The "Best of Both Worlds"? - There's No Such Thing!

Every once in awhile I come across a personal finance article that offers up shockingly bad advice which, if followed, would do much greater harm to an investor’s situation than it would to help them. A recent Forbes article does just that in claiming that there is a way to have “the best of both worlds” between actively and passively managed investment strategies.

As a passionate indexing advocate, my interest was piqued. The strategy is presented as follows: rather than invest in international stock funds, simply buy 10-30 foreign stocks according to the weightings of your favorite international mutual fund. The writer sums up the strategy’s “benefits” - “by avoiding the high fees of an actively managed fund, investors who buy a diversified portfolio of individual stocks are getting much of the same low cost advantage as index fund investors.” In reading that, I was speechless. Why recommend a much more difficult and costly strategy when it’s already been stated that your goal is to replicate the low-cost strategy of the index fund? Why not just buy an index fund?

Not only is this bad advice for obvious reasons – assets are being spread too thin and high transaction costs eat away at returns (the strategy is by no means low cost), it goes completely against the tenet that investors should keep investing simple. How is this strategy “the best of both worlds” when it so obviously involves actively managing your portfolio? After all, the investor is picking both the fund to replicate and the stocks to own when managing their money.

The writer even notes “owners of individual stocks also get the added advantage of being able to reduce their taxes by controlling when and how they sell individual shares. They can sell shares that have dropped in value, buy them back after 30 days, and then use the losses to offset other taxes.” Most of the individual investors I know have neither the time nor the patience to pull off such a bad strategy. Besides, indexing is inherently tax efficient which would negate any positive effect the above tax loss selling strategy would have over the low costs of indexing. Here’s a better idea then the one offered up in the article: buy an index fund and forget about everything else!

Ultimately, the article offers up no rational argument against indexing – the simplest and most efficient way to long-term wealth. Indeed, the article opens up explaining how indexers think:

Since you have no way of knowing which lucky manager will outperform, you're better off just buying the whole market and minimizing your fees with passive index funds. The evidence seems to largely bear this out as studies show that up to 80% of actively managed mutual funds underperform the market and that those that did outperform didn't tend to continue doing so over subsequent periods of time.  

The facts are all laid out for the reader. I’m at a loss for why people still try to justify owning actively managed funds – or an investor’s replication of an actively managed fund - provided there’s a passively managed fund that is considered an equal or greater representation of a specific area of the market as compared to the actively managed fund.

A World Without Soothsayers

Dictionary.com defines a soothsayer as "a person who professes to foretell events." Another name for this type of person is a prognosticator or clairvoyant, and I can't help but think that Wall Street is becoming populated more and more with these types of people and less and less with people who actually know something. In short, Wall Street is trying to sell you something that they shouldn't: their predictive power.

The problem with Wall Street analysts and strategists making predictions and claims is that they're never held accountable. They are free to predict Dow 36,000, economic malaise, food lines and the like without any system of checks and balances. After all, why should they have one? The people making these predictions get paid to make them and for the most part, get to keep their jobs even if they're wrong. Just like your local weatherman may think but never openly admit, "we have met the enemy and he is us".

All of this leads me to the question - what would a world without market soothsayers be like? If Wall Street's hype and prediction machine collectively ceased to exist, would things run more efficiently? For one, dissemination of facts and true information could be acted upon without the potential for personal judgment to be clouded by the opinions of others. It may sound like a perfect world, one in which Wall Street and the media have no ability to impact your investments. Indeed, it is a perfect world for all investors - it is the world in which we simply ignore what Wall Street's prognosticators are saying and enjoy our lives.

The More Things Change...

An old adage goes, "the more things change, the more they stay the same" and nowhere is this more applicable than on Wall Street. Many readers, especially those who came of age during the Internet era and subsequent dot com bubble, will remember vividly the days of dot com IPOs skyrocketing 1,000% or more in their public debut and frenzied day traders trying to get their hands on said shares. It's been over 10 years since we emerged from the dot com bubble and it appears as if a fresh bubble may be brewing...in Internet names. On May 18, LinkedIn, the business networking site, debuted and skyrocketed more than 80% during the trading day. Fresh on the heels of LinkedIn's debut, other Internet names like Groupon, Twitter, Facebook and Zynga are filing or expected to file for IPOs in the coming months. Some estimates peg Facebook's value upwards of $65 billion, larger than many major American companies. 


Is the Internet bubble back? Time will tell. The only constant is that the more things change on Wall Street, the more they stay the same.

Saving is Easy

It never ceases to amaze me how difficult some people find it to save money when such an activity should be a fact of life. I believe many people assume that the only people who are able to achieve financial independence, and ultimately, a comfortable retirement, are those that are already wealthy or who have extremely high paying jobs. Nothing could be further from the truth!

