had one of the world's highest economic growth rates-at times exceeding 10% per year-yet between 1993 and 2008, its stock market lost lost 3.31% per year. The same is true, to a lesser extent, for markets in the Asian "tigers" (Korea, Singapore, Malaysia, Indonesia, Taiwan, and Thailand), which since 1988 have all had lower returns than those in the low-growth United States. 3.31% per year. The same is true, to a lesser extent, for markets in the Asian "tigers" (Korea, Singapore, Malaysia, Indonesia, Taiwan, and Thailand), which since 1988 have all had lower returns than those in the low-growth United States.2 By contrast, stodgy old England, which during the twentieth century tumbled from world hegemon to open-air theme park, actually had high returns between 1900 and 2000. By contrast, stodgy old England, which during the twentieth century tumbled from world hegemon to open-air theme park, actually had high returns between 1900 and 2000.3 More systematic data confirm this pattern: good economies tend to be bad stock markets, and vice versa. More systematic data confirm this pattern: good economies tend to be bad stock markets, and vice versa.

What's going on here? In my opinion, three factors contribute to the "good economy/bad market" phenomenon. First, just as the prices of the stocks of poorly performing companies must fall to the point where they will entice investors with higher future returns, the same happens at the country level. Like unglamorous stocks, unglamorous stock markets markets must offer higher returns to attract buyers. must offer higher returns to attract buyers.

Second, both new and existing companies are constantly raising capital by issuing new shares, which dilutes the pool of existing shares. In many foreign countries, particularly in Asia, the rate of new share issuance is particularly high. This reduces per-share earnings and dividends, which in turn erodes overall stock returns.4 Third, in many developing markets, governments do not protect shareholders from the rapacity of management as well as they do in nations with more established legal systems. In other words, in these countries, management and controlling shareholders find it disturbingly easy to loot a company.

And even if I'm wrong about developing-market equities, their return will no doubt come at the cost of very high risk: twice in the past fifteen years, emerging-markets indexes have lost about two-thirds of their value, something that you don't often hear emerging-markets enthusiasts discuss.

New Truths As this postscript is being written, cash-like a.s.sets-Treasury bills, money market funds, and bank certificates of deposit-are yielding a near-zero return. Somewhat higher yields can be had by buying notes and bonds of longer maturity, but at the cost of higher risk. What's an investor to do?

As the old Wall Street saw goes, "More money has been lost reaching for yield than at the point of a gun." In such situations, I find Pascal's Wager to be a particularly useful paradigm.

Blaise Pascal, a seventeenth-century French mathematician and philosopher, famously chose to believe in G.o.d because of what we would today call "asymmetric consequences." If the devout person is wrong, then all he has lost is a single lifetime of fornication, imbibing, and the pleasure of skipping a lot of boring church services. But if G.o.d does exist, then the atheist roasts eternally in h.e.l.l. The rational person thus chooses to believe in Him.

The financial markets work the same way, and the canyons of Wall Street are littered with the bones of those who forgot this simple principle. Here's how it works with today's bond market: it is entirely possible that the Fed's unprecedented "kitchen sink" approach to both monetary and quant.i.tative easing will savage long-term bond investors through hyperinflation. Or not. I know a lot of very smart folks on both sides of this question and am myself an agnostic on the issue. I do, nonetheless, know one thing for sure: if you fear inflation, consequently keep your bond maturities short, and then turn out to be wrong, you've lost only a few percent of yield. But if you make the opposite bet, that is, ignore the inflationary possibility and reach for yield, and you turn out to be wrong, you may well find yourself greeting people at a Wal-Mart front door. Were Blaise Pascal around today, I suspect he'd be shortening his bond maturities.

[image]

The criticism most frequently leveled at this book's original printing was the short shrift given ETFs. Indeed, since the book was first published in 2002, the popularity of these vehicles has grown to the point where they are seriously challenging more traditional "open-end" mutual funds. Nonetheless, I remain dubious; there is nothing really wrong with ETFs, but I continue to believe that most investors are better off with the older open-end fund format. I do so for four reasons. First, the commissions and spread costs incurred by trading ETFs quickly eat up their minuscule expense advantage. Many ETFs are in fact more expensive to own than the corresponding Vanguard or Fidelity index funds. Second, the convenience of being able to trade ETFs throughout the day is in reality a disadvantage; unless you are able to predict intraday market moves-a fool's errand if ever there was one-you are faced with the often paralyzing choice of exactly when to buy or sell. Third, ETFs carry with them considerable inst.i.tutional risks. Many ETFs have already been liquidated, and I do not trust most of the ETF providers to support these products over the very long term. Last, avoid bond ETFs at all costs. The so-called authorized partic.i.p.ant process by which arbitrageurs minimize the discounts and premiums of these funds to their true net a.s.set value does not work well with thinly traded corporate and munic.i.p.al bonds. In late 2008, the discounts and premiums on many bond ETFs reached several percent for many of these funds, a problem that is not encountered with open-end funds.

That said, there are some areas in which an equity ETF does make sense. The first is the iShares MSCI EAFE Value Index, for which Vanguard offers no corresponding index/pa.s.sive open-end mutual fund. The second is the Vanguard FTSE All-World ex-US Small-Cap ETF, which does not charge the 0.75% purchase fee levied on investor cla.s.s shares and also carries a much lower expense ratio (0.38% vs. 0.60%). A third would be the iShares EPRA/NAREIT Developed Real-Estate ex-US ETF, for which there is no equivalent open-end fund available to most small investors.

[image]

Finally, the extreme market turbulence of late 2008 and early 2009 starkly illuminated the role of Treasury securities, money market funds, and certificates of deposit (CDs) in a well-managed portfolio. Consider the graph on the next page, which plots the return of one dollar invested in short-term (one- to five-year maturity) Treasury and corporate notes.

