But it will, over time, achieve better results than most mutual funds—and far better results than most individual investors achieve. Considering all the time, cost, and effort devoted to achieving better-than-market results, the index fund certainly produces a lot for very little.
The securities market is an open, free, and competitive market in which large numbers of well-informed and price-sensitive professional investors compete skillfully, vigorously, and continuously as both buyers and sellers. Nonexperts can easily retain the services of experts. Prices are quoted widely and promptly. Effective prohibitions against market manipulations are established. An index fund provides investment managers and their clients with an easy alternative.
They do not have to play the more complex games of equity investing unless they want to. Given the intensity and skill of the competition, superior knowledge is rare. The option to use an index fund enables any investor to keep pace with the market virtually without effort.
It allows you to play only when and where and only for so long as you really want to— and to select any part of the wide investment spectrum for deliberate action at any time for as long or as brief a period as you wish. Those following this path are sure to beat the net results after fees and expenses delivered by the great majority of investment professionals.
Berkshire Hathaway Annual Report, In the same vein, George J. For many years, economists assumed that people know what they want to achieve, know how to achieve it, and consistently strive to make rational, unemotional, self-interested decisions in order to achieve their objectives.
More recently, behavioral economists have shown that, as human beings, we are not always rational and we do not always act in our own best interests. Even though we know the odds are against us, we gamble at casinos and get caught up in bull and bear markets. On average, we also believe our children are above average. We now know that as human beings we are endowed with certain inalienable characteristics of mind and behavior that compel us to make imperfect decisions—even dreadfully serious mistakes—as investors.
His caution applies to all investors because we ourselves cause risks that are quite unnecessary and can easily be avoided if we would just recognize our unfortunate proclivities—and discipline ourselves to do no harm, particularly to ourselves and our investments. Usually by having too much in money market funds or bonds. If your investments went up 10 percent a year, that would be less then 1 percent a month.
If you check more than once a quarter, you are satisfying your curiosity more than your need for price information. If you make an investment decision more than once every year or so and are not devoting full time to the market, you are almost surely being too active in trading, and it will cost you. Changing mutual funds costs investors heavily: The average return realized by mutual fund investors is sharply lower than the returns of the very funds they invest in because investors sell funds with recent disappointing performance and buy funds with recent superior performance.
Three out of four of the fortunes that are lost get lost because borrowed money was used. Over and over again studies show that we substantially overestimate our own investment performance relative to the market. We smile when our stocks go up and frown or kick the cat when our stocks go down.
And our feelings get stronger and stronger the more—and the faster—the prices of our stocks rise or fall. Our internal demons and enemies are pride, fear, greed, exuberance, and anxiety. These are the buttons that Mr.
Market most likes to push. No wonder we are such easy prey for Mr. Market with all his attention-getting tricks. As an investor, your capabilities in two major realms will determine most of your success: your intellectual capabilities and your emotional capabilities. Your emotional capabilities include your ability to be calm and rational despite the chaos and disruptions that will—thanks to Mr.
Market—intrude abruptly upon you and your decision making. If you know yourself—your strengths and weaknesses—you will know the limits you must learn to live within in each realm. The place where your spheres overlap in a Venn diagram see I n v e s tor R i s k Zone of comfort Sweet spot Zone of competence Figure 5. A strong defense is the best foundation for a strong offense in investing, so stay inside your comfort and competence zones.
It is your money, so treat it with the care and respect it deserves—and you deserve—investing only when you know from experience that you have the requisite skill and can be consistently rational. In investing, there are three ways to achieve a desirable unfair competitive advantage.
Believers get up earlier in the morning and stay up later at night, and work on weekends. They carry heavier briefcases and read more reports, make and take more phone calls, go to more meetings, and send or receive more e-mails, voice messages, and text messages. They strive physically to do more and work faster in the hope that they can get ahead of the competition. They strive to think more deeply and further into the future so that they can gain truly superior insight and understanding of particular investment opportunities.