Saving and investing money is inherently easy on any income and here's why: If you really want to save your money, you will. This boils down to psychology because some people simply do not want to save, even though they should to ensure a comfortable future.

How can this be accomplished? Try cutting out unnecessary discretionary purchases and using that money instead to fund a retirement account that owns a basket of index funds. At this point, many readers might question this strategy since we most often derive much of our satisfaction from these purchases, but it doesn't have to be difficult. Instead, rotate every week, month, or whatever time interval you've chosen to changing which discretionary purchase you swap out for savings funds. If you go out to eat 5 times in an average month, try going out 2 or 3 times instead. For a family of four, you'll likely save well over $100 a month using this strategy. If your family likes to go out to eat, why not go out to eat 5 times again the next month but drink coffee at home each day instead of going to Starbucks? Scaling back these are the activities are one key way in which you will save a lot of money in the long run.

Of course, all of this goes without saying that you should follow the adage of "paying yourself first" and simply save a set percentage of your paycheck, say 10-20%, if possible and devote that to an investment account. You will be amazed at how much you can earn in 30+ years just by investing $100 a paycheck. This is the magic of compounding at work but it's only possible through disciplined saving. Saving money is inherently easy, it's just that many people don't find it fun because the rewards we realize from it do not satisfy us instantaneously.

Opening the Door to New Investors

I was excited to hear news out of Vanguard yesterday that they've lowered their minimum initial investments for their Target Retirement funds to $1,000 from $3,000. This is encouraging news as many young investors find it difficult to invest large amounts of cash at one time. This reduction in initial investment will open up some of Vanguard's most interesting offerings to new investors. 

At their core, target retirement funds set a specified retirement year - 2040 for example - and invest the fund's assets for an investor planning to retire in or around that year. Right now, the 2040 fund has 89.96% of assets invested in stocks, 9.98% in bonds and 0.06% in short-term reserves.

Ultimately, as 2040 approaches, the fund's managers will decrease the amount of equities in the portfolio in order to lower the fund's risk profile. Even better, the Target Retirement funds are funds of funds which own index funds and not individual stocks. This news is a welcome development for investors for another reason: as Vanguard attracts more assets, they benefit from economies of scale and will continue to lower fund expense ratios which benefits all investors.

The Anniversary of the Retail Index Fund

In 1976, Vanguard pioneered the index fund by offering it to retail investors for the first time. The company has not looked back and is now the leading manager of index funds and consistently one of the top 3 investment managers in the world by assets with $1.6 trillion under management as of February 2011. I'd like to take time in this post to reflect on what the availabilty of the index fund has meant to individual investors by posting an interview with two of Vanguard's experts - Sandip Bhagat, head of Vanguard Quantitative Equity Group, and Kenneth Volpert who oversees Vanguard's bond funds.

The whole interview is well worth reading but the best part about the interview is that both experts point out that the rise of new "fundamental" or "intelligent" indexes is not truly passively managed investing. In short, this is just another way for Wall Street to sell us an actively managed product that is likely to fail in its attempt to outperform the true passively managed index fund. As Mr. Bhagat notes, "The point is that any portfolio configuration that goes beyond the size of a company's market-determined value does not represent a passive approach to investing. It brings with it a belief that the market's prices are incorrect, and that some other factors merit more attention. "

This is key because many retail investors assume that a fundamental index offers a better way to capture the "true" value of a basket of stocks. Therein lies the problem - the true value of a company is really what the stock market dictates it is based on its current trading price. Yes, the future value of a company may be drastically different, but we cannot predict or know the future with certainty. The information that is used to create fundamental indexes is often based on earnings reports or other information that happened in the recent past. By attempting to place a fundamental value on stocks, the fundamental "index" winds up becoming nothing more than an actively managed impostor as stocks are changed based on earnings and other data.

Wouldn't it make more sense to simply take the reflection of the collective knowledge of every investor in the world - the price of a stock in the here and now - and build a true index around that? That's precisely what Vanguard did in 1976 and why they have been so successful. Need more proof? Since its inception in 1976, the Vanguard 500 Index (VFINX) has returned 10.79% on average, annually. What has your actively managed fund done for you lately?

A Video Intro to Indexing

Things have been pretty hectic around here so I'm going to offer up a quick video for anyone that wants to see how and why passively managed (indexed) investment strategies outperform actively managed strategies over the long-term. This is a video inspired by the Bogleheads - investors who follow Vanguard founder Jack Bogle's investment philosophy - and is right on the money. While it may seem goofy at first, there are plenty of truisms within that are often overlooked by investors.