Observe that Treasury notes had salutary returns in the teeth of the crisis, while the corporate notes took about a 7% hit. Over the full two-year period, however, corporates had a higher return.

[image]

One could conclude from this graph that all was right in the world, and that the markets were efficient; yes, the corporates had higher risk, but investors were ultimately rewarded with higher return for bearing it.

But suppose you needed liquidity in late 2008 or early 2009. Say you lost your job, a not unlikely event in a downturn. Or, more important for our purposes, say you needed cash to rebalance your portfolio by purchasing stocks at fire-sale prices. Selling short-term corporate bonds to do so would have incurred a considerable haircut. (Selling longer corporate bonds or even TIPS would have been worse; munic.i.p.al bonds also incurred losses, although less than corporates.) Conclusion: hold enough Treasuries, money markets, and CDs to see you through a prolonged period of downturn-related unemployment and to execute rebalancing purchases. These highly liquid a.s.sets will probably yield lower long-term returns than riskier bonds, but when the going gets tough, you'll be glad you have them.

[image]

Consider yourself privileged, then, to have lived through one of history's most dramatic periods of financial distress. Carry its brutal lesson about the connection of risk and return with you forever. Remember, the capital markets are fundamentally a mechanism that distributes wealth to those who have a strategy and can adhere to it from those who either do not or cannot. Know what to expect, develop your own strategy, and stick to it.

About the Author.

William Bernstein, Ph.D., M.D., has become a gra.s.sroots hero to independent investors everywhere. He has made a name for himself by questioning the value of Wall Street wisdom, skewering the recommendations of self-serving stockbrokers, and showing legions of investors how to successfully manage their own investments with intelligence and long-term vision.

Bernstein's first book, The Intelligent a.s.set Allocator The Intelligent a.s.set Allocator, remains one of the most honored investment books of recent times. Hailed by national publications, including BusinessWeek BusinessWeek, and by independent investment icons, including Vanguard founder John Bogle, it has become an instant cla.s.sic for its well-researched a.n.a.lyses and rules for successful investing. He has more recently published The Investor's Manifesto The Investor's Manifesto. He has also auth.o.r.ed two works of economic history: The Birth of Plenty The Birth of Plenty and and A Splendid Exchange A Splendid Exchange, the latter short-listed for the Financial Times/Goldman Sach's Business Book Award in 2008.

Bernstein is the editor of the a.s.set allocation journal Efficient Frontier Efficient Frontier, founder of the popular Web site EfficientFrontier.com, and a co-princ.i.p.al in Efficient Frontier Advisors. He is often quoted in national publications, including The Wall Street Journal The Wall Street Journal, has written for Barron's Barron's and and Money Money, and has also contributed to academic finance journals. He lives in Portland, Oregon.

1It is relatively easy to measure short-term risk by calculating something statisticians call a "standard deviation" (SD). This can be thought about as the degree of "scatter" of a series of values about the average. For example, the average height of adult males is about 69 inches with an SD of 3 inches. This means that about one-sixth of males will be taller than 72 inches and one-sixth will be shorter than 66 inches (one SD above or below the mean); about 2% will be taller than 75 inches (two SD above the mean). For the U.S. stock market, the average annual market return is about 10%, and the SD of market returns is about 20%. So, just like the hypothetical example cited above, a return of zero is one-half SD below the mean (that is, the average return of 10% is one-half of the 20% SD). In fact, the stock market loses money about one-third of the time, as predicted by statistical theory. A "worst-case" scenario is a minus two SD result (a loss of 30%), which should occur about 2% of the time. In fact, this is exactly what has occurred-four times in the past 200 years (2% of years), the U.S. market lost more than 30%. In Figure 1-12 Figure 1-12, I've plotted the frequency of annual market returns (the vertical bars) versus the "theoretical" probability (the bell-shaped curve) predicted by the laws of statistics. As you can see, the agreement is quite good.

1Many credit John Burr Williams, in his 1938 cla.s.sic, The Theory of Investment Value The Theory of Investment Value, with the DDM, and, indeed, he fleshed out its mathematics in much greater detail than Fisher. But The Theory of Interest The Theory of Interest, published eight years earlier, clearly lays out the principles of the DDM with sparkling, and at times, entertaining clarity.

2Well, not quite. A 10% nominal return with 3% inflation actually produces a 6.80% return, since 1.10/1.03 = 1.068. But close enough for government work.

1This nightmare played out in reverse in the 1980s with leveraged buyouts, in which the formerly acquired companies were spun back off with the use of debt of varying quality, and the investing public became rapidly acquainted with the meaning of "junk bonds." These companies, in hock up to their eyeb.a.l.l.s, often wound up in Chapter 11 Chapter 11, damaging not only individual bondholders but imperiling the banks and insurance companies that held the defaulted bonds issued by these companies.

1This software is available at a discount to readers of this book. You can find it at http://www.effisols.com. (Warning: This software does not come shrink-wrapped in a pretty box; you will need to be comfortable with Internet credit-card purchases and software downloads.)

1Here'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 started the year with $10,500 and ended with $12,000, your return was (12,000/10,500) 1.0 = 0.143 = 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, (12,000 150)/(10,500 + 150) = 1.113; your return was 11.3%. If you had a net outflow outflow of $300, then you do the reverse-add to the top, subtract from the bottom. So, (12,000 + 150)/(10,500 150) = 1.174; your return was 17.4%. of $300, then you do the reverse-add to the top, subtract from the bottom. So, (12,000 + 150)/(10,500 150) = 1.174; your return was 17.4%.