Magic Beans

For supposedly rational creatures we humans seem irrationally drawn to Magic Beans.  Being a geezer I’ve been around long enough to see quite a few flavors come and go.  What they all have in common is that by the time you start reading about them everywhere, the end is near.

Let’s see…

I remember Growth Stocks were all the rage awhile back.

Why, any management worth its salt should be able to plow profits back into the business and reach even greater heights.  Value Stocks that paid dividends?  Clearly run by managements with no vision, so lacking in ability that they could think of nothing better to do with profits than to pay them out.  You want growth!  Find companies with “forward thinking” (what a wonderful phrase!) leaders skilled in deploying capital.

Growth Stocks.  You couldn’t go to a party without some guy telling you about his latest killing.  Left everything in the dust.  Until they didn’t.

I remember Actively Managed Funds.

The investment world is littered with the remains of once super-star fund managers.*

I remember Houses.

Opps.  Strike a nerve?  Yep, stocks and bonds went up and down but houses?  Houses could only go up.  See people will always need a place to live, right?  Seemed to make sense at the time.  Why banks, and how could they ever be wrong, would even loan you money on all your equity.  You could cash out profits and still live in the place.  What could possibly go awry?

I’m sure glad I learned how to lose money in real estate back in the 80s and before it was fashionable.   Saved me a bundle in avoiding this latest debacle.

I remember Gold.

How could I not?  Every time I turned on the TV, opened the paper or listened to the radio people were spending huge sums of advertising money to tell me I, too, could get rich buying (preferably from them) Gold.  It is, after all, the one true store of value through human history.   There was even one place that offered to sell it to you and then, for a fee, store it for you as well.  You never even had to see the stuff.  Mmm, think about that for a moment.  Yikes.

A few weeks back it was pushing $2000 an ounce on its way to $5000.  Or $10,000.  Or, well, $1566 as of year end and falling.

I remember (reading about) Tulip Bulbs.

You can too:  http://en.wikipedia.org/wiki/Tulip_mania

Now?  Now it seems everywhere I turn the new flavor of Bean is Dividend Investing or, even more impressively, The Dividend Aristocrats.  Here’s an example:

http://www.mrmoneymustache.com/2012/01/02/guest-posting-the-dividend-aristocrats/

Go ahead.  Head on over there and have a read.  It is clear and well written.  Take some time to poke around Mr. MM’s site as well.  Its a good one.

Welcome back.  Now here’s my 2 cents:

http://jlcollinsnh.wordpress.com/2011/12/27/dividend-growth-investing/

As I mentioned at the end of that post, I actually made some money last year riding the Div-Stock wave.  Mmmm, with all this new popularity I should be taking my chips off the table soon.  No better sign than the end is near for them.

So no Magic Beans in The Dividend Aristocrats, but they likely won’t be as poisonous as some of the other Beans.  You’ll just lag behind the market over the next decade.  In fact here’s a bet that will likely make you more money:  Within 5 years you’ll be reading about how Growth Stocks are the sure path to prosperity and Value (dividend) stocks are for losers who can’t do the simple home work of analyzing the good stocks.  This will be wrong, too.

What is poisonous in The Dividend Aristorcats post is this:

“For a great primer on valuing stocks, check out the Intelligent Investor, by Warren Buffett’s mentor, Benjamin Graham. Read it, and then get to work combing the Aristocrats for bargains.”

It is a great book and by all means take the time to read it.  But remember, when Graham wrote it, Index Funds would not be invented for several more decades and mutual funds were few and far between.  Analyzing and choosing individual stocks was the only option.

But now, thank you Jack Bogle, we have index funds.  With these we can own the entire market and outperform over time all but the rarest of professional money managers.

This idea that if you read a few books and study what Warren Buffet has done you, too, will outperform the market is, to steal a phrase from Sean’s dad, Horse Hockey.  Dangerous horse hockey at that.

People have been trying for decades and yet, there is still only one Warren.  Think about it this way:

Remember Muhammad Ali?