This should be the easiest way. The easy way to gain—and sustain—an unfair competitive advantage as an investor is to invest through index funds. While some professional investors are so skillful, so well supported, and so independent that they really can add value by actively changing their investments, the records show over and over again that their number is fewer than most investors want to believe. More important, the chances of your identifying one of the great winners before the record has been established is very low.
The great advantage of concentrating on asset-mix decisions is that it helps you avoid the vain search for superior performance. Instead, it focuses your attention on the most important decision in investing—determining the long-term asset mix that will both minimize the odds of unacceptable outcomes caused by avoidable mistakes and maximize the chances of achieving your investment objectives. Most individual investors take many, many years, make many mistakes, and go through many unhappy experiences to learn these simple but never easy truths.
Fortunately, there is a convenient alternative: As Harry Truman recommended so wisely, we can all learn by reading history. Markets are markets and people are people, and together they have created or written a lot of history. Fees of 20 basis points 0. Expenses of 5 basis points versus 50 to 75 basis points. Commissions under 10 percent per year versus over percent for the average actively managed mutual fund. There are almost no records to keep.
The case for indexing accumulates greater and greater strength as the period for evaluation lengthens. Performance problems for actively managed funds come episodically. ETFs typically have lower expense ratios—0. Costs differ greatly quite unnecessarily. Virtually identical index funds have costs that are three times higher—for nothing. The same is true for ETFs. Costs are deducted from dividends on the underlying shares with the remainder paid out semiannually. A few index fund managers offer tax-managed index funds that reduce this already small disadvantage.
Investors should know that most of the growth in ETFs has not come from individual investor demand but from dealers and professionals hedging against particular risks, not investing for the long term. There are index funds and ETFs for every major market around the world and for small caps or large caps or growth or value— or global: the whole world stock market.
However, although each index is designed to replicate the market—or a sector of the market—fairly and accurately, indexes are not all created equal. They differ. The more turnover, the more taxes and the lower the accumulated returns. With short-term gains, which are often realized in mutual funds, the negative impact of taxes is even greater. The impact of turnover—and of taxes on turnover—is shown starkly in Figure 6. Two more decisions must be made: Which index or market and which particular index fund or ETF?
Figure 6. In this situation, investors had three sensible choices. For most investors the middle way—a total market index fund—is often the most sensible choice, particularly if you have no strong reason to be selective in a particular way.
And in fact, the middle way performed well after Starting with which market to index is another counterintuitive decision that warrants careful thought. Investors who decide to concentrate their investments in their home country are making an active decision to emphasize that one country over others.
But before making such a decision, every investor should at least ponder the reality that most investors in most countries invest mostly in their home country. British investors concentrate investments in the United Kingdom. So why should an American? For Americans, this would mean about half our portfolios would be invested outside the United States. Readers will recognize quickly one of the advantages of indexing: long-term holdings that afford the pleasures of benign neglect.
Investors can avoid timing problems—when to change from one market and its index to another—and almost all taxes by the simplest strategy: holding on for the very long term. Of course, this depends on selecting the right index fund at the beginning. For fairly rational investors, this will be a broad market index fund in their own country. For very rational investors, this will be a worldwide total market index fund. Fortune, November 22, THE paradox is that funds with very long-term purposes are not always being managed to achieve long-term objectives that are feasible and worthwhile.
Instead, they are being managed to meet short-term objectives that may be neither feasible nor important. Establishing the asset mix or portfolio structure best suited to meeting those risk and return objectives 4. In this work, success can be achieved fairly easily. Consistently beating the market rate of return by 0.
Virtually no large investment manager can hope to beat the market consistently by such magnitudes. T h e Pa r a d o x Of course, these calculations are mechanical. They present averages, ignoring that actual returns in individual years come in an impressive—and sometimes alarming—distribution of actual annual returns around those averages.
