Humans routinely exchange large amounts of money for excitement. One of the most consistent findings in behavioral finance is that people gravitate towards low-probability/high-payoff bets. For example, it's well known among professional horse race bettors that it is much easier to make money on favorites than on long shots. The reason is that the amateurs tend to prefer long shots, making the odds for the remaining favorites more advantageous than they should be. After all, it is much more exciting to bet at fifty-to-one odds than at two-to-five. On a more obvious level, why does anyone buy a lottery ticket when the average payoff is about fifty cents on the dollar?

As we saw in the discussion of initial public offerings (IPOs) in Chapter 5 Chapter 5, the same thing happens in the investment world, where small long shot companies attract too much capital, leaving less capital for duller, more established companies. This depresses the prices of the more established companies and increases their returns. And, as we've already seen, IPOs are a lousy business. (This is also the main reason why the returns of small cap growth stocks are so low, as we saw in Figure 1-18 Figure 1-18.) I've formulated my own model, called the "investment entertainment pricing theory" (INEPT), which describes this phenomenon. For each bit of excitement you derive from an investment, you lose a compensatory amount of return. For example, a theater ticket may be thought of as a security with a high entertainment value and a zero investment return. At the opposite end of the scale, a portfolio full of dull value stocks-USX, Caterpillar, Ford, and the like-is the most liable to have higher returns.

The Wrong Risk As we discussed in the first chapter, there are really two kinds of risk: short term and long term. Short-term risk is the knot we get in our stomachs when our portfolios lose 20% or 40% in value over the course of a year or two. It is a fearsome thing. Frank Armstrong, a financial advisor, writer, and ex-military pilot, observes he has known men who routinely faced death in the sky with equanimity but became physically ill when their portfolios declined 5%.

The fear of short-term loss drove investors out of stocks for a generation after the Great Depression, penalizing their returns by several percent per year. We can estimate that because of their fear of short-term loss, their portfolios were underexposed to stocks to the point where they lost 3% of return annually over the next three decades. Compounding 3% of underperformance over 30 years means that their final wealth was 59% less than it should have been. In other words, their fear of a 20% to 40% loss cost them 59% of their a.s.sets. In academic finance, this is called "myopic loss aversion"-focusing on short-term dangers and ignoring the far more serious long-term ones.

Why do we do this? Human beings experience risk in the short-term. This is as it should be, of course. In the state of nature our ancestors inhabited, an ability to focus on the risks of the moment had much greater survival value than long-term strategic a.n.a.lytic ability. Unfortunately, a visceral obsession with the here and now is of rather less use in modern society, particularly in the world of investing.

In Chapter 1 Chapter 1, after looking at the long-term superiority of stocks over fixed-income securities, you may have found yourself asking the question, "Why doesn't everybody buy stocks?" Clearly, in the long term, bonds were actually more more risky than stocks, in the sense that in every period of more than 30 years, stocks have outperformed bonds. risky than stocks, in the sense that in every period of more than 30 years, stocks have outperformed bonds.

In fact, many academicians refer to this as "The Equity Premium Puzzle"-why investors allowed stocks to remain so cheap that their returns so greatly and consistently exceeded that of other a.s.sets. The answer is that our primordial instincts, a relic of millions of years of evolution, cause us to feel more pain when we suddenly lose 30% of our liquid net worth than when we face the more damaging possibility of failing to meet our long-term financial goals. How bad is the problem? Richard Thaler, in an immensely clever bit of research, examined the interaction of the risk premium and investor preference. He estimated the risk horizon of the average investor to be about one year. Myopic indeed!

Trees Don't Grow to the Sky One of the most dangerous of all investment illusions is the great company/great stock fallacy. During the Nifty Fifty market of the early 1970s and the more recent mania over Internet and tech stocks, the importance of earnings growth was overemphasized. The only companies worthy of purchase were the well-run multinational firms, with strong growth arising from commanding market strength-Coca Cola, Disney, Microsoft, and the like. It certainly was a compelling story.