The Warren Buffet of Boxing in his day.  You and I could have followed his training regiment, maybe even engaged Angelo Dundee to show us the ropes.  We could have gotten in top shape, done all our homework.  Learned the “sweet science.”  And, after all that effort, would you climb in the ring with Joe Frazier or George Foreman or Sonny Liston?

Not me.  I’m no Ali.  Or Warren.  Neither are you. (Unless of course you are, in which case:  Welcome back.)

You know what Warren Buffet recommends for individual investors?  Broad based Index Funds.  Graham, were he still alive, would too.

A little humility goes a long way in saving your ass and your stash.

*Addendum: At various points on this blog I suggest only about 20% of active managers out-perform the index. That’s being a bit generous.

This is a ball park figure based on the many articles on this I’ve come across on this over the years. In fact you can Google this question and find several falling around this percentage. I’m not sure why they vary. Some look at different time frames. Some at different metrics. Some factor in costs, some don’t.

Clearly it is easier to get lucky and outperform the shorter the time you need to do it. Even I called the market almost exactly last year, and I can assure you it was no more than luck: :) http://jlcollinsnh.com/2014/01/01/1st-annual-louis-rukeyser-memorial-market-prediction-contest-2013-results-and-your-chance-to-enter-for-2014/

Vanguard has done research on this looking at a 15-year time frame:
https://personal.vanguard.com/us/insights/article/infographic-outperformance-112013
In it they point out that 45% of actively managed funds fail to even survive over that time, let alone outperform. Only 18% both survived and outperformed. And even those frequently had long periods of underperformance.

So even if you are lucky enough to pick one of the out-performers, it will be tough to live with.

This article references studies done for an even longer period: 1976-2006, 30 years: http://www.marketwatch.com/story/almost-no-one-can-beat-the-market-2013-10-25

The results are even more shocking. As the article says:
“Barras, Scaillet and Wermers tracked 2,076 actively managed U.S. domestic equity mutual funds between 1976 and 2006.

“And — are you sitting down? Only 0.6% — you read that right, 0.6% — showed any true skill at beating the market consistently, ‘statistically indistinguishable from zero,’ the three researchers concluded.”

On reflection, calling the out-performers at 20% I am too generously off the mark. :)

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11 Comments

  1. Posted January 2, 2012 at 7:02 pm | Permalink

    Nice post, thoroughly enjoyed it. and your right we can train and be like them all we want, but we won’t be able to because we all have our own traits and we have to use ours to our own advantage just as they used theirs.

  2. Posted January 2, 2012 at 7:59 pm | Permalink

    Hello, sir. Enjoyed your response. And you are right to caution against thinking you can beat the market after only reading a few books (or blog posts ;) ). I certainly did not mean to imply that in any way. (In my defense, I did say there are no shortcuts and you must do your homework.)

    You’re right – there are no magic beans in investing. The thing is, I regard blind index investing as the biggest set of magic beans of them all. The growing popularity of the notion that it’s “impossible” for individual investors to beat the market is puzzling to me, when it is provably false. Here’s one study to look at: “http://www.people.hbs.edu/jcoval/Papers/persist.pdf”

    In fact, it’s vastly easier for individual investors to beat the market than professional fund managers, because the professionals are subject to significant regulatory constraints and liquidity requirements, and because they typically have so much money they must put into play that they effectively cannot concentrate on a smaller number of stocks without moving the markets with their purchases. Individual investors have none of these handicaps.

    It’s not impossible to beat the market, but it isn’t easy, either. Index investing is probably the right choice for most investors, because few are willing to do what it takes to succeed. But you CAN succeed if you ARE willing to do what it takes.

    • Posted January 2, 2012 at 9:02 pm | Permalink

      Hi Sean…

      Welcome and thanks for your response. Glad to have you over here.

      Hope my post didn’t come across as too harsh. I enjoyed your post. I suspect we have more to agree about than otherwise.

      My comment regarding reading a few books was less directed at you personally than the overall group of writers who casually paint picking individual stocks, dividend or otherwise, as easy. It is not. It is vanishingly difficult. Is it possible? Perhaps. But for every one who succeeds there will be 10,000 left in the road bleeding.

