Thursday, July 20, 2017

The Dangers of Personifying the Stock Market

Most people understand that the stock market reflects the collective actions of all stock traders, but we often personify the market, talking about it as though it has its own free will. This can lead to investing errors.

When we say that “stock markets struggled this week,” we don’t literally mean that there exists some sentient entity called the “market” that has the desire to rise, but was unable to do so this week. But thinking of it this way can create the illusion that you have only a single foe when you trade stocks.

It can also create the illusion that we can all somehow succeed against the market. When someone says that some past market event was easily predictable, such as the 8-year recovery from the 2008-2009 crash, many would agree. But it can’t be true. If we all knew stocks would rise so much, then buyers would have driven prices up right away.

When we see the stock market as the collective action of all buyers and sellers, it becomes clear that there had to be a lot of uncertainty among traders 8 years ago because stock prices just rose slowly instead of jumping all the way back up immediately. In fact, we must always be in a state where most traders are uncertain, because, if they weren’t, stock prices always shift up or down until they were uncertain.

If you’re trying to beat the market by getting higher than market returns, your real opponents are all the other stock traders, not just some single entity. Traders can’t all be winners. For every dollar of market outperformance, there has to be a dollar of underperformance.

So, when you try to beat the market, you have to ask yourself whose trading dollars you expect to take. Even worse, because almost all trading is done by professional investors these days, you need to ask yourself which investment pros’ dollars you expect to take.

None of this proves that you can’t beat the market. But it does show that the deck is stacked against anyone who tries, particularly after factoring in the costs associated with trying to beat the market.

Monday, July 17, 2017

The Four Pillars of Investing

While reading William J. Bernstein’s book The Four Pillars of Investing, I was unsure of how to summarize it. After finishing I’d say that it aims to give readers the right knowledge and expectations to become successful do-it-yourself investors. Without a solid grounding in each of the four pillars, investors are at risk of making expensive mistakes.

The first pillar, called “theory,” is less intimidating than it sounds. It teaches the link between risk and reward and that “high previous returns usually indicate low future returns, and low past returns usually mean high future returns.” This is particularly true of stocks because they show more mean reversion than you’d expect just from randomness.

We tend to think of money market funds as safe, but they get their returns in part from commercial paper that “does occasionally default.” There is no excess return without some risk.

Bernstein explains the Gordon equation, which states that the market return is equal to dividend yield plus the rate of dividend growth. He goes on to explain that to this we have to add the rate of stock buybacks and subtract the rate of new share issuance. One point I’d add is that companies can make their dividend growth appear higher for a few years by increasing the proportion of earnings they pay out in dividends. For this reason, one might substitute earnings growth for dividend growth. But this has its own problems for companies that game their earnings accounting.

An amusing bit was using Trump Casinos as an example of a business with a high risk of defaulting on loans. I doubt Bernstein had any idea that years after writing it, his book would come to seem political.

It’s not hard to see what Bernstein thinks of active management when he refers to a mutual fund’s advisory fees as “what the chimps get paid.” He also says “It should be painfully apparent by now that most of the investment industry is engaged in nonproductive work.” He sums up his arguments with “Stock picking and market timing are expensive, risky, and ultimately futile exercises. Harness the power of the market by owning all of it—that is, by indexing.”

Because of the possibility of high inflation, the author believes that “Long-duration bonds are generally a sucker’s bet.”

The second pillar is the history of investing. The main purpose of this pillar is to teach readers that market bubbles and crashes happen fairly regularly, and we need to keep our wits about us and stick to a plan. As George Santayana said, “Those who cannot remember the past are condemned to repeat it.”

I’ve written before about Bernstein’s distinction between investing and saving, and I won’t say any more about it here.

I enjoyed a joke at the expense of the company “Yahoo!” where Bernstein asked if the name is an interjection “or was it simply a noun, meant to describe the company’s shareholders.”

The third pillar is the psychology of investing. People consistently make many types of investing mistakes. The first step in avoiding these mistakes is to understand them.

Some examples of mistakes are assuming “that the immediate past is predictive of the long-term future,” and our search for patterns that aren’t there. “The pricing of stocks and bonds at both the individual and market level is random: there are no patterns.”

Another mistake is seeking status through the types of investments you use. “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 partnerships, and the like—are designed to bleed them with commissions, transaction costs, and other fees.”

The fourth pillar is the business of investing. This pillar is a warning about the financial industry. “The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks.” “Under no circumstances should you have anything to do with a ‘full service’ brokerage firm.”

Most mutual-fund companies aren’t much better: “The primary business of most mutual-fund companies is collecting assets, not managing money.”

