Have you ever noticed that the prices of items at a convenient store are significantly more expensive than identical items at a grocery store? Have you ever noticed that, although it is a one-stop shop, the size of a Walmart Supercenters is 175,000 sq. ft. on average? We know that the rich get richer and the poor get poorer, but there are very few identifiable expenses that explain the difference.
One reason is convenience charges. Unlike buying tickets off Ticketmaster or other online retailers, where “convenience charge” appears on the itemized receipt, most convenience charges are explained only by strange pricing differentials. Your closest convenience store is not going to sell as many gallons of milk as your grocer for a couple reasons. One, because the price of milk is more expensive at the convenience store. Two, because there are so many more convenience stores than grocers. Whether one is a chicken and the other is an egg, I do not know. But a convenience store will earn more on each unit of milk sold – while a grocer will have lower margins and a higher volume of sales.
Why buy from a convenience store, instead of your grocer? There is no discernible reason to, unless you just like paying more (which, arguably would be the opposite of reasonable, as the I-didn’t-pay-enough tax fund in Arizona has proven). Except, there is a matter of convenience.
It is easier to drive a block to the closest convenience store to buy milk than to go to your local grocer or even a Walmart Supercenter. The building is smaller, so everything is closer together. The higher prices limit the number of customers, so there is no wait. You can get a gallon of milk in five minutes from a convenience store, or you can spend 20 minutes going to Walmart and back. Time is money, so there are people willing to pay for convenience.
Your pizza order is going to be subject to a delivery charge if you have it brought to you. (Ditto for Grubhub, UberEats, Postmates, and the like.) We know them as a delivery charge. A convenience charge by any other name would still reach as high.
What is the problem with convenience charges then? They become very expensive if you do not realize when you are paying them. If you cannot be bothered to leave your home for a meal, and you want fast-food instead of preparing something at your house, then you have every right to order delivery – but it comes at a price. You could have saved more by slightly “inconveniencing” yourself, either by planning ahead and stocking cupboards with easy meals or by stopping at a drive-through before coming home.
The great debate among people who say that they never splurge is when they rack up these expenses repeatedly – daily, even multiple times a day. Not being aware of how much more you pay than you should does not mean it does not exist. When the counterpart of the debate say they are living below their means, this is a big part of what they mean. They can afford convenience charges, but they opt for more inconvenient options to avoid them. They can afford bigger homes or nicer cars, but they transfer the benefits obtained from those purchases and redirect it elsewhere, most likely into their own wealth accumulation. I remember going to lunch with a friend of mine who had a (quite frankly) surprisingly nice car! I told him how great his car looked, to which his kneejerk reply was, “thanks, I’m not sure it is worth how much I pay for it.”
There are conveniences that come with a nice car, to be sure, but whether the sum of those conveniences match the price is another issue. The hidden expenses of a nicer car, including the higher quality tires and more expensive repairs and maintenance, add up subtly.
Sunday, September 29, 2019
Saturday, September 14, 2019
Indexing Made Easy - But Too Easy?
Indexing is easy. As I (and others) have said repeatedly. That simplicity could be its biggest drawback based on people's confirmation bias that finance is risky or at least tricky. People who want to believe that there is a good reason why they are not investing will believe those who say index returns are average returns. In reality, active management is a zero-sum game so for every dollar earned over the index return is at the expense of a dollar under-performing the market. While it is often simplified as saying "for every winner, there is a loser," and therefore index returns would be average, the reality is that the "winning" dollars are often disproportionately distributed, and there are several people losing a few dollars to a few winners claiming a lot of dollars. Just behind the returns of those few winners are the returns of index funds.
This week, I saw that Jim Cramer had touted the benefit of index investing, but upon further research, this latest claim was not the first time he had said as much. Even back in June 2014, he must have made similar statements because I found an article from MarketWatch's Retirementors recording the statement. That article is reprinted in full below, along with an interesting reader comment that warrants further discussion.
Jim Cramer likes index funds — Who knew?
https://www.marketwatch.com/story/jim-cramer-likes-index-funds-who-knew-2014-06-26
By Mitch Tuchman
Jim Cramer, the "Mad Money" cable TV host known for using his perch to preach stock-picking to the masses, has a simple message for retirement investors: Don't buy stock-picking mutual funds.
Yes, he still believes that picking stocks is time well-spent for some, but in a recent episode of his hugely popular show, Cramer launched into a tirade against the stock-picking industry, at least as it's sold to retail investors via actively managed funds. And he unabashedly supported owning low-cost, simple index funds in their place. in their place.
