The Successful Investor Today, by Swedroe

Introduction

Irrational exuberance seems to occur every 40 years, long enough for existing investors to forget and a new generation of investors to emerge. 1920’s: automobile/ tv/ radio revolution; 1960’s: Nifty Fifty; 1990’s: tech boom.
Bull markets enrich those already invested, by lowering expected future returns. Bear markets help those not already invested by increasing expected future returns.

Truth 1: Active Investing is a Loser’s Game

Information and trading costs are inversely related: low information, leads to low efficiency, but high trading costs (bid-ask spread, market impact, commissions). Cash drag costs estimated 0.70% average for active funds.
Active managers held the least cash before market corrections and most following. Goldman Sachs study showed that based on percentage of cash holdings, active managers miscalled all nine major market turning points.
Periods when active funds outperform passive can be attributable to size and style deviations from the benchmark. When compared to a broad based benchmark like the Wilshire 5000, over 5-, 10-, and 15-year periods, only about 15% of active funds outperform.
Study finds no evidence of stock indexing affecting price performance of a stock beyond an initial one week “pop” post entry into the S&P 500 index. Indexing does not drive prices.

Truth 2: The Past Performance of an Actively Managed Fund Is a Very Poor Predictor of Its Future Performance

From 1987-2000, just 10% of 145 major pension funds outperformed a simple 60/40 % mix of S&P 500 and Lehman Agg.
Brian Cunningham 1999 study found that after factoring in loads and taxes, the S&P 500 outperformed >95% of surviving large-cap funds, over 20-, 15-, 10-, 7-, 5-, and 3- year periods.
FRC study “Predicting Mutual Fund Performance”: manager tenure, turnover, past performance, star ratings, and asset size had little predictive ability. Only statistic to demonstrate reliable predictability was expenses.
In the 1980’s decade, not one of the largest 80 funds with R² > 95 managed to outperform Vanguard S&P 500 Index fund after taxes.
Fund success breeds future failure: increasing size leads to larger market impact costs, loss of sell discipline from larger trading costs, manager less willing to risk fees from underperformance, style drift to larger market cap.
Peter Lynch: average 6% outperformance came predominantly when the fund was small cap. When fund drifted to large cap, outperformance decreased (to 2%) as expected.
Bill Miller record can be expected by Nassim Taleb’s “Fooled by Randomness” theory. Also it is unimpressive when measured against value benchmarks.

Truth 3: If Skilled Professionals Don’t Succeed, It is Unlikely that Individual Investors Will

DFA (which are generally more tax-efficient) matched or outperformed its Russell counterpart funds in every major equity asset class—even before taxes. Russell has 60 fund analysts, covering some 1700 managers.

Truth 4: The Interests of Wall Street and the Financial Media are Not Aligned with Those of Investors

For brokers, the winning investment strategy (low-cost index funds) is a losing business strategy.
Honest sell-side analysts face conflicts of interests from investment banking clients, can be shut out of analyst conference calls, and may be fired for upsetting large firm clients.
In personal finance journalism: “it doesn’t matter if the advice turns out to be right, as long as it’s logical.” Notable honest journalists: Scott Burns, Jonathan Clements, Humberto Cruz, Beverly Goodman, Jason Zweig.

Truth 5: Risk and Reward are Related

The greater the perceived risk, the greater the ex-ante expected return. Expected returns are expected, not guaranteed.
Growth companies out-earn value companies, but value companies’ shareholders out-return growth company shareholders.
Value stocks have high volatility of earnings and dividends, and high leverage—thus they have higher expected returns because they are more risky. Zhang’s “The Value Premium” explains that value returns are asymmetrical: much more risky in bad times and slightly less risky in good times. Investors, on average highly risk averse, coupled with their own employment risk in bad times, create a persistent value premium.
Jensen and Mercer study combining monetary policy with Fama-French 3-Factor Model: big value premium in expansionary periods, little value premium in restrictive periods; small cap premium only in expansionary periods.
Growth stocks are like long duration bonds—their earnings are projections into the far future, and they are more sensitive to interest rate and risk premium changes; value stocks are like short duration bonds—they are priced based on liquidation value and current earnings, and less sensitive to rates.
Don’t confuse: growth stocks have low business risk (thus low expected returns) but have high price risk. Value stocks have high business risk, risk that is also correlated with economic-cycle risk, but low price risk (since the stock is already heavily discounted).

Truth 6: The Price You Pay Matters

The greater the perceived risk, the higher the expected return, which is reflected in lower valuations. The key word is ‘expected’—if the returns were guaranteed, there would be no risk.
Average historical market P/E is around 15. Its inverse the earnings yield (E/P), has been a reasonably good predictor of long-term returns. The S&P 500 returned 11.0% annualized from 1926–2000; it returned just 3.8% from 1926–1949.
Trevino and Robertson February 2002 study “P/E Ratios and Stock Market Returns” found: as P/E increased future returns decreased (significance increases with horizon, significant at horizons >5 years); even when stock P/E ratios were high, stocks still outperformed Treasury bonds; P/E tends to be high when current interest rates and risk premiums are low. P/E estimated regression model (20.7 – 0.6 * current P/E) is a more accurate (5-year horizon) predictor than historical stock averages.
Asness March 2002 study normalized P/E by using an inflation-adjusted 10-year moving average of earnings and also found high predictive value of P/E. Same conclusion reached in study of emerging markets, using both E/P and Book-to-Market ratios.
Rough formula for estimating long-term stock returns: GNP Growth (~3%) + Current Dividend Yield (~2%) + Inflation Rate (yield on TIPS ~2%) = ~7%.
Risk premium was restored in bear market of 1973–4, when the S&P 500 fell 15% and 26%.