This is where the market separates the winners from the losers. Serious investors do the math; amateurs listen to stories. Here's the math, that most forgot to do: In the free market system, the life of even the largest of corporations is positively Hobbesian-nasty, brutish, and short. Less understood is that company glamour is even more ephemeral. A glamorous company is one with strong growth, usually selling at a very high multiple of earnings. For example, at the height of the market froth in the spring of 2000, the three companies mentioned in the last paragraph sold at 48, 84, and 67 times earnings, respectively-from three to four times the valuation of a typical company. This means the market expected these companies to eventually increase their earnings relative to the size of the market relative to the size of the market to three or four times their current proportion. to three or four times their current proportion.

This is a tricky concept. Let us a.s.sume that the stock market grows its earnings at 5% per year. This means that over a 14-year period, it will approximately double its earnings. (This is according to the "Rule of 72," which states that the earnings rate times the doubling time equals 72. In the above example, 72 divided by 5% is approximately 14. Or, alternatively, at a 12% growth rate, it takes only six years to double earnings.) If a glamorous growth company is selling at four times the P/E ratio of the rest of the market-say, 80 times earnings versus 20 times earnings-then the market is saying that during this same 14-year period, its earnings will grow by a factor of eight (4 2 = 8). This requires a growth rate of 16% per year sustained over the 14-year period. While a very few companies are able to turn this trick, the vast majority do not.

How long does the high growth of the most glamorous companies actually persist? On an economic scale, not much longer than a heartbeat. In a 1993 landmark study of earnings growth persistence, Thaler protege Russell Fuller and his colleagues looked at the popular growth stocks-the top fifth of the market in terms of their P/E ratio. Their data showed that these very expensive companies increased their earnings about 10% faster than the market in year one, 3% faster in year two, 2% faster in years three and four, and about 1% faster in years five and six. After that, their growth was the same as the market's.

In other words, you can count on a growth stock increasing its earnings, on average, about 20% more than the market over six years. After that, nothing. Let's a.s.sume that the 20% excess growth found by Fuller occurs immediately in a company selling at 80 times earnings. If the price does not react to the 20% b.u.mp in earnings, it is now selling at 64 times earnings and has only the growth potential of the rest of the market has only the growth potential of the rest of the market. What do you suppose the market does to a stock selling at 64 times earnings when it finds out that it has only ordinary growth potential? In the hackneyed words of the market strategist, it is "taken out and shot." Sooner or later (and, experience shows, sooner-in about two to three years), this happens to almost all growth stocks; this is the main reason why they have lower returns than the market.

Even most professionals are unaware of just how ephemeral earnings growth is. If you simply look at stocks with high prior earnings growth, you discover that their future earnings growth is exactly the same as the market's, a phenomenon referred to as "higgledy piggledy growth" by its discoverer Richard Brealey. Market partic.i.p.ants have better methods to find stocks with higher future growth than simply looking at past growth (although screening for raw past growth is a favorite neophyte technique) and a.s.sign those stocks high P/E ratios. It's just that they don't do a very good job; these stocks wind up getting grossly overpriced relative to their actual future growth.

If you find this a bit confusing, don't despair; it's not an easy concept. Let's examine things in yet another way, by imagining two companies, Smokestack Inc., selling at 20 times earnings, and Glamour Concepts Inc., selling at 80 times earnings. This means that for every $100 of stock, Smokestack produces $5 of earnings ($100/20 = $5) and Glamour, $1.25 ($100/80 = $1.25). This is because the market expects Glamour to grow its earnings much more rapidly. If Smokestack grows its earnings at a rate of 6% per year, then after six years, it will increase its earnings by 48%-from $5 per share to $7.40 per share. So far, so good. How does Glamour do? The data from Fuller and his colleagues show that over the same six-year time frame, it will grow its earnings by 20% more than the market-in other words, by 78% (1.48 1.20 = 1.78). This means that its earnings will grow from $1.25 per share to $2.23 per share. After that, it will have the same earnings growth as Smokestack, which, as we just calculated, is earning $7.40 per share. Somewhere in this sequence of events, usually just as its earnings growth is slowing down, the market sees that Glamour is grossly overpriced and clobbers its shareholders.