"If you're investing in mutual funds you're most likely, well, to put it delicately — how about 'getting hosed,'" Cramer said.
The reason why is cost, Cramer explained. Mutual funds make money by increasing the number of dollars they manage. That means spending money to attract new investors.
A small number of active mutual funds can beat the market, but usually only barely and not by enough to offset the fees they must charge to advertise and draw in those new investors — their real business model.
"What they're being paid to do is bring in more money from you, from more investors," Cramer warned. "That's part of the reason why in study after study, year after year, it's shown that the actively managed mutual funds underperform the benchmarks."
Price of admission
The other problem is that mutual fund success, in the instances where it happens, tends over time to lose effectiveness.
"When a mutual fund delivers such great results for so long, if the manager is a decent guy or woman they'll stop accepting new investors because when a fund gets too big it becomes incredibly difficult to beat the market," Cramer pointed out.
Hold on to that thought for a moment. If the goal is to beat the market, and size makes it harder to do so, isn't the better option to instead own the whole market, to just own the index? Cramer thinks so.
An index fund thus becomes the world's best mutual fund, clearly the most consistently successful way to invest over time and one whose price of admission is extremely low.
That's the reason the SDPR S&P 500 exchange-traded fund SPY, -0.07%, which owns the Standard & Poor’s 500 Index SPX, -0.07%, has a $167 billion market cap, nearly triple the No. 2 ETF — which also happens to track the S&P 500, the iShares S&P 500 Index ETF IVV, -0.07%.
It's also the reason a range of indexing ETFs have gained such broad allegiance over the past decade. They and their index-fund brethren are cheap to own and they deliver the kind of drama-free return retirement investors seek.
Cramer has some negative things to say about the proliferation of exotic ETFs, and he's right. More choice isn't always better, as he points out. But he's also correct in arguing that there really are two kinds of investors: Those ready and willing to commit to being traders and to sweating the daily ins and outs of stock selection, and the rest of us.
A clear choice
For retirement investors, the choice increasingly is clear, Cramer contends.
"You want a cheap, low-cost index fund that mirrors the market as a whole, one that mimics the S&P 500. You have a vehicle that will let you participate in the strength of the market without spending the time picking individual stocks," he concluded. "This may sound like a really simple solution, but don't overthink it. The whole point of putting your money in the fund is to save you from time and effort to manage your own portfolio of stocks."
We agree with Cramer's general argument. We would add only that at least some retirement investors benefit from financial adviser guidance from time to time, and that owning a basket of index ETFs operating as a risk-adjusted portfolio is a better choice than a 100% stock portfolio, even if it is held as a single ETF. He likely would agree on both points.
Naturally, portfolio-quality ETFs can and should be absolutely minimal in terms of cost and minimalist in design. From there, simple rebalancing and cautious oversight are all you need to build and maintain an optimal long-term retirement plan.
Not new news, but for a man like Jim Cramer who has appeared on TV shows such as Arrested Development as his abrasive on-screen character, it is quite an endorsement for the merits of indexing. Of course, there are still deniers. People believe the Earth is flat, despite overwhelming evidence. People similarly believe indexing is inferior or flawed.
I enjoyed this comment, which was largely valid, that even the most successful actively managed funds have an unspoken disadvantage for investors where they tend to close to new investors so the portfolio managers can continue to manage them successfully without an onslaught of incoming assets. This investor noted T. Rowe Price New Horizon, which was closed to new investors after successfully outperforming the index.
Pretty alluring. In June 2014, it was even an enviable position. If you had been forced to place money in Vanguard Total Stock Market Index Fund, instead of the closed TRP Fund, five years ago, then how would the returns have compared to opportunity cost of missing out on the TRP Fund? I ran a five-year comparison between the two funds on MarketWatch, and the results were amusing.
Investing $10,000 in the index fund back in September 2014, would have earned $54,100. Investing the same amount hypothetically into the TRP fund back in September 2014 would have earned $25,725.
This week, I saw that Jim Cramer had touted the benefit of index investing, but upon further research, this latest claim was not the first time he had said as much. Even back in June 2014, he must have made similar statements because I found an article from MarketWatch's Retirementors recording the statement. That article is reprinted in full below, along with an interesting reader comment that warrants further discussion.
Jim Cramer likes index funds — Who knew?
https://www.marketwatch.com/story/jim-cramer-likes-index-funds-who-knew-2014-06-26
By Mitch Tuchman
Jim Cramer, the "Mad Money" cable TV host known for using his perch to preach stock-picking to the masses, has a simple message for retirement investors: Don't buy stock-picking mutual funds.