Truth 7: The Most Likely Way to Achieve Above Average Returns Is to Stop Trying to Beat the Market

Game theory (and free-throw shooting example) shows only the best will play the active game. Competition increases as time goes on, because only the best of the best stay in the active game since less-skilled losers will switch to the passive game.
Earning market returns beats the average investor, after taxes and fees.
Active investing requires two conditions: inefficiency and low transaction costs. Neither is likely to be decreasing.

Truth 8: Buying Individual Stocks and Sector Funds is Speculating, not Investing

Good risk is compensated for, bad risk is not. Single company stock is bad risk since it can be diversified away and is not compensated for.

Truth 9: Reversion to the Mean of Earnings Growth Rates is One of the Most Powerful Forces in the Universe

Harris’ study “The Accuracy, Bias, and Efficiency of Analysts’ Long Run Earnings Growth Forecasts” found: high profit forecasts (growth stocks) had higher errors than low profit forecasts (value stocks); the best forecast was to assume one in line with GNP growth. May be explained by conflicts of interests between (sell-side) analysts and companies they cover.
Fama and French study “Forecasting Profitability and Earnings” found: reversion to the mean is when profits are highest or lowest (economic argument); very low earnings revert faster than very high earnings; analyst forecasts tend to underestimate the speed of reversion to the mean. Helps explain value outperforming growth phenomenon.

Truth 10: The Forecasts of Market Strategists and Analysts Have No Value, Except as Entertainment

Many studies have concluded that economists, market strategists, stock newsletters cannot forecast accurately. Study from 1979–1995 found that almost all economists missed turning points, forecasting skill is about as good as guessing, and neither sophistication nor consensus provided any accuracy improvement.
Barber and Lehavy 1998 study: “Can Investors Profit from the Prophets”: 9% annual excess returns from using consensus analyst forecasts (mostly effective in smaller caps), however trading costs eat up the returns. Estimated trading costs for a round-trip trade: large (70%), medium (20%), and small (10%) are 0.73%, 1.94%, and 4.91%, respectively.
Funds’ top holdings, best analyst picks, focus funds, do not outperform more than what would be dictated by randomness.
Hulbert 1997 study found that no newsletter portfolio outperformed the S&P 500 over previous 10-year period. A study covering 1980-1992, involving 237 market-timing newsletters, found that only 5% of the newsletters survived the period, and their average performance was less than the S&P 500 even before transaction costs and taxes.
“There are only 3 types of market forecasters: those who don’t know, those who don’t know they don’t know, and those who know they don’t know but get paid a lot of money to pretend that they do.”

Truth 11: Taxes are Often the Largest Expense Investors Incur

In order to materially reduce the negative impact of taxes, turnover needs to be super-low, below 20%.
After taxes, the wide underperformance of active large funds is asymmetrical to the narrow outperformance of the 8% of active large funds that beat the Vanguard S&P 500 Index fund benchmark (1982-91).
Managing portfolios as if they were tax-exempt is irresponsible, though doing so is the industry standard.
The average large-cap fund is 85% tax-efficient; the average large-cap index is 95% tax-efficient.

Truth 12: Knowledge of Financial History is Critical to Successful Investing

“Those who cannot remember their financial history are condemned to repeat it.”

Truth 13: Adding International Assets to a Portfolio Reduces Risk

Home asset bias: familiarity breeds overconfidence and an illusion of safety. Domestic ownership shares: U.S. 90%, Japan 96%, U.K. 92%, Germany 79%, France 89%.
Behavioral finance distinguishes between risk, where probabilities are known, and uncertainty, where probabilities are unknown. Investing domestically is indication of uncertainty aversion.
Research on international allocation (1970-96, 0.48 correlation): 40% EAFE allocation produced highest Sharpe; a 20% EAFE allocation reduced negative returns by one-third and 90% confident that raising the allocation can reduce risk.
U.S. safer place to invest? If so, then it should have lower risk premium and lower expected returns. International markets, with higher perceived risk—and thus larger risk premiums, would be expected to follow U.S. example of enacting strong regulatory standards going forward.
Currency risk has no expected return but has diversification value. Not owning international currency risk exposes one to domestic currency risk—the risk of a falling standard of living.
International diversification best achieved through international small-cap and emerging markets; international large-caps have slightly higher correlation to U.S markets. U.S. multinationals behave like U.S. stocks.

Truth 14: There Is No One Right Portfolio

For reducing portfolio volatility, short-term fixed income (<3 years) is ideal since it provides low volatility and low correlation with equities.
Investors susceptible to “tracking-error regret” should build a portfolio more resembling the broad market (large-caps).
Value and small-cap stocks offer higher returns but are sensitive to economic cycle. Value stocks tend to be highly leveraged, thus benefiting from inflation.
Tilt allocations away from factors that are correlated with the investor’s individual intellectual (human) capital—highly cyclical job should lead to lower value and small-cap factor exposure.
Mid-caps are not necessary since it offers risk/ reward attainable with combo of large- and small-caps. Mid-caps tend to be tax-inefficient because of higher turnover in index.
Asset location in order of increasing tax-efficiency: taxable fixed income, small value, large value, emerging markets, real estate, small cap, large cap, international.

Finished: Nov-2007

The Successful Investor Today: 14 Simple Truths You Must Know When You Invest, by Larry E. Swedroe