      We need to be very careful in our advice, seems to me.

      Is index investing perfect? Perhaps not, but to call it “blind” is to misunderstand the approach. Like Democracy, it is simply better than the alternatives.

      While I don’t agree with the opening premise of your third paragraph, you are absolutely correct in your description of some the obstacles pros face. That individuals don’t face these same obstacles, however, doesn’t help them overcome those they do.

      Individuals also don’t have access to the advantages of the pros. If you’ll indulge me in quoting myself:

      “Convinced I could win this game, after all I’d just bought a stock that tripled, I even took a major pay cut to join an investment research firm mid-career. There I was, surrounded by exceedingly bright people. Each focused on one, maybe two industries and perhaps 6-10 stocks. More than one had been honored in the trade press as “Analyst of the Year” for their work.

      “They knew each of these companies inside and out. They knew the top executives. They knew the middle-managers and the front line people. They knew the customers. They knew the suppliers. They knew the cute receptionists. They spoke to them all weekly. Sometimes daily.

      “They still didn’t get info before anyone else (that’s insider trading, fool proof and, ah, illegal). But they did know exactly when and how the info would be released. Of course, so did every other competent analyst around the world. Any new information was reflected in the stock price within minutes.

      “They issued reports our institutional investor clients paid dearly for. And yet, predicting stock performance remained frustratingly elusive.”
      http://jlcollinsnh.wordpress.com/2011/06/02/why-i-can’t-pick-winning-stocks-and-you-can’t-either/

      Sonny Liston’s shortcomings didn’t make it any easier for the next guy facing Ali. Was it possible to beat Ali? Yep. Would I have gotten in the ring with him, or advised you to? Nope.

      Cheers!

      JC

      • Posted January 2, 2012 at 10:15 pm | Permalink

        I hope I didn’t come off as too harsh either ;) Passions always seem to run high on this topic. I think you’re right that we can probably agree on more than we disagree.

        Do check out that paper I linked to, though. There’s a good deal of evidence there that the rate of investors that can get outsized returns is closer to 1 in 10 than 1 in 10,000. I tend to discount studies of professional money managers, since I believe their limitations outweigh many if not most of their advantages, ironically for precisely the same reason that many believe beating the market is impossible: their informational advantage is not that great. Individual investors, on the other hand, are much better able to ACT on information.

        You might also check out these posts from Early Retirement Extreme:

        http://earlyretirementextreme.com/the-cult-of-index-investing-why-it-will-be-gone-in-ten-years.html

        http://earlyretirementextreme.com/trading-different-players-and-beating-the-market.html

        That said, I still think index investing is a reasonable strategy for most people, especially when combined with steady dollar cost averaging, as you mentioned over at MMM. I even do it myself in my 401(k) (of course my only other option there is managed funds;) ).

        Cheers,
        Sean

        • Posted January 2, 2012 at 10:57 pm | Permalink

          Not at all, Sean…

          …and you are welcome here anytime.

          Glad to hear you do a little index investing. and, as I’ve confessed, I do still play at picking stocks. but even when, like 2011, they go my way I am always keenly aware of how large a role luck played and how easily I could have been left bleeding on the side of the road.

          You are right about Jacob over at ERE. He’s no fan of indexing and I always had the sense that he might be one of the few who could actually beat the indexes. Maybe you are, too. But even if the odds are 10 to 1, I cringe at pointing folks down that path.

          But what Jacob, MMM and I all agree on is: Spend less than you earn, invest the balance and avoid debt. You, too, I’ll bet. :)

          • Mark
            Posted January 6, 2012 at 12:52 pm | Permalink

            Being a Boglehead myself, I read the ERE article to see what he had to say. I had to sigh when I got to this: “Index investing is basically equivalent to a buy and hold strategy with very low turnover of a few large growth companies.” This is absurd. The S&P 500 is just one index. There are indexes for large cap, small cap, growth, value, US, Europe, emerging markets, REITs, every kind of bond, you name it. Index investing is about choosing an asset allocation that matches your need and willingness to take risk, and using low-cost index funds to hold the most diversified position possible within those asset classes. Why is it that the people bashing “index investing” have so little understanding of what it is?