Yes, he still believes that picking stocks is time well-spent for some, but in a recent episode of his hugely popular show, Cramer launched into a tirade against the stock-picking industry, at least as it's sold to retail investors via actively managed funds. And he unabashedly supported owning low-cost, simple index funds in their place. in their place.
"If you're investing in mutual funds you're most likely, well, to put it delicately — how about 'getting hosed,'" Cramer said.
The reason why is cost, Cramer explained. Mutual funds make money by increasing the number of dollars they manage. That means spending money to attract new investors.
A small number of active mutual funds can beat the market, but usually only barely and not by enough to offset the fees they must charge to advertise and draw in those new investors — their real business model.
"What they're being paid to do is bring in more money from you, from more investors," Cramer warned. "That's part of the reason why in study after study, year after year, it's shown that the actively managed mutual funds underperform the benchmarks."
Price of admission
The other problem is that mutual fund success, in the instances where it happens, tends over time to lose effectiveness.
"When a mutual fund delivers such great results for so long, if the manager is a decent guy or woman they'll stop accepting new investors because when a fund gets too big it becomes incredibly difficult to beat the market," Cramer pointed out.
Hold on to that thought for a moment. If the goal is to beat the market, and size makes it harder to do so, isn't the better option to instead own the whole market, to just own the index? Cramer thinks so.
An index fund thus becomes the world's best mutual fund, clearly the most consistently successful way to invest over time and one whose price of admission is extremely low.
That's the reason the SDPR S&P 500 exchange-traded fund SPY, -0.07%, which owns the Standard & Poor’s 500 Index SPX, -0.07%, has a $167 billion market cap, nearly triple the No. 2 ETF — which also happens to track the S&P 500, the iShares S&P 500 Index ETF IVV, -0.07%.
It's also the reason a range of indexing ETFs have gained such broad allegiance over the past decade. They and their index-fund brethren are cheap to own and they deliver the kind of drama-free return retirement investors seek.
Cramer has some negative things to say about the proliferation of exotic ETFs, and he's right. More choice isn't always better, as he points out. But he's also correct in arguing that there really are two kinds of investors: Those ready and willing to commit to being traders and to sweating the daily ins and outs of stock selection, and the rest of us.
A clear choice
For retirement investors, the choice increasingly is clear, Cramer contends.
"You want a cheap, low-cost index fund that mirrors the market as a whole, one that mimics the S&P 500. You have a vehicle that will let you participate in the strength of the market without spending the time picking individual stocks," he concluded. "This may sound like a really simple solution, but don't overthink it. The whole point of putting your money in the fund is to save you from time and effort to manage your own portfolio of stocks."
We agree with Cramer's general argument. We would add only that at least some retirement investors benefit from financial adviser guidance from time to time, and that owning a basket of index ETFs operating as a risk-adjusted portfolio is a better choice than a 100% stock portfolio, even if it is held as a single ETF. He likely would agree on both points.
Naturally, portfolio-quality ETFs can and should be absolutely minimal in terms of cost and minimalist in design. From there, simple rebalancing and cautious oversight are all you need to build and maintain an optimal long-term retirement plan.
Not new news, but for a man like Jim Cramer who has appeared on TV shows such as Arrested Development as his abrasive on-screen character, it is quite an endorsement for the merits of indexing. Of course, there are still deniers. People believe the Earth is flat, despite overwhelming evidence. People similarly believe indexing is inferior or flawed.
I enjoyed this comment, which was largely valid, that even the most successful actively managed funds have an unspoken disadvantage for investors where they tend to close to new investors so the portfolio managers can continue to manage them successfully without an onslaught of incoming assets. This investor noted T. Rowe Price New Horizon, which was closed to new investors after successfully outperforming the index.Pretty alluring. In June 2014, it was even an enviable position. If you had been forced to place money in Vanguard Total Stock Market Index Fund, instead of the closed TRP Fund, five years ago, then how would the returns have compared to opportunity cost of missing out on the TRP Fund? I ran a five-year comparison between the two funds on MarketWatch, and the results were amusing.
Investing $10,000 in the index fund back in September 2014, would have earned $54,100. Investing the same amount hypothetically into the TRP fund back in September 2014 would have earned $25,725.