The crucial question is not simply whether long-term returns on common stocks would exceed returns on bonds or T bills if the investor held on through the many startling gyrations of the market. The crucial question is whether the investor will in fact hold on for the long term so that the expected average returns can actually be achieved. The problem is not in the market but in ourselves, our perceptions, and our all too human reactions to our perceptions.
This is why it is so important for you to develop a realistic understanding of investing and of capital markets—so Mr. The more you know about yourself as an investor and the more you understand the securities markets, the more you will know what long-term asset mix is really right for you and the more likely it is that you will be able to ignore Mr. Market and sustain your commitment for the long term. In reality, few investors have developed clear investment goals. Only you know your own tolerance for changes in market prices, particularly at market extremes when investment policies seem least certain and the pressures for change are strongest.
While responsibility for it can be abdicated, responsibility really cannot be delegated. Each investor should think through his or her own answers to six important questions. And investment managers would be wise to urge all their clients to do this kind of homework. First, what are the real risks to you of an adverse outcome, particularly in the short run?
Unacceptable risks should never be taken. Nor would it make sense to invest in stocks all the money saved for a house just two or three years before the intended date of purchase. T h e Pa r a d o x Second, what are your probable emotional reactions to an adverse experience? The emphasis is on informed tolerance. Sometimes astute investing seems almost perversely counterintuitive. Suggestion: Go to your library and spend several hours reading the daily newspapers from the summer and fall of , the fall of , the dot-com era, or the cruel fall of Getting up close and personal can help you understand how it feels to be in a storm and may help you learn how to remain calm in the next one.
An investor who is well informed about the investment environment will know what to expect. He or she will be able to take in stride the disruptive experiences that may cause other, less informed investors to overreact to either unusually favorable or unusually adverse market experiences. Fifth, are there any legal restrictions on your investments? We all know that it can be hard for individual investors to continue taking the long-term view when markets are rising rapidly—or, worse, falling rapidly.
All too few individual investors assert themselves and take up their real responsibilities to themselves and to their families. If investors are not willing to act like principals, we can be sure that the paradox will remain in force for a long, long time.
Observers of the paradox that haunts investment management say it is unrealistic to expect investors to take on the self-discipline of doing all that homework or to expect investment managers to risk straining client relationships by insisting on a well-conceived and carefully articulated investment policy with explicit objectives when investors seem uninterested in going through the discipline.
Escaping from the paradox depends on your asserting your role as the expert on your own needs and resources, and developing appropriate investment goals and policies. For that important work, while we may get some real help, we must look to ourselves.
Time—the length of time investments will be held, the period over which investment results can be measured and judged—is crucial to any successful investment program because it is the key to getting the right asset mix.
Time transforms investments from least attractive to most attractive—and vice versa—because while the average expected rate of return is not at all affected by time, the range or distribution of actual returns around the expected average is greatly affected. Given enough time, investments that might otherwise seem unattractive become highly desirable and vice versa. The longer the time over which investments are held, the closer the actual returns in a portfolio will come to the expected average.
The actual returns on individual investments, in contrast, will be more and more widely dispersed as the time period lengthens. As a result, time changes the ways in which portfolios of different kinds of investments can best be used by different investors in different situations and with different objectives. But if the time period for investing is abundantly long, a wise investor can commit without great anxiety to investments that in the short run appear very risky.
The conventional time period over which rates of return are usually calculated—their average and their distribution—is just one year. While convenient and widely used, this month time frame simply does not match the time periods available to all the different kinds of investors with all their different constraints and purposes.
Some investors are investing for only a few days at a time, while others will hold their investments for several decades. The difference in the time horizon matters greatly in investing.
Such brief time periods are clearly too short for investments in common stocks because the expectable variation in return is too large in comparison to the expected average return.
Such short-term holdings in common stocks are not investments; they are rank speculations. However, this deliberate one-day burlesque of the conventional use of annual rates of return leads to a serious examination of the differences in investor satisfaction when the measurement period is changed. That examination shows why an investor with a very long time horizon might invest entirely in common stocks just as wisely as another investor with a very short time horizon would invest only in Treasury bills or a money market fund.