          • Posted January 6, 2012 at 1:31 pm | Permalink

            Hi Mark…

            Always good to meet a fellow Boglehead. Warren Buffet is typically helded up, with good reason, as the pinnacle of all that’s good in investment. He certainly has an impressive record.

            But for my money (pun intended), no one has done more for the individual investor than Jack Bogle. With Vanguard and its unique structure that benefits shareholders to Index Funds he is a financial saint and a personal hero.

            You are, of course, correct. The S&P Index is only the first of its kind and but now is one of many. Each tailored to a unique need. As mentioned elsewhere I use/need only three, plus a money market fund.

            As to why people bash them with little understanding, all I can say is that seems to be a common human trait.

            I have a lot of respect for Jacob. He’s clearly very bright and thoughtful. Why he choose to dismiss Indexing in the manner he does, baffles me.

            As to why people who do take the time to understand indexing and who still reject it, I think there is a lot of psychology behind it:

            1) It is very hard for smart people to accept that they can’t outperform something that basically buys every thing. It seems it should be so simple to spot the good companies and avoid the bad. It’s not. This was my personal hangup and I wasted years and $$$ in the pursuit of outperformance.

            2) To buy the index is to accept “average.” People have trouble seeing themselves or anything in their life as average. Of course, in this case average puts you somewhere in the top 80% or so of funds.

            3) The financial media is filled with stories of individuals and pros who have out performed the index for a year or two or three. Or in the rare case, like Buffet, who has done it over time. But investing is a long term gain. You’ll have no better luck picking and switching winning managers than winning stocks over the decades.

            4) People underestimate the drag of costs to investing. 1 or 1.5 or 2 percent seems so low, especially in a good year. As Bogle says, performance comes and goes. Expenses are always there.

            5) People want quick results. They want to brag about their stock that tripled or their fund that beat the S&P. Letting an Index work its magic over the years isn’t very exciting. It is only very profitable.

            6) People want exciting. Heck, I’ve even admitted to playing with individual stocks with a (very) small fraction of my stach. But I let the Indexes do the heavy lifting and they are the ones that got me F-you Money.

            7) Finally, and perhaps most influential, there is a huge business dedicated to selling advice and brokering trades to people who believe they can outperform. Money managers, mutual fund companies, stock analysts, newsletters, blogs, brokers. Billlions are at stake and the drum beat of marketing the idea of outperformance is relentless. In short we are brainwashed.

  3. Steve
    Posted July 12, 2012 at 8:36 am | Permalink

    http://www.fool.co.uk/news/investing/2012/03/22/buffett-takes-on-the-hedge-funds.aspx
    Your quite right.Warren Buffett has a bet on to prove it.
    It will be interesting to see the outcome

  4. Posted December 18, 2013 at 12:03 pm | Permalink

    Hi Jim,
    I may have misunderstood you, but are you implying that dividend investing could be considered the next ‘magic bean?’ What are your thoughts on individuals who are betting their retirements on dividend stocks/payouts? (e.g. Dividend Mantra). Seems risky from my POV.

    • jlcollinsnh
      Posted December 18, 2013 at 12:48 pm | Permalink

      Hi Kyle…

      Dividend investing has been one of the most popular “magic beans” in recent years, second only perhaps to gold.

      I’m not a fan. Here are just a couple of quick reasons:

      1. It is a strategy of picking individual stocks something that in and of itself is a loser’s game.
      2. It focuses a portfolio on only one narrow category of stocks: Large cap, dividend focused companies.
      3. It often assumes that these companies will somehow last forever. Google “The Nifty 50″ and see how untrue this is.
      4. It often seems to assume that during downturns dividends won’t be cut. Companies try not to perhaps, but still do it all the time.

      For more: http://jlcollinsnh.com/2011/12/27/dividend-growth-investing/

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