Saturday, August 17, 2019
The Full Motley – 3Q, 2019
I have been remiss in updating this blog since my 10th anniversary in February, but I have consistently been rebalancing quarterly. This week’s rebalance came amid a volatile week in the market. Losses of 800 points one day or gains of 500 points the next day evened out to end the week with a tolerable 300-point drop. Reactions to the daily volatility would be enough to convince market-watchers that big changes were occurring daily, but from a weekly view, those changes were rather minimal. This is the difference between investing for the short-term or investing for the long run. Our retirement investments are long-term investments. It is important to understand why (and how) the investments work, and that responsibility is falling to the individual – as many other things are as well.
This week, I was listening to a panel of Asian Americans speak about their cultural difference between their home countries (or origin countries, for those who were born here) and the United States, and a lot of the differences and obstacles that they identified sounded to be as much generational situations as cultural differences. The old way of succeeding was to keep quiet, keep your head down, and you would be rewarded for loyalty. The new way of succeeding is to carve out a path for yourself and you will be rewarded with opportunity.
Times are changing, in many ways – for better or worse. Among these changes, financial stability might have been one of the advantages lost in the shift away from "keep quiet and keep your head down" being sound advice. Just as workers are not rewarded for loyalty to companies; companies are not rewarded for loyalty to the workers. The idea of retirement pensions upon completion of a 40-year career with a single company is passe (both the pension, and the 40-year career with a single company). Now we speak up for ourselves. We assert our freedoms and individuality nowadays, but our financial stability was included in that shift. We can celebrate greater financial freedom now, but that requires taking the same approach of speaking up, asking questions and not keeping our heads down. Our financial success is up to us.
Investing in mutual funds spreads loyalty (the risks and rewards) to a single company by diversifying. Diversifying will mitigate the rewards when that company succeeds greatly, but it will limit the losses if the company fails. My investments are in the Vanguard Total Stock Market Index Fund, Vanguard PRIMECAP Fund, Vanguard Total International Stock Index Fund, Vanguard Bond Market Index Fund, and Vanguard Total International Bond Index Fund. These five investments provide me access to the global market, from domestic equities (both passive and active) to international equities, as well as domestic and international bonds. While I could diversify further with higher risk investments in alternative investments (such as real estate or commodities, including gold), I keep my 401k spread across the global marketplace and leave those investments for my individual accounts, such as my Roth IRA.
Interestingly, my rebalance for this quarter pulled from all assets to place into the Total International Stock Index Fund. That fund had been underperforming relative to the other funds in my account, but there are many strategic advantages to putting more money into that fund at this time, including the slowing American economy and/or the weakening American dollar will hit my largest funds the hardest. Whether the international index appreciates or just holds ground better, it is a good investment away from those investments that are most at-risk of those looming threats. If I read the headlines in the financial media (and I do), then I could become convinced that those threats are large and nearing. In a reactionary state of mind, I would pull more from those at-risk investments and shuffle the money into this international index. But much as the weekly market movement was relatively minor compared to the daily volatility seen, watching investments too closely can be hazardous to your wealth (and mental health). I will just endure what may come with my quarterly rebalancing. I am not convinced that any changes would be best in the long run, which is where I am truly invested.
This week, I was listening to a panel of Asian Americans speak about their cultural difference between their home countries (or origin countries, for those who were born here) and the United States, and a lot of the differences and obstacles that they identified sounded to be as much generational situations as cultural differences. The old way of succeeding was to keep quiet, keep your head down, and you would be rewarded for loyalty. The new way of succeeding is to carve out a path for yourself and you will be rewarded with opportunity.
Times are changing, in many ways – for better or worse. Among these changes, financial stability might have been one of the advantages lost in the shift away from "keep quiet and keep your head down" being sound advice. Just as workers are not rewarded for loyalty to companies; companies are not rewarded for loyalty to the workers. The idea of retirement pensions upon completion of a 40-year career with a single company is passe (both the pension, and the 40-year career with a single company). Now we speak up for ourselves. We assert our freedoms and individuality nowadays, but our financial stability was included in that shift. We can celebrate greater financial freedom now, but that requires taking the same approach of speaking up, asking questions and not keeping our heads down. Our financial success is up to us.
Investing in mutual funds spreads loyalty (the risks and rewards) to a single company by diversifying. Diversifying will mitigate the rewards when that company succeeds greatly, but it will limit the losses if the company fails. My investments are in the Vanguard Total Stock Market Index Fund, Vanguard PRIMECAP Fund, Vanguard Total International Stock Index Fund, Vanguard Bond Market Index Fund, and Vanguard Total International Bond Index Fund. These five investments provide me access to the global market, from domestic equities (both passive and active) to international equities, as well as domestic and international bonds. While I could diversify further with higher risk investments in alternative investments (such as real estate or commodities, including gold), I keep my 401k spread across the global marketplace and leave those investments for my individual accounts, such as my Roth IRA.