The examination also shows why an intermediate-term investor would, as his or her time horizon is extended outward, shift investment emphasis from money market instruments toward bonds and then more and more substantially toward equities.
Despite the constancy of the average expected rate of return— no matter what the time period—the profound impact of time on the actual realized rate of return is clearly demonstrated in the chart in Figure 8. The one-year-at-a-time rates of return on common stocks over the years are almost incoherent. They show both large and small gains and large and small losses occurring in a seemingly random pattern.
At best, you could have earned There are, for example, few periods with losses, and the periods with gains appear far more often and consistently Time 60 50 40 30 Percent 20 10 0 —10 —20 Stocks —30 Bonds Cash —40 —50 —60 1-year 5-year year year Periods year year Figure 8. Shifting to year periods further increases the consistency of returns. Only one year loss is experienced, and most periods show average annual gains of 5 to 15 percent.
Again, the power of the average rate of return—now compounded over a full decade—overwhelms the single-year differences.
Moving on to year periods brings even more consistency to the rate of return. There are no losses, only gains. And the gains cluster more closely together around the long-term expected average rate of return. Appreciating that actual experiences in investing are samples drawn from a continuous stream of experience is vital to understanding the meaning contained in the data.
Similarly, in investing, the patient observer can see the true underlying patterns that make the seemingly random year-by-year, month-by-month, or day-by-day experiences not disconcerting or confusing, but splendidly predictable—on average and over time. In weather and investments, larger and more numerous samples enable us to come closer and closer to understanding the nature of the normal distribution from which the sample is drawn. This understanding of the normal experience enables you to control your own behavior so that you can take advantage of the dominant normal pattern over the long term and not be thrown off by the confusing daily or even yearly events that present themselves with such force in the short term as Mr.
Market gyrates to catch your attention. Analyses of asset mix show over and over again that the trade-off between risk and reward is driven by one key factor: time. A year horizon usually leads to an ratio. A year horizon typically results in a ratio. And so it goes. They are all far too short for an investor with an investment horizon of 20 to 50 years or even more—and most investors will be living—and investing for more than 20 years. It is clear that if more investors used truly long-term thinking, they would invest differently and would earn higher long-term returns.
Investors who devote most of their time and skill to trying to increase returns by capitalizing on changes in market prices—by outsmarting each other—are making a big mistake. Changes in market price are caused by changes in the consensus of active investors about what the price of a stock ought to be.
Market—are very human and nonrational. The ways in which investors perceive and interpret information and the ways they react to developments have a great impact on market prices, particularly in the short run. The irony is that for most investors, professional or individual, most of this activity really does not matter— not because the investment professionals are not highly talented, but because so many competitors are equally highly talented.
For all the surface complexity in the process, two main areas are dominant in evaluating common stocks. The second is the consensus of investors on the discount rate at which this stream of estimated future dividends and earnings should be capitalized to establish its present value. Mean reversion characterizes the physical world, too. While a landlubber may get more and more anxious about tipping over as the sailboat heels farther and farther, an experienced sailor knows that the forces that prevent further heeling are increasing.
And the children of unusually tall people are usually less tall. Investors want to know the most probable investment outlook for the years ahead. Caution: If the market has been going up, investors—who usually evaluate future prospects by looking into the rearview mirror— will add some upward momentum, and if the market has been trending down, they will add some downward momentum.
The wise investor will adjust for this unfortunate human tendency. For investment results, as the holding period over which an investor owns an investment lengthens, the importance of the discount factor decreases and the importance of corporate earnings and the dividends paid increases. For a very long-term investor, the relative importance of earnings and the dividends received is overwhelming. For a short-term price speculator, everything depends instead on the day-to-day and month-to-month changes in investor psychology and what other people are willing to pay.
Like the weather, the average long-term experience in investing is never surprising, but the short-term experience is constantly surprising. Bonds in turn have higher returns than those of short-term money market instruments.
