Just stand there

Posted by TEBI on June 1, 2019

Just stand there

 

Market analysts and commentators in the United States have become increasingly anxious in recent weeks about trade wars, mainly with China.

The Dow Jones dropped below 25,000 on Friday, falling 1.4% on the day, amid concerns over President Trump’s  threat to impose escalating tariffs on Mexico. The selloff capped the Dow’s sixth straight losing week, the longest slump since June 2011. 

If all this is making you nervous, it’s time for some much-needed perspective. As our columnist RICK FERRI explains, the temptation in these situations is to take some sort of action. But for investors with an appropriate financial plan, the best advice its usually to do nothing.

 

The Feds may or may not raise interest rates in 2019. Trade wars with China may or may not escalate, and Mexico could be next. It’s business as usual in the markets, with the usual mixed messages tempting investors into trying to time interest rates, predicting global economies, and forecast the stock market’s next big move.

The recent correction in stocks is causing some investors to question valuations while, others see a buying opportunity. What’s an investor to do, buy or sell? The desire to do something is part of our DNA. We have a hunter-killer mindset on one side of our brain and a hide and survive instinct on the other. We don’t have a do-nothing instinct. 

But being passive is exactly what it takes to win in the markets. That’s because earning a market return passively beats both trying to outperform and trying to hide. Most people who try to beat the market don’t come close to it, and those try to avoid bear markets by selling usually regret it.

The best strategy is to be a passive investor and do nothing — well, almost nothing. You must choose an appropriate allocation in stocks, bonds and cash at the start, select a few low-cost index funds or exchange-traded funds (ETFs) that track the markets, implement your plan, and leave it alone. When the markets tempt you, remember what John Bogle, the founder and former CEO of the Vanguard Group, said: “Don’t do something, just stand there!”

I published my sixth book, The Power of Passive Investing a few years ago to encourage people to invest the Bogle way — buy a few stock and bond index funds based on your needs and let the markets make you wealthy. The book is packed with academic studies about why this works, and dozens of sad stories about those who didn’t heed this advice and let profits slip away. John Bogle graciously wrote the book’s foreword.

With new crises du jour in front of us and talking heads telling us it’s time to reconsider the funds we are invested so that our portfolios are better positioned for what’s coming, the lessons in The Power of Passive Investing remain timeless. Picking winning funds isn’t easy, and if some expert tries to convince you otherwise, they probably have skin in the game. Avoid the trap — just stand there.

Here is an excerpt from the book: 

Investors should select the best way to manage their portfolio to have the highest probability for success.

Finding an actively managed mutual fund that delivers alpha is a challenge for any investor. Trying to select a portfolio of active funds that outperforms a portfolio of index funds is another matter entirely. The odds of a portfolio using actively managed funds outperforming an all index fund portfolio is much lower than a single fund, and the odds drop with each additional active fund added to a portfolio, and the longer the funds are held.

Active fund investors have strong headwinds against them. The probability of selecting a winning fund is low; the average payout for those winning funds does not compensate them enough for the shortfall from being wrong; the addition of several active funds in a portfolio reduces the probability of success; and the longer that portfolio is held, the odds drop even more. That’s a lot of headwind!

Investors who are seeking alpha are looking for skilled managers, and this assumes skill is identifiable. Is it? About one-third of [surviving] managers beat the market over a five-year period, but are all these managers skilful? Are any skilful? Perhaps the winning managers just got lucky.

Often a manager has one or two big winning years and then their performance fizzles out. Where there’s no consistency, there’s no talent. It should be no surprise that most winning active managers don’t have consistency, which means they don’t have skill. They just got lucky.

If it’s possible, as some claim, to select skilled fund managers in advance, then what’s the methodology for doing so? It certainly would have been revealed in academic studies by now. Do such studies exist? If so, what’s the secret?

By far, the two most popular factors used in fund selection by the public are past performance and fund ratings. Other factors are fee analysis, the amount of assets in a fund, and qualitative factors such as where the manager went to college. Unfortunately, I was unsuccessful in identifying any comprehensive study on mutual fund selection that provided evidence that a successful fund selection method exists.

There were a few studies that suggested ways of narrowing down the field by eliminating funds that had certain characteristics such as the highest fees, or only including funds that had certain qualitative features such as a large personal stake in the fund by the manager, but no single factor worked consistently.

Recall that the very reason academics began studying mutual funds in the 1960s was to discover managers who had skill. Their efforts were unsuccessful back then and new efforts remain unsuccessful today. If the Ph.D.s can’t figure out how to pick winning managers, then it’s not likely that an individual investor or investment advisor is going to do it.

As one Amazon reviewer put it, The Power of Passive Investing “sticks a fork in active investing starting in Chapter 1 and by the end of the book it’s a virtual blood bath… While I had heard many of the arguments before, I’ve never read such a concise summary of the debate. And at the end it really crystallised my understanding of the market and how active funds underperform the market relative to their costs.”

If you’ve not yet read the book, it may be a good time to do so.

 

RICK FERRI runs Ferri Investment Solutions, a pay-by-the-hour financial advice service, and is based near Austin, Texas. You can follow him on Twitter @Rick_Ferri.

On the subject of investor discipline, you might also find Rick’s previous post helpful:

Six steps to staying the course

 

 

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