Interestingly, my rebalance for this quarter pulled from all assets to place into the Total International Stock Index Fund. That fund had been underperforming relative to the other funds in my account, but there are many strategic advantages to putting more money into that fund at this time, including the slowing American economy and/or the weakening American dollar will hit my largest funds the hardest. Whether the international index appreciates or just holds ground better, it is a good investment away from those investments that are most at-risk of those looming threats. If I read the headlines in the financial media (and I do), then I could become convinced that those threats are large and nearing. In a reactionary state of mind, I would pull more from those at-risk investments and shuffle the money into this international index. But much as the weekly market movement was relatively minor compared to the daily volatility seen, watching investments too closely can be hazardous to your wealth (and mental health). I will just endure what may come with my quarterly rebalancing. I am not convinced that any changes would be best in the long run, which is where I am truly invested.
Sunday, February 10, 2019
The Full Motley -- 10 Year Anniversary (1Q, 2019)
No matter what age you are or which period you are tracking, ten years is a long time! As it is, ten years ago today was when I started tracking my 401(k) because the markets were about as low as I could imagine them, and I was so curious what was next. As it turned out, the markets would bottom out within a month and then begin on a record long bull run that did not end until December 2018. Basically, it was a 10-year period in which it was much harder to lose money than make money!
Regardless, a lot happened in that time: I quit my job, I went to school, I attempted to re-career from the finance industry into the legal field, I ended up in the legal department of a finance company, and I had to modify my 401(k) investments when my provider changed the investment options. As of today, I am also halfway through a M.B.A. program! Having worked in finance for 10 years though, this program feels more like it is papering down my knowledge base than brand new studies, which is not a bad thing.
My current ECON class textbook had an interesting take on active management versus indexing:
"Mutual fund investors have a choice between putting their money into actively managed mutual funds or into passively managed index funds. Actively managed funds constantly buy and sell assets in an attempt to build portfolios that will generate average expected rates of return that are higher than those of other portfolios possessing a similar level of risk. In terms of Figure 35.3, they try to construct portfolios similar to point A, which has the same level of risk as portfolio B but a much higher average expected rate of return. By contrast, the portfolios of index funds simply mimic the assets that are included in their underlying indexes and make no attempt whatsoever to generate higher returns than other portfolios having similar levels of risk.
"As a result, expecting actively managed funds to generate higher rates of return than index funds would seem only natural. Surprisingly, however, the exact opposite actually holds true. Once costs are taken into account, the average returns generated by index funds trounce those generated by actively managed funds by well over 1 percent per year. Now, 1 percent per year may not sound like a lot, but the compound interest formula of equation 1 shows that $10,000 growing for 30 years at 10 percent per year becomes $170,449.40, whereas that same amount of money growing at 11 percent for 30 years becomes $220,892.30. For anyone saving for retirement, an extra 1 percent per year is a very big deal.
"Why do actively managed funds do so much worse than index funds? The answer is twofold. First, arbitrage makes it virtually impossible for actively managed funds to select portfolios that will do any better than index funds that have similar levels of risk. As a result, before taking costs into account, actively managed funds and index funds produce very similar returns. Second, actively managed funds charge their investors much higher fees than do passively managed funds, so that, after taking costs into account, actively managed funds do worse by about 1 percent per year.
"Let us discuss each of these factors in more detail. The reason that actively managed funds cannot do better than index funds before taking costs into account has to do with the power of arbitrage to ensure that investments having equal levels of risk also have equal average expected rates of return. As we explained above with respect to Figure 35.3, assets and portfolios that deviate from the Security Market Line (SML) are very quickly forced back onto the SML by arbitrage, so that assets and portfolios with equal levels of risk have equal average expected rates of return. This implies that index funds and actively managed funds with equal levels of risk will end up with identical average expected rates of return despite the best efforts of actively managed funds to produce superior returns.
"The reason actively managed funds charge much higher fees than index funds is because they run up much higher costs while trying to produce superior returns. Not only do they have to pay large salaries to professional fund managers, but they also have to pay for the massive amounts of trading that those managers engage in as they buy and sell assets in their quest to produce superior returns. The costs of running an index fund are, by contrast, very small since changes are made to an index fund’s portfolio only on the rare occasions when the fund’s underlying index changes. As a result, trading costs are low and there is no need to pay for a professional manager. The overall result is that while the largest and most popular index fund currently charges its investors only 0.18 percent per year for its services, the typical actively managed fund charges more than 1.5 percent per year.