That's not to say that growth stocks always underperform value stocks. For the five years between 1995 and 1999, large growth stocks outpaced large value stocks by 10.7% per year per year, only to blow all of that lead in the next 15 months. As you might imagine, results are best and enthusiasm is greatest for growth stocks during tech-driven bubbles, while value stocks tend to do best in their aftermath.

The Faces in the Clouds If there is one skill that separates us from both computers and the rest of the animal kingdom, it is our ability to recognize highly abstract patterns. Newton's intuition of the gravitational equation from a falling apple and Darwin's extrapolating the theory of evolution from observing gardeners and farmers select for favorable plant characteristics are two spectacular examples of this ability. We all rely on pattern recognition in our everyday lives, from complex professional tasks down to things as mundane as the route we take to work or the way we organize our closets.

But in investing, this talent is usually counterproductive. The simple reason is, for the most part, the pricing of stocks and bonds at both the individual and market level is random: there are no patterns there are no patterns. In such a chaotic world, the search for patterns is not only futile, it is downright dangerous. For example, after the 1987 market crash, the financial page of most newspapers printed a plot of the pre-crash stock rise and fall in the 19251933 period, superimposed with that of the 19821987 period. The implication was that, since the plots matched so closely before both crashes, a further catastrophic fall in stock prices similar to that of 19291933 was all but certain.

For a whole host of reasons, starting with the fact that the Fed managed the 1987 crash with far more skill than in 1929, no such thing happened. The point is that there are no repeatable patterns in security prices. If there were, the world's wealthiest people would be librarians.

I don't envy financial journalists. These benighted folks have to come up with fresh copy every week, and in some cases, every day. There is no way that the average journalist can produce the requisite number of column inches without resorting to interviews with market strategists and active money managers. The business pages are therefore filled with observations that go something like this: "We've found that on the nine previous occasions that widget inventories rose above the past six months' sales, stock prices fell more than 20%." This was no doubt true in the past. The problem is that sifting through numerous pieces of economic and financial data will produce some strong a.s.sociations purely by chance, just like the Bangladesh b.u.t.ter production/S&P 500 correlation we previously discussed.

There are certainly pieces of data that are predictive of future economic activity, the best known being the monetary policy of the Fed and "leading indicators" such as housing starts or the length of the average industrial working week. The problem is that everyone knows, watches, and a.n.a.lyzes these statistics, and the results of such a.n.a.lysis have already been factored into stock and bond prices. You say that the Fed will be easing interest rates and this will be good for stocks? Well, the rest of the world knows this too, and stocks have already already risen because of it. Acting on this information is thus likely to be of no value. Remember Bernard Baruch's famous dictum: risen because of it. Acting on this information is thus likely to be of no value. Remember Bernard Baruch's famous dictum: Something that everyone knows isn't worth knowing.

And lastly, even when patterns are well established, they can change. The cla.s.sic example of this is the relations.h.i.+p between stock and bond yields. Before 1958, each time stock dividend yields fell below bond yields, stock prices fell. Before 1958, each time the stock yield fell below the bond yield, had you sold your stocks and waited for stock yields to rise again before repurchasing them, you'd have done handsomely. Until 1958. That year, stock yields fell below bond yields and never looked back. Had you sold your stocks then, you'd still be waiting to get back in. And you'll be waiting a good while longer.

Regrettable Accounting Human beings are not very good at taking losses or admitting failure. For example, the most consistent bit of irrational investment behavior is the commonplace observation that we are less likely to sell losers than winners. This is known in behavioral finance circles as "regret avoidance." Holding onto a stock that has done poorly keeps alive the possibility that we will not have to confront the finality of our failure.

I don't find this one particularly troublesome. If you believe that the markets are efficient, then the performance of a fallen stock should not be any different than a successful one. Yes, a stock that has done poorly is quite likely to go bankrupt. But enough of these companies will rebound in price, making up for the ones that fail. In fact, Thaler has found that stocks that have recently fallen have, on average, higher expected returns than the market. This should not surprise anyone, since these tend to be value stocks.

