When Dumb Money Becomes Smart Money

“For those who invest and then drop out of the game and never pay a single unnecessary cost, the odds in favor of success [in the stock market] are awesome,” proclaims John Bogle, founder of Vanguard Funds and the author of The Little Book of Common Sense Investing.

As a guy who’s made just about every stock market mistake in the book, what I’m going to share with you here addresses every one of those mistakes… finally. I was undermined several times by my emotions to sell-off when the market tanked, then get back in again trying to time the market-a losing proposition. As Warren Buffett puts it, “For investors as a whole, returns decrease as motion increases.”

I’ve read a plethora of investment books including authors who claim to know Warren Buffett’s strategy, attended investment classes, purchased “money making” software, did point-and -figure charting, pursued the up-trending sectors with that charting, used bullish-percentage charting, studied moving average charting in conjunction with both Relative Strength Index (RSI) and Moving Average Convergence-Divergence (MACD) charting, subscribed to an investment letter, attended product seminars, listened religiously to investment broadcasts, etc., all proved nothing more than financial snake-oil. As Peter Lynch wrote, “Thousands of experts study overbought indicators, oversold indicators, head-and-shoulder patterns, put-call-ratios, the Fed’s policy on money supply, foreign investment, the movement of the constellations through the heavens, and the moss on oak-trees, and they can’t predict the markets with any useful consistency, any more than the gizzard squeezers could tell the Roman emporers when the Hun’s would attack.”

Like the vast majority of investors, I’m just a layman, a light-weight, and was managing dumb money, a light-year removed from the Buffett and Cramer guru types. And we laymen are dealing with an animal that by its nature, is schizophrenic, affected by every tidbit of emotional news on a daily basis… it goes up it goes down, it goes down it goes up, in many cases for no good reason, even contrary to reason, making it an emotional roller-coaster-ride for most of us, and maddening to deal with.

Green is Good 
Until I read Green. That’s Alexander Green, in his book The Gone Fishin’ Portfolio. Every once in a while someone comes along and clears the air, offering insight that elicits the aha moment. Alexander Green is one of those people. I picked up his book to brief through it expecting another typical rehash of investment babble-talk. Well, surprise, enlightenment! Writing with great clarity, his approach is conceptual, not merely suggestions, but exactly what to do. Yes, he is a guru who picks stocks and most of the time beats the S&P, but denounces that approach unless you’re prepared to do as he does-eat, drink and sleep stock picking as a pro; instead he shows the layman how to invest smart with shear simplicity, bringing the emotionalism always attendant with the stock market to near zero.

Green writes, “Fortunately, the Gone Fishin’ Portfolio take’s life’s unavoidable risks and uncertainties and turns them into your ally. It allows you to reach financial independence, not because of how much you know, but, ironically, by conceding how much you don’t know.” So let’s get right to it. The three main constructs are these:

-Index Mutual Funds 
-Rebalancing at Year End 
-Extremely Broad Diversification

Index funds are used because of the low expenses they offer. Typically index funds’ expenses are 75% lower than managed funds; this is not to be confused with loaded funds which is an up-front fee just for the honor of buying the fund-index funds are no-load funds. Total expenses are far more important than most people realize. The following graphic I think, says it all:

Graph of costs over 50 years impacing returns

The above data comes from John Bogle’s book mentioned earlier, The Little Book of Common Sense Investing, and is an excellent compliment to Alexander Green’s book. You can see the phenomenal impact costs have on returns. Beside the low expense costs, index funds don’t have the expenses of the buy and sell trading within the fund because they don’t trade; and therefore you’ll avoid paying the income tax charged each year on the declared capital gains of stocks sold-off from managed funds. Since you won’t be trading stocks yourself you’ll avoid trading commissions, and by being self-directed, you’ll also escape managed portfolio fees. As the graph shows, costs to Wall Street eat up the lions share of your investments, where the first year eats 2%, the 10th year 21%, the 30th year 50%, and by the 50th, 70%. Bogle writes, ” The investor who put up 100% of the capital and assumed 100% of the risk, earned 32% of the market return.”