"So why are actively managed funds still in business? The answer may well be that index funds are boring. Because they are set up to mimic indexes that are in turn designed to show what average performance levels are, index funds are by definition stuck with average rates of return and absolutely no chance to exceed average rates of return. For investors who want to try to beat the average, actively managed funds are the only way to go."
Fairly rousing endorsement for what I have been following in the past 10+ years. Of course, the recurring question has been whether rebalancing quarterly has been too often, but this past quarter is a good example of its merits. On November 10, 2018, we had no idea what the next three months would be like! The markets were shaky, but a Christmas Eve Massacre saw the Dow plummet 650 points.
There were two ways to go: one, panic and make immediate changes or two, stay the course. In this case, staying my course involved weathering the fall for the next two months and then buying into the depleted markets by moving other assets that might have appreciated in that time. As it turned out, the market has recovered most of its losses since its recent lows, so staying the course was the best choice.
Therefore, my move for this rebalance was minor (as the past several have been). Instead of taking money from the stock funds though, this time I put money into those stock funds. Specifically, I took 1.5% from my International Stock Index Fund, 4.7% from my Bond Market Index Fund, and 4% from my International Bond Fund, and I placed that amount into my PRIMECAP Fund (53%) and my Total Stock Market Index Fund (47%). Nothing close to approaching 10%, but just like in baseball, winning in wealth creation is more about the consistent singles and doubles than the occasional home runs.
Regardless, a lot happened in that time: I quit my job, I went to school, I attempted to re-career from the finance industry into the legal field, I ended up in the legal department of a finance company, and I had to modify my 401(k) investments when my provider changed the investment options. As of today, I am also halfway through a M.B.A. program! Having worked in finance for 10 years though, this program feels more like it is papering down my knowledge base than brand new studies, which is not a bad thing.
My current ECON class textbook had an interesting take on active management versus indexing:
"Mutual fund investors have a choice between putting their money into actively managed mutual funds or into passively managed index funds. Actively managed funds constantly buy and sell assets in an attempt to build portfolios that will generate average expected rates of return that are higher than those of other portfolios possessing a similar level of risk. In terms of Figure 35.3, they try to construct portfolios similar to point A, which has the same level of risk as portfolio B but a much higher average expected rate of return. By contrast, the portfolios of index funds simply mimic the assets that are included in their underlying indexes and make no attempt whatsoever to generate higher returns than other portfolios having similar levels of risk.
"As a result, expecting actively managed funds to generate higher rates of return than index funds would seem only natural. Surprisingly, however, the exact opposite actually holds true. Once costs are taken into account, the average returns generated by index funds trounce those generated by actively managed funds by well over 1 percent per year. Now, 1 percent per year may not sound like a lot, but the compound interest formula of equation 1 shows that $10,000 growing for 30 years at 10 percent per year becomes $170,449.40, whereas that same amount of money growing at 11 percent for 30 years becomes $220,892.30. For anyone saving for retirement, an extra 1 percent per year is a very big deal.
"Why do actively managed funds do so much worse than index funds? The answer is twofold. First, arbitrage makes it virtually impossible for actively managed funds to select portfolios that will do any better than index funds that have similar levels of risk. As a result, before taking costs into account, actively managed funds and index funds produce very similar returns. Second, actively managed funds charge their investors much higher fees than do passively managed funds, so that, after taking costs into account, actively managed funds do worse by about 1 percent per year.
"Let us discuss each of these factors in more detail. The reason that actively managed funds cannot do better than index funds before taking costs into account has to do with the power of arbitrage to ensure that investments having equal levels of risk also have equal average expected rates of return. As we explained above with respect to Figure 35.3, assets and portfolios that deviate from the Security Market Line (SML) are very quickly forced back onto the SML by arbitrage, so that assets and portfolios with equal levels of risk have equal average expected rates of return. This implies that index funds and actively managed funds with equal levels of risk will end up with identical average expected rates of return despite the best efforts of actively managed funds to produce superior returns.
"The reason actively managed funds charge much higher fees than index funds is because they run up much higher costs while trying to produce superior returns. Not only do they have to pay large salaries to professional fund managers, but they also have to pay for the massive amounts of trading that those managers engage in as they buy and sell assets in their quest to produce superior returns. The costs of running an index fund are, by contrast, very small since changes are made to an index fund’s portfolio only on the rare occasions when the fund’s underlying index changes. As a result, trading costs are low and there is no need to pay for a professional manager. The overall result is that while the largest and most popular index fund currently charges its investors only 0.18 percent per year for its services, the typical actively managed fund charges more than 1.5 percent per year.