The sections of the book on the four pillars are strong, but the “assembling the four pillars” section isn’t as strong. A couple of the reasons for this aren’t Bernstein’s fault: the discussion of specific investments is getting dated and is too U.S.-centric for a Canadian like me.

My main criticism is that he ends up building portfolios that are too complex. For most people, the potential benefit of slicing up portfolios into ETFs or funds based on market caps, growth/value, geography, and other factors is too small to justify the extra work. No doubt some people could manage all this well, but many investors would make mistakes and end up spending too much on commissions, spreads, higher MERs, and realized taxes. Simpler is usually better.

The short section on investing with children is excellent. He advocates buying index funds for children, letting them watch the ups and downs once each quarter, and letting them spend some dividends. I tried to do something similar for my sons, but mostly failed. Bernstein’s approach would have been better.

Bernstein is very positive about an approach to investing called value averaging. It doesn’t work. I’ve discussed why here and here, and described some experiments I ran here.

The subsection on rebalancing places a lot of emphasis on which method gives the highest returns. This can be misleading for investors. When you own many stock funds based on various factors, rebalancing can give a small boost in returns. However, most investors just rebalance between stocks and bonds. The purpose in this case is to control volatility, not boost returns.

Overall, I found this to be an excellent book for steering investors toward making good decisions about the things they can control, and remaining calm about the things they can’t control. Readers who get through the whole book are likely to become better investors.

Wednesday, July 12, 2017

Are We Saving or Investing?

When we buy shares in a company, are we saving or investing? Most of the world would call this investing, but William J. Bernstein disagrees. In his excellent book The Four Pillars of Investing, he explains why he calls this saving:

“When you and I purchase shares of stock or a mutual fund, we are not investing. After all, the money we pay for our shares does not go to the companies, but, instead, to the previous owner of the shares. In economic terms, we are not investing; we are saving.”

He continues

“Only when we purchase shares at a so-called ‘initial public offering’ (IPO) are we actually providing capital for the acquisition of personnel, plant, and equipment. Only then are we truly investing.”

It’s certainly important to make a distinction between a simple change of ownership of shares and a company getting new money to run its operations. But I find the terms Bernstein uses very unsatisfying.

When I commit money to my trading account with the intent to leave it there for a long time, I am saving. When I choose to convert cash to shares, I’m not saving again. The word most people use for this activity is “investing.” If we wish to make the distinction Bernstein is making, then I think “trading” is a better word than “saving.”

But even this doesn’t describe the situation fully. It’s true that the net actions of buyer and seller provide no new capital to the company. But the buyer has aligned his economic outcome to the fate of the company. The buyer’s viewpoint is that he has invested in the company and the seller has withdrawn his investment, even if the company doesn’t see it this way.

The most troubling part of this semantic game is that it gives an opening for obnoxious types to derail any type of investment discussion with “actually, you’re not investing at all.” It’s amazing how often people in a narrow technical field think they can police the meaning of a word that has one meaning in the technical field and another well-established meaning among the broader public.

The point Bernstein was leading up to in his book is that IPOs have historically been poor investments, on average. So, investors would do well to avoid IPOs altogether. This is a good point to make, but we need better terms when discussing the distinction between IPOs and the secondary market than investing/saving.

Friday, July 7, 2017

Short Takes: Macroeconomics, Unlocking Phones, and more

Here are my posts for the past two weeks:

Payday Loan Information

Are Payday Loan Users Victims?

Enough: True Measures of Money, Business, and Life

Arguments Against Index Investing

Here are some short takes and some weekend reading:

Preet Banerjee interviews Luke Kawa, a Bloomberg reporter, to talk about macroeconomics. It was good to get some buzzwords explained, but this interview didn’t change the feeling I’ve had for some time that macroeconomics is wild guesswork.

Big Cajun Man reports that new CRTC rules will eliminate phone unlocking fees on 2017 December 1. He uses the example of Bell’s policies to show how onerous these fees can be.

Canadian Couch Potato reports on new index ETFs from Royal Bank.

Boomer and Echo ask whether your assets under management are really being managed.

Thursday, July 6, 2017

Arguments Against Index Investing

I’m accustomed to reading arguments against index investing. The valid ones tend to point out that few index investors actually stick to their plans. The “other” arguments make less sense but get repeated frequently anyway. Jack Mintz managed to bring a great many of these less sensible arguments together in a recent short article. Here I examine Mintz’s claims.

“What happens if the day comes that the entire stock market becomes solely made up of passive investors?”

This won’t happen. We’re not close to it now. If we ever got close enough to 100% index investing, active stock picking would become profitable.