But it highlights a much more serious problem, which is known as "mental accounting." This refers to our tendency to compartmentalize our successful and unsuccessful investments, mentally separating our winners and losers. This is particularly dangerous because it distracts us from what should be our main focus: the whole portfolio. A perfect example was the advisor I mentioned earlier who was extremely proud of his "ability" to pick successful active domestic and foreign stock managers but who ignored the fact that his overall portfolio performance was poor.

If you ask the average investor how his investments are performing, you will likely find out that he is doing quite well. How does he know? Because he owns some stocks and funds that have made a lot of money. Has he calculated his overall investment return? Well, no. (The most recent example of this phenomenon was that of the infamous Beardstown Ladies, who did not realize that deposits didn't count as investment return, thus grossly overestimating the results they trumpeted in their best-selling The Beardstown Ladies' Common-Sense Investment Guide The Beardstown Ladies' Common-Sense Investment Guide.) What has happened is the all-too-human strategy of treasuring our successes and burying our failures. In the world of investing, this is much more than a harmless foible; it enables us to ignore the overall failure of our portfolio strategy. As a consequence, we suffer miserable long-term returns for the simple reason that we are not aware of just how bad they are.

The Country Club Syndrome This is the peculiar affliction of the very wealthy. If you have your own jet, vacation in tony resorts, and send your children to the most exclusive private schools, then surely you can't use the same money managers as the little folks. You're above all that. You You must engage investment firms and apply techniques available only to the elite. After all, telling the swells at the country club that you send your checks to Vanguard simply will not do. must engage investment firms and apply techniques available only to the elite. After all, telling the swells at the country club that you send your checks to Vanguard simply will not do.

So you use the best private money managers. Hedge funds. Limited partners.h.i.+ps. Offsh.o.r.e vehicles. And, because you're too busy and important, you don't keep track of the expenses incurred or your overall returns.

The problem with all of these vehicles is that there is scant public information available on their performance. But what we do know is not encouraging. Private managers are easiest to dispose of. They come from exactly the same pool of folks that run the pension funds. If the pension funds of GM, GE, and Disney, with tens of billions to invest, cannot beat the indexes, what chance do you have of attracting a skilled manager with your piddling $500 million? There are good theoretical reasons why this should be so, which we've already covered: expenses and tracking error. Even the rich can't avoid them. In fact, the biggest indexers are already busy in this playpen. If you have the $100 million ante, Vanguard will index the S&P 500 for just 0.025% per year. Now that's that's a club I'd like to join. a club I'd like to join.

Hedge funds attract a lot of interest because of their exclusivity. Hedge funds are investment companies, similar to a mutual fund. But because of the small number of investors allowed-no more than 99-they are free of the constraints of the Investment Company Act of 1940 and are able to hold concentrated positions, extensively hedge or leverage their holdings, and employ other exotic strategies forbidden ordinary mutual funds. (From a legal point of view, hedge fund investors are a.s.sumed to be highly sophisticated and have little protection when things turn sour.) Sunlight here is scarce. In the first place, since most of these funds are "hedged," that is, their market exposure is limited by the employment of futures and options, their returns are quite low. When you adjust for risk, their performance looks better, but their compensation structure alone should give pause-managers are often paid a hefty percentage of returns, and in some years, total fees can easily exceed 10%. These are the kinds of margins that even Lynch and Buffett in their heydays would have trouble overcoming.

Lastly, there is the risk of picking the wrong hedge fund. The list of inst.i.tutions and wealthy investors shorn by Long-Term Capital Management's flameout in 1998, which almost single-handedly devastated the world economy, const.i.tuted the cream of the nation's A List. If it could happen to them, it could happen to anybody.

My experience is that the wealthier the client, the more likely he is to be badly abused. Brokerage customers are judged by their ability to generate revenues for the firm. Small clients are naturally not accorded the time and effort given to larger ones (or "whales," as the biggest are known in the brokerage business). This actually works in the small client's favor, as he or she is likely to be put into a load fund or a few stocks and forgotten about. On the other hand, the high-net-worth client is the ultimate brokerage firm cash cow and is likely to be traded in and out of an expensive array of annuities, private managers, and limited partners.h.i.+ps.

The wealthy are are different than you and I: they have many more ways of having their wealth stripped away. different than you and I: they have many more ways of having their wealth stripped away.