"So why are actively managed funds still in business? The answer may well be that index funds are boring. Because they are set up to mimic indexes that are in turn designed to show what average performance levels are, index funds are by definition stuck with average rates of return and absolutely no chance to exceed average rates of return. For investors who want to try to beat the average, actively managed funds are the only way to go."
Fairly rousing endorsement for what I have been following in the past 10+ years. Of course, the recurring question has been whether rebalancing quarterly has been too often, but this past quarter is a good example of its merits. On November 10, 2018, we had no idea what the next three months would be like! The markets were shaky, but a Christmas Eve Massacre saw the Dow plummet 650 points.
There were two ways to go: one, panic and make immediate changes or two, stay the course. In this case, staying my course involved weathering the fall for the next two months and then buying into the depleted markets by moving other assets that might have appreciated in that time. As it turned out, the market has recovered most of its losses since its recent lows, so staying the course was the best choice.
Therefore, my move for this rebalance was minor (as the past several have been). Instead of taking money from the stock funds though, this time I put money into those stock funds. Specifically, I took 1.5% from my International Stock Index Fund, 4.7% from my Bond Market Index Fund, and 4% from my International Bond Fund, and I placed that amount into my PRIMECAP Fund (53%) and my Total Stock Market Index Fund (47%). Nothing close to approaching 10%, but just like in baseball, winning in wealth creation is more about the consistent singles and doubles than the occasional home runs.
Wednesday, January 16, 2019
Remembering John Bogle (1929-2019)
On Jack Bogle
https://about.vanguard.com/who-we-are/a-remarkable-history/founder-Jack-Bogle-tribute/by Tim Buckley
As you may already know, this is a sad day for Vanguard.
We lost a good friend. And mutual fund investors everywhere have lost one of their most passionate advocates.
Jack Bogle was the founder of our company, and its leader for more than two decades.
By creating a client-owned company—or as he himself liked to say, “the only mutual mutual fund company,” Jack Bogle put billions of dollars back into the pockets of investors.
And he influenced the entire mutual fund industry in a positive manner. Without Vanguard, I'm certain that costs would be higher for investors across the mutual fund industry.
In many ways, Jack was a man of contrasts:
- He was a student of history … but he was also a forward-thinking innovator.
- He could readily quote lines from Shakespeare or Sophocles … but he could just as capably tell you what just about any Vanguard fund returned yesterday. And the day before. And the day before that.
- He valued conventional principles like hard work and thrift … but he took tremendous personal and professional risks to follow his vision.
- He revolutionized the complex mutual fund industry … but he did so with fundamentally simple concepts like low costs and client-focus.
You know, Jack was fond of saying that he left his old job at Wellington Management Company—where he had worked for almost 2½ decades—in the same way that he began his new job at Vanguard: “Fired with enthusiasm!”
He carried that enthusiasm throughout his Vanguard career, and he inspired millions as a crusader for the everyday investor.
He liked to remind us that our clients are “honest-to-God, down-to-earth, human beings, each with their own hopes, fears, and financial goals.”
In a daily business that is so often characterized by numbers and forms and paperwork, that perspective is refreshing—and so important. It’s why we’re here.
We send our condolences to Jack’s wife, Eve, to their children and grandchildren, and to all those who were close to Jack over the course of his remarkable life.
Saturday, November 10, 2018
The Full Motley -- 4Q, 2018
It has been a highly active three months, even though the amount of my rebalance would perceive it as rather uneventful. Political uncertainty dragged the markets down significantly for several weeks last month leading into the mid-term elections, and then the market recovered sharply in the wake of the elections when the House and Senate were split. Overall, the spread of the fluctuations this past month were about 10% but it ended just about where it was three months ago.
Despite the activity, rebalancing now was insignificant. However, these shaky markets serve as a microcosm for the value that periodic rebalancing provides against longer market activity. Any temptation to move during the height of market uncertainty was neutralized because my next scheduled rebalance was known. If the market retreat continued, then my rebalance at that time would have been more impactful (potentially buying more shares of the equity funds when they were lower). As it turned out, the markets recovered so the dip in values meant nothing as they virtually recovered in the same amount of time. In short, it took the emotion out of the equation during the most emotional time to invest.
As I discussed in my last update, I recently modified my target 85/15 allocation (due to changes at Vanguard) with 30% to Total Stock Index Fund and PRIMECAP Fund, 15% to Total International Stock Index Fund, 11% to Total Bond Index Fund, and the remaining 4% to Total International Bond Index Fund. After all the market activity, only Total International Stock Index Fund was off by 1%, so my reallocation involved fractional percentages coming from the other four funds to make up that percentage point.