In other words, rates of return appear more normal over longer periods of time. While daily, monthly, and annual returns show virtually no predictive or predictable pattern, they are not really random. Hidden within Mr. Individual investors would be well advised to learn enough about the language of statistics to have an awareness of what is meant by mean and normal distribution and what is meant by two standard deviations as a measure of the frequency with which unusual events are expected to and do occur.
In addition to learning the importance of describing the distribution of returns around the mean, we have learned to separate out the different components in the average rate of return and to analyze each component separately. This work has been done in a series of landmark studies by Roger G. Ibbotson and Rex A. The analysis is informative. Most of the time you do get your money back—with its purchasing power intact.
But that is all you get. There is virtually no real return on your money, just the return of your money. See Figure 9. The market continuously adjusts prices to changing interest rates. The maturity premium is estimated at 0. It makes sense that returns on common stocks are higher than returns on bonds, which guarantee to pay interest and face value at maturity. Stocks make up for not having such guarantees with a risk premium built into their nominal returns.
However, we can get a very useful approximation of what returns have actually been and what they are most likely to be, and that is all we really need to establish investment policies for the long term. Unless you buy in at the start of the period measured, sell out at the end, and take your money out of the market, performance data are simply representational statistics.
Two further propositions on returns are important. The second proposition on returns is that differences in rates of return that may appear moderate in the short run can, with Returns compounding because interest is paid not only on the principal but also on the reinvested interest , multiply into very large and quite obvious differences in the long run. Before leaving the happy realm of investment returns, take another look at Figure 8. Beware of averages. If stocks return an average of 10 percent per year, how often over the past 75 years did stocks actually return 10 percent?
Just once in Only three times. Try asking four questions and then ask other people to examine your reasoning process with you: 1. What could go really right, and how likely is it?
What could go wrong, and how likely is that? If the price goes down, will I really want to buy a lot more? Returns End Notes 1. Fortune, November 22, 2. My father loved bridge and played often. The opportunity missed was too great to forget.
Risk is different from uncertainty. Risk describes the expected payoffs when their probabilities of occurrence are known. Actuarial mortality tables are a familiar example. The actuary does not know what will happen in 14 years to Mr. Frank Smith but does know quite precisely what to expect for a group of million people as a group—in each and every year. Risk is not having the money you need when you need it. Risk is both in the markets and in the individual investor.
Some of us can live comfortably with near-term market volatilities—or, at least, resist the primal urge to take action—knowing that over the long run, more market volatility usually comes with higher average returns.
Active investors typically think of risk in four different ways. If you think a stock might be high, you know you are taking price risk. If this occurs, the stock will drop. Again, you were taking business risk. Real risk is simple: not enough cash when money is really needed—like running out of gas in the desert.
The old pros wisely focus on the grave risk all investors—and k investors in particular—should focus on: running out of money, particularly too late in life to go back to work. Another way to look at risk has come from the extensive academic research done over the past half century. Two other kinds of risk can be avoided or even eliminated, so investors are not rewarded for accepting these unnecessary and avoidable kinds of risk.
The risk that cannot be avoided is the risk inherent in the overall market. This market risk pervades all investments. It can be increased by selecting volatile securities or by using leverage— borrowed money—and it can be decreased by selecting securities with low volatility or by keeping part of a portfolio in cash equivalents.
But it cannot be avoided or eliminated. It is always there. Therefore, it must be managed. The two kinds of risk that can be avoided or eliminated are closely associated. Interest-sensitive issues such as utility and bank stocks will all be affected by changes in expected interest rates. Stocks in the same industry—autos, retailers, computers, and so forth—will share market price behavior driven by changing expectations for their industry as a whole. The number of common causes that affect groups of stocks is great, and most stocks belong simultaneously to several different groups.
To avoid unnecessary complexity and to avoid triviality, investors usually focus their thinking on only major forms of stock-group risk. Read Rising Strong - Bren? Read Seamos personas de influencia: C?
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