“The lure of sharply reduced investment fees has enticed millions of investors to shift their portfolios to passive investments.”

Calling low fees a “lure” implies that index investors can expect to get caught somehow. Mintz offers nothing to back this up.

“There are problems with all this passivity.”

I got to the end of the article without seeing anything to back up this vague claim of problems index investors can supposedly expect.

“Much of the argument in favour of passive investment is based on the presumed failure of active funds to provide superior pre-tax returns on a consistent basis compared to index funds.”

The failure of active funds to keep up with index funds is extremely well studied and documented. There is nothing “presumed” about it.

“But passive investment works when market prices convey all the information about a security.”

The implication here is that passive investment doesn’t work when market prices don’t convey all the information about a security. This isn’t true. The fact that the average index investor gets higher returns than the average active investor is based on simple arithmetic, not some variant of the Efficient Market Hypothesis. Only a small minority of active investors can outperform the index. The more efficient the market is, the tinier the minority of active investors who can outperform the index over the long term.

“In the presence of informational inefficiency, there is value to research and hiring advisers.”

The vast majority of trading is done by investment professionals. They can’t all beat the index. After factoring in costs, only a small minority can beat the index over the long run. Average investors have no idea which advisors will help them outperform. Trying to guess this correctly is as hard as being a superior stock-picker.

“Passive investors freeload on active investors in the presence of informational inefficiencies. Through their research, active investors will reallocate capital from poorer-performing to better-performing assets, thereby increasing the overall value of an index, making passive investors better off too.”

This is true, but it’s an argument in favour of index investing, not against it. The work of active investors sets good prices that index investors enjoy. Perhaps we’re supposed to be embarrassed to be considered freeloaders. I think active money managers can be considered freeloaders for the huge fees they charge for a service that consistently produces poor outcomes for investors.

“It’s obvious that relying only on an index is absurd.”

So far we’re being lured, we have problems, we’re freeloaders, and now we’re behaving absurdly. Flinging around such characterizations is easier than making a logical argument.

“Nortel made up 36 per cent of the TSX in 2000 and went bust a few years later. Meanwhile, funds based on an index will often end up holding many unprofitable firms.”

On the other hand, index investors rode Nortel on the way up, and they own many profitable firms. The implication here is that active managers avoided Nortel’s implosion (as a group, they didn’t), and they can avoid companies that will be unprofitable in the future (as a group, they can’t).

“When the U.K. ended embedded commissions, the result was that lower-wealth investors would not or could not pay for advice, leaving them less well-prepared for retirement.”

Lower-wealth investors in Canada are already very poorly served. Most of the time, salespeople sell them expensive mutual funds without providing meaningful advice. Quality financial advisors are almost exclusively available to investors with substantial portfolios.

“Instead of favouring passive investing over active investing, policy should instead remove barriers that make financial planning costly. Ottawa charges GST on financial-management fees.”

It’s not clear to me that removing the GST from financial-management fees would lower investors’ costs. Costs are unreasonably high now. What would stop fund companies from raising fees to fill the GST gap? If you think of the GST as an extra cost for investors, you probably want to remove it. If you think of the GST as taking a slice of fees away from fund companies and advisors, then you probably want to keep it (unless you work for a fund company or advisor).

“Fans of ETFs and the companies that market the funds insist that active investing can never beat passive investing, since no human can consistently outperform the market.”

Few people claim that no human can consistently outperform the market. After all, most of us have heard of Warren Buffett. What index investors claim is that the average index investor gets higher returns than the average active investor after factoring in fees.

“The overwhelming number of studies that test the difference between active and passive funds are deficient in some respects.”

To back up this claim, Mintz cites nitpicks about benchmarks and observes that some studies found that active management beat passive in certain time-frames or under other circumstances. The truth is that the overwhelming majority of studies clearly back up the simple arithmetic argument that active managers as a group cannot beat indexes.

It’s hard to know the real motivation of those who make arguments like this. One plausible guess is that while the arguments are easy to refute, they give advisors something convincing to say to their clients in a one-on-one setting with nobody there to offer counterarguments.

One point to be clear about here is that active investing is not the enemy. For one thing, active investors help to set good prices. Investors’ real enemy is high costs. In the U.S., Vanguard offers active mutual funds with low costs. These funds serve investors well.

The best criticism of index investing is that so many investors fail to stick to their plan. Some bail out when stock prices fall. Others tinker so much with their allocations that they’re effectively market timers. Some are poorly diversified.

The passive versus active debate isn’t going away any time soon. There are too many people who make their livings from expensive mutual funds to expect them to just give up.