Summing It Up In the words of Walt Kelly, "We have met the enemy, and he is us." I've described the major behavioral mistakes made by investors-the herd mentality, overconfidence, recency, the need to be entertained, myopic risk aversion, the great company/great stock illusion, pattern hallucination, mental accounting, and the country club syndrome. This shopping list of maladaptive behaviors will corrode your wealth as surely as a torrential rain strips an unplanted hillside.

8.

Behavioral Therapy In the last chapter, we examined the many sins to which the frail investment flesh is heir. In the next pages, we'll formulate strategies for defeating the enemy in the mirror. As always, the execution is a good deal harder than the planning, since we are attempting to vanquish some of the most primeval forces of human nature. In most cases, this will be the financial equivalent of "stop smoking," "lose weight," and "try not to get upset." But with enough effort and attention, you can at least tone down many of these damaging behaviors. Even modest improvements can greatly augment your bottom line.

Corral the Herd As we've already seen, an investment that has become a topic of widespread conversation is likely to be overpriced for the simple reason that too many people have already invested in it. This was true of real estate and gold in the early 1980s, j.a.panese stocks in the late 1980s, the Tiger nations in the early 1990s, and most recently, technology companies in the late 1990s. In each case, disaster followed. So when all your friends are investing in a certain area, when the business pages are full of stories about a particular company, and when "everybody knows" that something is a good deal, haul up the red flags. In short, identify current conventional wisdom so that you can ignore it.

What I find most disturbing about the present market environment is that "everyone knows" that stocks have high long-term returns. The most optimistic interpretation of this situation is that there is almost no one left to buy stocks, suggesting that further price rises will be much harder to come by. A less sanguine outlook is that when everyone owns a particular a.s.set cla.s.s, many of these investors will be inexperienced "weak hands" who will panic and sell at the first sign of real trouble.

This suggests two strategies that I have found to be extremely helpful. First, as we've already mentioned, identify the era's conventional wisdom and a.s.sume that it is wrong. At the present time, the most prevalent belief is that stock returns are much higher than bond returns. While this statement may have been true in the past, it may not necessarily be true going forward.

The second strategy is to realize that the a.s.set cla.s.ses with the highest future returns tend to be the ones that are currently the most unpopular. This means that owning the future best performers will not provide you with a sense of investment solidarity with your more conventional friends and neighbors. In fact, they may actually express disapproval. (As anyone who has recently bought precious metals and j.a.panese stocks, or who bought junk bonds in the 1990s, experienced.) Although some people enjoy shocking others, most do not.

If you do not like being set apart from your friends by your investment habits, then my advice is to treat your investments as a bit of personal dirty linen that you do not discuss in public. When asked about your financial strategy, simply wave it aside with a blithe, "My advisor handles all that; I never look at the statements." Then change the subject.

Don't Let it Go to Your Head The first step in avoiding overconfidence is to learn to recognize it. Do you think that you have above average driving ability, social skills, and physical good looks? The odds that you have all three are only one in eight! If you believe that your stock picking prowess will enable you to beat the market, ask yourself if you are really smarter than the folks on the other side of your trades. These are almost always savvy professionals whose motivation far exceeds yours. Further, they will have resources at their command that are simply out of your league.

Do you think that you can successfully pick market-beating fund managers? I hope that the data in Chapter 3 Chapter 3 on fund performance has convinced you otherwise. If you actually were able to do so, then you would have a lucrative career as a pension fund consultant ahead of you, since the nation's largest corporations would pay you handsomely to identify superior money managers to shepherd their employees' retirement a.s.sets. on fund performance has convinced you otherwise. If you actually were able to do so, then you would have a lucrative career as a pension fund consultant ahead of you, since the nation's largest corporations would pay you handsomely to identify superior money managers to shepherd their employees' retirement a.s.sets.

How do you avoid overconfidence? By telling yourself at least a few times per year, "The market is much smarter than I will ever be. There are millions of other investors who are much better equipped than I, all searching for the financial Fountain of Youth. My chances of being the first to find it are not that good. If I can't beat the market, then the very best I can hope to do is to join it as cheaply and efficiently as possible."

