Category Archives: Investing

How a good column on the bad lottery fell apart

Writing from Miami, Florida

A recent column in The Wichita Eagle by Randy Scholfield starts out fine, but falls apart near the end. (“Is the lottery the best bet for workers?” February 24, 2006, available at http://www.kansas.com/mld/kansas/news/columnists/randy_scholfield/13945602.htm.)

Mr. Scholfield tells us how the lottery is not a very good bet. He references a survey that tells us how about half of us believe we have a better chance of obtaining a retirement nest egg through winning the lottery rather than by saving and investing.

He then tells us that the large majority of those playing the lottery are poor and don’t have college degrees.

What Mr. Scholfield writes is true. I’d like to illustrate in more detail just how true it is.

Here is how the math works: If you invest $1.00 each week of the year, and you earn 10% on those contributions, at the end of 30 years you will have $9,409. After 40 years you would have $25,316.

These amounts may not seem like much, but you get that for saving just $1.00 per week. If you saved $10.00 each week (I suspect many people spend that much or more on the lottery each week) you would have about $253,000 after 40 years. That’s a significant sum of money.

Plus, if you hold these savings in a Roth IRA, this money will be tax-free when you withdraw it. Lottery winnings are taxed.

Can you earn 10% on your savings? You almost certainly can if you invest these funds in a mutual fund that invests in a broad range of U.S. stocks. That is, invest in an index fund that is based on the S&P 500 index or a broader stock market index. (See Book Review: The Random Walk Guide to Investing.)

The 10% figure is approximately the return of the U.S. stock market over the last 100 or so years. Some years the market goes up more than that, and some years it goes down a lot. But over a long period of time, we can expect returns of about 10%. (If investing in something that has risk concerns you, consider the risk of gambling on the lottery.)

The index fund you select must have low costs. An index fund with high costs will return much less. An index fund that has expenses of 1.5% per year, which some do, would return only $16,682 instead of $25,316 for each dollar invested each week. That’s due to the power of compounding over long periods. You must also select a fund with no sales charges, called a “no-load” fund. If you selected a “load” fund, where part of what you save goes to sales commissions rather than shares of the fund, you might have less than $16,000 rather than the $25,316 you could have by selecting a no-load fund.

(To simply these calculations, I have assumed that you make the contribution for the whole year at the start of the year, rather than a little each week. This doesn’t have much impact on the final figures.)

Now consider the lottery: The average jackpot of the Super Kansas Cash game over the last year was about $360,000. By investing $22 each week as illustrated above, you would have about that much after 40 years.

If you instead spent $22 each week on this game (each play costing $.50, probability of jackpot is 1 in 2,517,200) for 40 years, you would have about a 1 in 28 chance of ever winning the jackpot. Contrast this with the near certainty of the long-term returns of the stock market.

There are other lesser prizes that you would certainly win many of as you made all these bets, and I haven’t considered these prizes. But offsetting these small prizes is the realization that you’d pay income tax on the jackpot from the lottery. The earnings in a Roth IRA, on the other hand, are yours tax-free.

So far, so good for Mr. Scholfield. But then his column takes a downward spiral. We’ll see just how far down it goes in a future post.

John Bogle on Investing: The First 50 Years

John Bogle on Investing: The First 50 Years
John C. Bogle
McGraw-Hill, 2001

“The one great secret of investing is that there is no secret.”

“Investment success, it turns out, lies in simplicity as basic as the virtues of thrift, independence of thought, financial discipline, realistic expectations, and common sense.”

John C. Bogle, whom I greatly admire, founded Vanguard investment management company, a mutual fund company owned by its shareholders. He pioneered the no-load mutual fund and the index fund. These two ideas have made it possible for the average person to be in charge of their investments and do better than any of the Wall Street professionals that make up the financial establishment.

A no-load mutual fund is one that charges no sales fee or commission, either to buy or sell the funds.

An index fund is one that is managed to match the performance of a broad market index, such as the S&P 500 Index or the Wilshire 5000 Index for stocks. There are bond indexes, too. Investing in an index mutual fund is like buying everything (“the haystack”) instead of searching for needle.