Point 2, and my favorite, there is rebalancing at the end of the year. Green outlines ten broadly diversified index funds for you with a certain percentage allotted for each fund. At the end of the year you would rebalance those percentages to their original percentage amounts. Those that did well, a portion would be sold off, and those that didn’t you’d buy more shares. What is the great value in this? It forces you to do what eludes the great majority of investors-Buy Low and Sell High! Very neat.

Point 3, a broadly diversified uncorrelated fund portfolio reducing risk dramatically, diversifying with large cap, small cap, international, emerging, some gold, REIT’s, and bonds; all with index funds. That’s basically the concept. Again, a quote from the Oracle of Omaha, Warren Buffett, “That’s when dumb money becomes smart money;” Peter Lynch, Jim Cramer and William Bernstein agree.

Indexes Beat Active Funds 
The S&P Indices Versus Active funds scorecard (SPIVA) studies show indexes beating actively-traded funds in almost every asset class, style and fund category. Over the last five years more than 65% of the large-cap active managers trailing behind the S&P 500, more than 81% of mid-cap funds were outperformed by the S&P MidCap 400, and over 77% of the small-cap funds were outperformed by the S&P SmallCap 600. This is just as true for bond funds. Then it follows, portfolios of actively managed mutual funds underperform portfolios of all index funds, not only because active funds underperform individually, but because a portfolio of them underperforms even more as there is a compounding of negatives in play. I think two of the reasons managed funds don’t perform as well is because of the internal trading costs they incur from buying and selling, and the fact many hold large amounts of cash and are not fully invested in the market as index funds always are.

Reversion to Mean 
The other very significant point I learned about the market from John Bogle other than the insidious monumental costs that can ravage your investment, is becoming aware of and taking comfort in what has consistently occurred in the stock market for two-hundred years-Reversion to Mean.

S&P chart Last 25 Years

As an example, this chart depicts the S&P 500 growth for the last 25 years. To it I added a mean-line (in red), a straight trend-line representing where something started and where it is now. The straggly line is the actual gyrations of the S&P Index for that time period, and what you will notice is that however the gyrations behave, cartoon: investors riding wall street roller coasterthere is always a Reversion to the Mean-the gyrations always return to the mean-line… the arrows show five of them. You might look at the mean-line as reflecting the actual growth of businesses, and the market gyrations as a mad-dance around it due to societal emotionalism, always returning to mean after the emotional highs and lows of investors and speculators subside and return to Earth. So, what does that time-honored unchanging fact mean to you utilizing this strategy? When you rebalance each fund each year, you take advantage of the market every time it goes above or below that mean-line. You sell off some profits of those funds at year end that have increased in value to reestablish their original percentages, and buy more shares of the funds that decreased in value reestablishing their original percentages. When the market inevitably returns back to the mean-line you have capitalized on it in both instances, working both ends to your favor-worth mentioning again, buying low and selling high. You are actually counting on uncertainty-making it your ally-rather than going through the typical hand-wringing experience that accompanies the unknown.

In Conclusion 
This of course is a long term investment strategy, a Pulitzer Prize winning one at that, won by Harry Markowitz in 1990 when his paper proved how a portfolio constructed of uncorrelated assets allow you to master uncertainty and generate excellent investment results, and not the proverbial get rich quick nonsense. It greatly frees up your time dealing with it only once a year, thus the title Gone Fishin’, but perhaps more importantly it releases you emotionally from the constant churning of the market and relentless angst over what the market is going to do next.

Out of the last nine years up to and including 2011, this portfolio and concept beat the S&P 500 eight times with less risk. This year, 2012, it didn’t, yet I still received a 12.4% return. When the S&P 500 does falter, as it will, I will buy more of its shares since it’s one of funds of the portfolio, and have an excellent chance of beating it because of the broad diversification I hold. Is this a guarantee? Absolutely not. What it is, is a mechanism that puts the odds dramatically in your favor for success-in life, you can’t ask for much more than that.

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