To reintroduce the graph for these numbers, which I have not used in five years (back when I started at my current position), here was the impact of this quarter's reallocation:
Vanguard Total Stock Market Fund 30.3% / -0.3% / 30%
Vanguard PRIMECAP Fund 30.4% / -0.4% / 30%
Vanguard Total Int'l Stock Fund 14.0% / 1.0% / 15%
Vanguard Total Bond Market Fund 11.1% / -0.1% / 11%
Vanguard Total Int'l Bond Fund 4.2% / -0.2% / 4%
Despite the activity, rebalancing now was insignificant. However, these shaky markets serve as a microcosm for the value that periodic rebalancing provides against longer market activity. Any temptation to move during the height of market uncertainty was neutralized because my next scheduled rebalance was known. If the market retreat continued, then my rebalance at that time would have been more impactful (potentially buying more shares of the equity funds when they were lower). As it turned out, the markets recovered so the dip in values meant nothing as they virtually recovered in the same amount of time. In short, it took the emotion out of the equation during the most emotional time to invest.
As I discussed in my last update, I recently modified my target 85/15 allocation (due to changes at Vanguard) with 30% to Total Stock Index Fund and PRIMECAP Fund, 15% to Total International Stock Index Fund, 11% to Total Bond Index Fund, and the remaining 4% to Total International Bond Index Fund. After all the market activity, only Total International Stock Index Fund was off by 1%, so my reallocation involved fractional percentages coming from the other four funds to make up that percentage point.
To reintroduce the graph for these numbers, which I have not used in five years (back when I started at my current position), here was the impact of this quarter's reallocation:
Vanguard Total Stock Market Fund 30.3% / -0.3% / 30%
Vanguard PRIMECAP Fund 30.4% / -0.4% / 30%
Vanguard Total Int'l Stock Fund 14.0% / 1.0% / 15%
Vanguard Total Bond Market Fund 11.1% / -0.1% / 11%
Vanguard Total Int'l Bond Fund 4.2% / -0.2% / 4%
Sunday, October 28, 2018
Smoke Screen or True FIRE
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| Even firefighters can get burned |
Recently, the FIRE (financial independence, retire early) movement traded barbs with financial wisdom expert Suze Orman when she made disparaging remarks about early retirement. The ridicule coming back was fierce, and “escalated quickly” to align with Millennial nomenclature.
Unfortunately, what Orman’s critics do not understand – and what many FIRE proponents have not learned yet -- is that there are a lot of unforeseeable changes ahead. Orman is coming from the perspective of having lived through all the changes that she has, and she knows how unpredictable life gets. She knows that even the best laid plans often go awry. And she knows, but she graciously did not say it, that, in the case of a majority, FIRE is a fad.
As troublesome as instant gratification in everything is, delaying gratification in everything is fraught with its own pitfalls. As tragic as it is to say, witnessing the early deaths of fellow FIRE proponents or other friends will make many re-evaluate those priorities. And in terms of gratification, it is very rewarding to put $10,000 aside today and have it equal $15,000 within two years.
If their target is to retire between the ages of 35 through 40, then they are more likely than not earning a salary that reflects a full college education and equal work experience. That means that they started about 10 years ago, at most 15 years. Therefore, whatever little amount that they had invested in the markets were not devastated in 2008-09. They remind me of my peers who attempted early retirement based on the rising markets of the late-90s, most of whom refigured (or abandoned) their plans once the market retreated. While setting aside $10,000 and having it rise to $15,000 within two years reinforces that behavior, having that amount then equal $8,000 after five years will be a different story altogether. If the early deaths of peers do not make them reconsider their commitment, this financial loss could start a paradigm shift away from the lifestyle.
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| More to say than Twitter allows |
It is not that today’s FIRE kids cannot retire early. Suze Orman and I (and others) know that upwards of 90% simply will choose not to retire early.
To be clear, I am not rooting against the FIRE proponents. I am crediting that at least 10% of them will see the commitment through (and I hope it is more). Besides, plenty of FI/RE proponents will experience the markets tumbling below where they started investing, and immediately think “it’s a FIRE sale!” (Which, for the record, was my reaction in 2008 when it happened in relation to my own purchases in 2003 and thereafter.) But having a bit more experience and wisdom in life and in the markets, I am just a lot more skeptical and more reasonable to believe that most of the FIRE kids will see it through.
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