Actively managed funds employ high-powered investment professionals who use many different techniques to select securities that they believe will perform better than other funds. It would seem that these funds should do much better than the passive index fund strategy. But the results don’t show this to be true. That’s what Mr. Bogle means when he says there is no secret.

For the period 1987 through 1997 (this is from a speech given in 1999), Morningstar selected what they term the equity fund “Manager of the Year.” For these managers, not even one of them beat the S&P 500 Index in the following year. Not even one was able to turn in an above average result.

From 1993 through 1998 the New York Times asked five investment managers to manage a hypothetical portfolio. The portfolios started with $50,000. At the end the average advisor portfolio grew to $103,500. Does that seem like a lot of growth? Most people would probably be happy with that. But the market average, as represented by the S&P 500 Index, grew to $156,100 over the same period.

Any comparison of index funds to actively managed funds will show that, over time, the index funds do better. For short periods, some actively managed funds will do better than the index funds. The problem is that we don’t know which funds will do better.

Why do index funds outperform actively managed funds over time? The answer, according to Mr. Bogle, is costs. Investors pay costs in the form of sales charges or loads when they buy (and sometimes when they sell) funds, actively managed funds often have some portion of their assets held as cash reserves, actively managed funds incur high transaction costs as they buy and sell securities, and actively managed funds usually charge higher management fees. Plus, actively managed funds can generate tax bills for their holders, too. These costs substantially reduce the return to investors in actively managed funds. The tyranny of compounding tells us that even small differences in returns can make huge differences in the amount of money one can have as they start retirement. An investment in the S&P Index would be worth about twice as much as an investment in the average equity fund over the period 1949 to 1998.

The innovations that Mr. Bogle has been responsible for are invaluable. The collections of speeches in this book are fascinating to read, and following the advice in them will lead to a lifetime of success in investing. It is not, however, the same advice you’ll get from a stockbroker or from most financial advisors.

The Random Walk Guide to Investing

The Random Walk Guide to Investing: Ten Rules for Financial Success
Burton G. Malkiel
W.W. Norton & Company, 2003

The title of this book derives from the author’s famous book A Random Walk Down Wall Street, published in 1973. That book, and this too, refer to the theory of efficient markets. In the author’s words: “The main premise of the theory is that the stock market is an extraordinarily efficient institution for reflecting without delay any information that arises. When news arises, an army of profit-seeking Wall Street professionals pounces on it rapidly, driving stock prices up or down. As a result, stock prices reflect whatever good or bad news there is about each individual company or about the economy as a whole.”

News is unpredictable. If not predictable and random, it wouldn’t be news, and today’s prices would reflect that information. So the price of a stock tomorrow is based on unpredictable — and therefore random — events. There is nothing contained in the past prices of a stock that has any value in predicting tomorrow’s price.

This is quite a powerful theory. It has many implications. For example, have you seen the stock analysts on television known as “technical analysts?” They look at charts of past prices, and spotting things like “support,” “resistance,” or “head and shoulders,” they predict what will happen in the future. But according to the efficient markets theory, there is not a single thing in those charts that is useful in predicting future prices.

It also means that in the long run, there is no hope of beating the market as a whole. That means that a huge chunk of the financial services industry is engaged in selling services that don’t work in the long run or even the short run, and, in fact, are harmful to the average person.

Consider “actively managed” mutual funds. These are funds where the managers, by using various strategies, attempt to earn large returns. These managers are among the smartest people on Wall Street. Yet each year about 80% fail to “beat the market,” which is to say they didn’t perform as well as broad market indexes such as the S&P 500 index. In fact, for the 10 years ending December 31, 2002, the S&P 500 index beat the average equity mutual fund by 2.09%, and for the 20 years before the same date, by 2.42%.

Of course, each year there are some funds that do very well, and some that are able to maintain high performance for a few years in a row. These are the funds that everyone talks about, and many people buy. But on page 129 there is a sobering table of figures. It shows the 20 best-performing funds (out of the 851 funds with more than $100 million in assets) from 1997 to 1999. These funds averaged annual returns of 44% to 66% during those years. Their managers were hailed as geniuses and treated as celebrities.

