The Big Investment Lie

SEC hires purveyor of Suckers of the Future game

I wrote earlier about financial literacy, and how it was a good idea but could too easily be captured by the sales culture of the financial industry and bent to its own objectives.

Susan Antilla of Bloomberg.com highlights just that concern in an excellent article, titled "Suckers of the Future Groomed With Stock Game". Antilla points out that the Securities and Exchange Commission's new deputy director of investor education, Kathleen M. Floyd, was formerly executive director of the Stock Market Game, "a virtual-investing program that’s given hundreds of thousands of students a $100,000 make-believe portfolio to play with."

"Her employer was a foundation financed by the Securities Industry and Financial Markets Association, Wall Street’s main lobbying group. Floyd’s hiring brings new attention to the popular Stock Market Game, which gets money from donors like Morgan Stanley, Merrill Lynch and A.G. Edwards."

This game, however, educates students not to be investors, but gamblers on short-term stock prices -- in other words, to be brokerage firms' dream customers, their Suckers of the Future.

One commentator in Antilla's article says, “You could teach kids the basic rules of blackjack and have a more lasting and beneficial impact.” Well yes, more beneficial for the kids perhaps. But teaching the game will have a lasting and beneficial impact for its Wall Street sponsors, providing them with an endless parade of future suckers.

Active vs. Passive: Going on for years

We got a query from a journalist who wanted "a fund company or wealth manager to explain why actively managed funds are better than ETFs or index funds.This is an argument that's been going on for years."

The journalist will never get anyone to claim that actively managed funds as a class are better than ETFs or index funds—unless of course the respondent is a fraud. Overwhelming and irrefutable evidence shows that actively managed funds on average do worse, after fees, than lower-cost passively managed funds. (It’s only the fees that make the difference—otherwise the average pre-tax performance of actively and passively managed assets would be the same.)

The big question is whether some actively managed funds, or even only a very few actively managed funds are better than index funds, and in particular—the big, big question—whether it’s possible to identify the actively managed funds that will perform better in advance.

Unfortunately, there’s no clear statistical evidence that this is possible, though just enough to keep the hope alive. That’s where the debate lies.

Not so fast on those Roth IRAs

The concerns of our colleague Dave Loeper, writing in Advisor Perspectives, about the rush to invest in Roth IRAs (precipitated by the advice of many advisors) are well-founded. There’s too much excitement about Roths going around without adequate justification.

Furthermore, there are an amazing number of flat wrong calculators out there—even several well-respected providers that should know better offer access on their web sites to Roth IRA vs. Traditional IRA calculators that are wrong.

Given the huge uncertainties about future projections, complicated calculations are mostly a waste of time, unless to refute other complicated—or mathematically incorrect—calculations that tell you to do the wrong thing. The simple prescription is that if you’ve got a very good and sound reason to believe your tax rate will be higher after retirement than it is now then the Roth is a good way to go; otherwise not.

Some advisors ostentatiously give detailed advice (to make their expertise seem important to you) on tax-deferral options that make little difference in your after-tax rate of return (given that skipping tax loopholes and just investing in a naturally tax-deferring index fund costs you only 70 basis points/year over an investing lifetime). This often obscures the fact that their high fees obliterate the benefits that their tax-deferral advice provides, even if it’s right.

TIPS hedge against interest rate volatility

Suppose in October, 2009, you buy a 10-year TIPS contract (Treasury Inflation-Protected Security) for $1,000, and its real interest rate is 2%. That is, it will pay you a 2% coupon on its value each year, but its value will rise with inflation.

Suppose the general expectation is that inflation will average 2% over those 10 years. So you expect a 4% return (2% inflation + 2% coupon). The interest rate on non-inflation-protected Treasuries will probably be about 4% too.

Now suppose that by January, 2010, the general expectation of future inflation has risen a lot, to 5%. The Treasury issues a new 10-year TIPS contract you can buy for $1,000, again with a 2% coupon.