The most liberating aspect of an indexed approach is recognizing that by obtaining the market return, you can beat the overwhelming majority of investment professionals who are trying to exceed it.

Ignore the Past Ten Years This peccadillo is a reasonably easy one to avoid. You need to constantly remind yourself of two things. The first is that purchasing the past five or ten years' best-performing investment invariably reflects the conventional wisdom, which is usually wrong. The second is that, more times than not, the purchase of last decade's worst worst-performing a.s.set is a much better idea.

We've briefly discussed why this is the case. There is a weak tendency for a.s.set cla.s.ses to mean revert over periods of longer than a year or two-the best performers tend to turn into the worst, and vice versa. This is only a statistical trend, not a sure thing. Recognize that the returns data for an a.s.set cla.s.s of less than two or three decades are worthless-the fact that a particular market or market sector has done well over the past decade tells the intelligent investor nothing. (Recall from the first chapter that even the performance of bonds over the 50-year period before 1981 was highly misleading.) Dare to Be Dull Understand that in investing there is an inverse correlation between the sizzle and the steak-the most exciting a.s.sets tend to have the lowest long-term returns, and the dullest ones tend to have the highest. If you want excitement, take up skydiving or Arctic exploration. Don't do it with your portfolio. I'd even go one step further than that. If you find yourself stimulated in any way by your portfolio performance, then you are probably doing something very wrong. A superior portfolio strategy should be intrinsically boring. Remember, we are trying wherever possible to reduce portfolio volatility-the zigs and the zags-while retaining as much return as possible. Recall also that exciting investments are those that have attracted the most public attention and are thus "over-owned," that is, they have garnered excess investment dollars because of their publicity. This drives up their price, thus lowering future returns.

In most cases, the ultimate object of a successful investment strategy is to minimize your chances of dying poor-to obtain portfolio returns that will allow you to sleep at night. In other words, to be . . . boring.

If you still crave financial thrills or feel compelled to have exciting investments to talk about with folks at parties, then designate a very small corner of your portfolio as mad money, to be deployed in "exciting" investments. Just make sure to promise yourself that when it's gone, it's gone.

Get Your Risks Straight Myopic risk aversion-our tendency to focus on short-term losses-is one of the most corrosive psychological phenomena experienced by the investor. It is best demonstrated by this apocryphal story: An investor places $10,000 in a mutual fund in the mid-1970s and then forgets about it. Shocked by the October 19, 1987, market crash, she panics and calls the fund company to inquire about the state of her account. "I'm sorry madam, but the value of your fund holdings has fallen to $179,623."

When you take risk, you should be earning a "risk premium," that is, an extra return for bearing the ups and downs of the market. Or you can turn the risk premium around and call it a "safety penalty," the amount of return you lose each year when you avoid risk. Let's be on the conservative side and a.s.sume that the safety penalty is just 3% per year. That means that for each dollar you make by investing in perfectly safe a.s.sets, you could have made $1.34 in risky a.s.sets after 10 years, $1.81 after 20 years, and $2.43 after 30 years. (Realize that these figures represent expected expected returns; there's an outside chance that after 30 years you might have as little as $1.20 or as much as $5.00. If you were guaranteed $2.34, there would be no risk.) You would have forgone those higher returns all because you were afraid of having a few bad months or, at worst, losing one-third or one-half of your money in a severe bear market (from which the markets usually, but not always, recover). returns; there's an outside chance that after 30 years you might have as little as $1.20 or as much as $5.00. If you were guaranteed $2.34, there would be no risk.) You would have forgone those higher returns all because you were afraid of having a few bad months or, at worst, losing one-third or one-half of your money in a severe bear market (from which the markets usually, but not always, recover).

Combating myopic risk aversion is the most difficult emotional task facing any investor. I know of only two ways of doing this. The first is to check on your portfolios as infrequently as possible. Behavioral finance experts have found both in the research lab and in the real world that investors who never look at their portfolios expose themselves to higher risk and earn higher returns than those who examine their holdings frequently. Think about your house. It's a good thing 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 quoted 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 panicked 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 visceral 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. .h.i.t, 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 produced long-term sustained earnings increases, but the odds of your picking one of these winning lottery tickets ahead of time ahead of time from the stock pages are slim. 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 Chapter 13 that this isn't always possible, 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." that this isn't always possible, 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."