The next columns of the table report the funds’ rank for the period 2000-2002. The highest rated of these was at position 500 (out of 851 funds). Most were ranked worse than 750, and there are quite a few ranked worse than 830. Their returns averaged negative 32% per year. (In three years at -32% per year, $100 turns into $31.) Patterns like this were found in earlier time periods, too.

We might think that we would be smart enough to get out of these high-flying funds as they start to tumble. But the managers of most of these funds have wide latitude as to the strategies they can use, and they weren’t smart enough to switch to some other investment. How can the average person expect to know more than these managers?

Some people believe that they can do well by purchasing last year’s best funds. Professor Malkiel reports on a study where he took the funds with best recent performance, and these portfolios produced below-average returns. He also took Morningstar’s best-rated funds, and found that a portfolio of them produced much lower returns than an index fund. From 1990 to 2002, the Morningstar best rated funds grew in value by about 110% (judging from a graph), while the Wilshire 5,000 Index grew by about 300%. Over a lifetime of investing, that’s the difference in being relieved there’s Social Security and being independently wealthy.

One of the reasons why actively-managed funds fail to beat the market in the long run is that the actively-managed funds have large costs. Index funds are very inexpensive to operate. Costs like this are very important in investing. Small differences, even just 1% per year, make a lot of difference when subjected to compounding over a lifetime. That’s why Malkiel strongly recommends reducing the costs of investing. Still, many people purchase “load” funds where perhaps as much as 6% of your investment goes to sales charges, and funds that have large ongoing management fees to pay every year (including marketing fees). Now there are “wrap” accounts that many people are lured into using, where the investor pays an annual fee, usually 1% to 3%, for the services of a professional money manager. I recently had experience with someone who had a wrap account from a very large investment company, one whose advertisements on television are commonplace. The advisor charged 1.5% per year, and the investor’s portfolio consisted of a variety of mutual funds, all actively managed, and all of which had high sales charges and high annual fees. This investor had absolutely no hope of earning anything near what an index fund would return.

It’s no surprise that Malkiel is not well-liked by Wall Street and investment professionals, as the efficient market theory tells us there’s no way to beat the market in the long run. Yet a huge industry tries to sell us products we are led to believe will beat the market. As the advisor I mentioned a moment ago said to me in an effort to get my business after I told him I was a self-directed investor, “You pay a little more, and you earn a lot more.” He may even believe that. The sad fact is that most people have no idea how well their investments are performing. Calculating returns, especially when investment is made periodically, is difficult. Do you remember the Beardstown Ladies, an investment club that produced fabulous reported returns for several years running? It turned out that their calculations treated their contributions as though they were returns that their investments earned. Mistakes like that are easy to make. A few years ago a well-known website had a portfolio-tracking service that I used for a while to track the returns of my 401(k) plan. I thought I was doing really well, until I realized that it treated my twice-monthly contributions as through they were investment returns. I inquired about this, but the service admitted no error. Since then, they have discontinued this “service.”

The first chapter of this book, titled “Fire Your Investment Advisor,” is quite blunt about its topic. If people are willing to study a little, perhaps by reading a short book like this, and then to trust themselves, I agree. Otherwise, you may want to use the services of an investment professional. In this case, people would do well to use a fee-based planner instead of one who is paid by sales commissions or annual fees.

The next two chapters explain the four investment categories (cash, bonds, stocks, and real estate), and the important relationship between risk and returns.

Then the rules start: Start saving and investing now, in order to take advantage of the powerful effect of compounding over time. (“The most powerful force in the universe,” Einstein reportedly said.) Save and invest regularly. Have proper insurance and cash reserves. Invest with an eye towards minimizing taxes. Allocate assets amongst the four categories according to your time horizon and your capacity and temperament towards risk. Diversify appropriately. Bow to the wisdom of the market (this is where the efficient market theory is important). Invest in index funds. Don’t be your own worst enemy: avoid stupid investor tricks.

This is a valuable book for anyone who is interested in their financial security. Please don’t think that because you may not have a lot of money to invest that it isn’t important for you to take investing seriously. The less money you have, the more important it is to start saving and investing now, and to invest wisely. This book will show you how.