Now what is the value of your old TIPS contract, the one you obtained when the inflation expectation was only 2%?

Answer: $1,000. It does not change. Its terms are exactly the same as the terms of the new TIPS.

But you know what surely has changed: interest rates.

Prevailing interest rates reflect, more than anything else, the expectation of future inflation.

If the nominal interest rate climbs but the real interest rate stays the same, the value of your TIPS will stay the same.

The same cannot be said for non-inflation-protected securities -- far from it. If you had bought 10-year non-inflation-protected Treasuries in October when the prevailing interest rate was 4%, their value has probably dropped about 21%. That's because the interest rate rose from 4% to 7% in anticipation of a 3% hike in the expected future inflation rate.

Hence, TIPS protect you not only against future inflation, but against future fluctuations in the interest rate. They won't protect you against volatility in the real interest rate -- that is, the interest rate adjusted for future inflation -- but that is usually less volatile than the nominal interest rate anyway.

What does rebalancing do for you?

Like so much prescriptive advice in the investment advisory field, the admonition "You should rebalance your portfolio" has been repeated so often, without full and clear explanation why, that it has acquired the character of a shibboleth.

"Rebalancing" means restoring the asset allocation of a portfolio -- mainly the allocation between stocks and bonds -- to what you set it to in the first place. Why should you do this? What are the arguments for rebalancing?

There are basically two arguments for rebalancing, a risk argument and an expected return argument:

1. You decided on the risk level you were comfortable with when you first established your portfolio's asset allocation; you need to reset it to that allocation periodically to make sure you don't exceed your risk level.

2. A rebalancing discipline buys an asset class when its price is lower than it was, and sells some when it is higher than it was -- buying low and selling high, and taking advantage of "reversion to the mean".

Unfortunately, both of these arguments are questionable.

Argument 1.

In the first case, the assumption is that you measure risk using something like the short-term volatility of your returns. If that is indeed your measure of risk, then if you don't rebalance, your risk will drift out of its bounds.

But what if your risk measure is the chance of unacceptably low cash flows in 30 years? And what if you control that risk by holding part of your portfolio in 30-year Treasury bonds to provide a secure safety net?

If you rebalance periodically you won't maintain your risk hedge, you'll destroy it. Suppose, for example, you start out with 50% stocks and 50% Treasuries, which you will hold to maturity. Suppose the market drops 20%. Rebalancing means you'll have to sell some of the Treasuries that provide your safety net.

Argument 2.

Let's address Argument 2 with a little data study. An alternative to rebalancing is set-it-and-forget-it, or buy-and-hold; that is, let the stock-bond mix readjust naturally as markets fluctuate.

Which yields the better risk-adjusted return, rebalancing or buy-and-hold?

The answer is, it comes out the same. We ran the two strategies, beginning with a 60/40 stock-bond mix, for all 20-year periods between 1926 and 2008. The average return for rebalancing was 9.3% with a standard deviation of 2.4%, and the average return for buy-and-hold was 9.9% with a standard deviation of 2.8%. (You'd expect buy-and-hold to have higher average stock allocation and therefore higher return and volatility.) The average risk-free Treasury-bill return was 4.1%. Using these statistics, the Sharpe ratio -- a measure of risk-adjusted return -- was 2.2 for rebalancing and 2.1 for buy-and hold, virtually the same.

Stocks are riskier in the long run

In 1995, Boston University finance professor Zvi Bodie published a paper in the Financial Analysts Journal, "On the Risk of Stocks in the Long Run." The article should have been immediately regarded as a seminal work. Instead, it was largely ignored -- confirming that academia, too, tends to throw its weight toward bandwagon-bubble phenomena.

Bodie peformed a calculation showing that the cost to insure a stock portfolio against poor performance grows over time. If the portfolio underperforms the risk-free rate, the insurance makes up the difference in wealth accumulation.