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 overhead. Ignore them. When dealing with the markets, the safest and most profitable a.s.sumption 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 anything 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 each month, quarter, year, or decade, you will have one or two a.s.set cla.s.ses that you will kick yourself for not owning more of. There will also be one or two dogs you will wish you had never laid eyes on. Certain a.s.set cla.s.ses, particularly precious metals and emerging markets stocks, are quite capable of losing 50% to 75% of their value within a year or two. This is as it should be. Do not allow the inevitable small pockets of disaster in your portfolio to upset you. In order to obtain the full market return of any a.s.set cla.s.s, you must be willing to keep it after its price has dramatically fallen. If you cannot hold onto the a.s.set cla.s.s mutts in your portfolio, you will fail. The portfolio's the thing; ignore the performance of its 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 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. If your math skills aren't up to the task, it's well worth paying your accountant to do it.

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 partners.h.i.+ps, 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 market, so it is unlikely that the investor with $10 million or even $1 billion 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-figure portfolios. This is probably not exclusive enough for your tastes but should keep you clear of most of the unwashed ma.s.ses 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 a.s.set'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 entertainment from your investments is liable to lead you to the poorhouse.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.

PILLAR FOUR.

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 mistake 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 bypa.s.sed completely. You will will have to deal with the fund industry, and we'll discuss the lay of the land in this vital area. 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 journalism.

In our modern society, it is impossible to avoid newspapers, magazines, the Internet, and television. You will need to understand how the financial media works and how it plays a central role in the survival of the brokerage and fund industries.

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 trades to make money. to make money.

Joseph Nocera, from A Piece Of The Action A Piece Of The Action Imagine for a moment that you're a businessman who's been a.s.signed 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 quickly discharged home. But your spouse notices something curious while you're asleep: your abdomen seems to be ticking ticking. Sure enough, you go into a quiet room and are able to detect a faint, regular noise emanating 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 wrist.w.a.tch 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 pa.s.s. And as soon as you pa.s.s, you can hang out a s.h.i.+ngle. 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 piece de resistance piece de resistance: upon entering the hospital you signed an agreement to submit all disputes to an arbitration board whose structure is mandated by the Churnovian Medical a.s.sociation. 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 necessary to enter the field. Simply pa.s.s 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 theory. 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 estimate returns.* Brokers have no fiduciary responsibility toward their clients. Although the legal definition of "fiduciary" is complex, this basically 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 h.o.a.ry old broker adage expresses this objective perfectly: "My job is to slowly transfer the client's a.s.sets to my own name."* Almost all brokerage houses have you agree, at the time of opening 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 single-handedly pioneered the financial services industry in the period surrounding World War II. The rise and fall of his dream-the brokerage 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 climate of the late 1920s, with its bucket shops and overt stock manipulation, and strove to be different. Wall Street then was the ultimate insider'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 pa.s.sage of the Securities Acts of 1933 and 1934, and the Gla.s.s-Steagall Act, which still shape the financial 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 leaders.h.i.+p of a new firm: the merged Merrill, Lynch & Co. and E.A. Pierce and Ca.s.satt, 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 excessively in order to generate fat fees.

Merrill wanted to send a message to the investing public that his brokers were different from the commission-hungry rogues of his compet.i.tors. By contrast, his salaried employees would act as the objective, disinterested stewards of the public's capital. He would not charge for collecting dividends, as did other "wirehouses" (as brokerage firms, which communicated over private phone lines, were known). Commissions would be the minimum allowed by the exchange. Although high by today's standards, a Merrill customer would get rates offered only the biggest clients at other firms. A Merrill broker would always disclose the company's interest in a particular stock, something that was not required by law and unheard of elsewhere in the industry (and rarely done even today). Hot tips were replaced by a.n.a.lytic research.

Merrill's revolution succeeded. By the time he pa.s.sed 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 ma.s.s market 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, backward 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."