A poor -- and poorly-specified -- measure of risk has become entrenched in the finance community: the annualized standard deviation of returns. It is poorly specified because there is no universally-accepted standard as to how it should be calculated. It is a poor measure because it measures poorly how much money an investor risks.

Bodie used a superior measure. How better to compare two risks than by the cost of insurance to avert them?

By that measure, stocks are riskier in the long run than in the short run.

Misled by the wrong measure, most academicians and advisors thought stocks were more risky in the short run -- that is, more "volatile", having a larger annualized standard deviation -- than in the long run.

But Bodie's calculation shows that while the chance of falling short of the risk-free rate may be smaller in the long run, the cost of that shortfall is likely to be larger. When you consider the cost to make an investor whole after poor long-run returns, it turns out that the risk of poor long-term stock market performance is greater than the short-term risk.

That is why we often recommend taking the edge off the potential long-run downside by investing a bedrock portion of the portfolio -- enough to ensure at least the bare essential minimum income stream in the future -- in safe long-term assets like TIPS (Treasury Inflation-Protected Securities), held to maturity.

Why we need to teach the efficient market model

The efficient market hypothesis (EMH) has many problems, not least of which is that it is not clear what it says.

One of its most common formulations is that "the market price reflects all available information". How does it reflect it? The hypothesis does not tell us.

It is sometimes understood to mean that the market price of a security is the best estimator of its true value.

What, then, is the true value? How can it be defined? Is it the present value of the future earnings that will actually occur, which we would know if only we had a crystal ball?

No, it cannot be that; it can only be the present value of the best current estimate of unknown future earnings, not the earnings that will actually come to pass. But how is one to know what is the best current estimate of future earnings?

The efficient market hypothesis has come under attack because it seems that in bubbles the market consensus -- because of groupthink, trends, fads, bandwagon effects, and market participants racing each other not to be the last greater fool -- can be drastically wrong on occasion.

But the EMH's most important lesson has not been absorbed.

Even if the EMH is not universally correct, it is correct often enough, and nearly enough, to be instructive. And the lesson it teaches, which is correct almost all of the time, has not been absorbed by the vast majority of investors.

That lesson, to put it in simple and familiar terms, is past investment results are not predictive of future results.

Most investors do not understand or believe this, because they don't understand or believe that the efficient market hypothesis is almost always true within an unimportant margin of error. They think that, as in other fields that produce data, you can use those data to determine trends, and rely on those trends to continue into the future.

Not so in the investment field. If people understood the efficient market hypothesis better they would understand why.

Academicians in finance respond to perverse incentives too

At last someone has written a whole article pointing out that academicians in the finance and economic fields are conflicted because they respond to financial incentives in their fields. "After all," says author Devesh Kapur, "many of the intellectual underpinnings of the causes of the current crisis – be it financial innovations, capital account convertibility, deregulation or stock options – come from the best and brightest in US academia."

Devesh says that a "troubling reason behind the failure of academics in the current crisis is the nature of their financial incentives and the resulting conflicts of interest – not dissimilar to what so many in Wall Street faced." He adds:

"One factor, in particular, needs highlighting: the hidden financial conflicts of interest that a growing number of academics face. Many academics, particularly those from institutions that enjoy high prestige and reputation, now have serious business interests and an array of financial ties to the very institutions that their studies address. These interests range from lucrative speaking fees, advisory roles at financial institutions, managerial roles and stakes in private equity and hedge funds to corporate non-executive directorships."

These incentives have caused the academic field of finance to become a travesty, responding like Pavlov's dog to incentives to add fuel to -- or at least not to totally debunk -- any fad that adds lucratively to the coffers of financial institutions.

Those who forget Heisenberg will be doomed to reinvent him

The bursting of two asset bubbles in the 2000s -- the tech-stock bubble and the housing bubble -- has shined a light on a long-accepted theory in academia, the Efficient Market Hypothesis, or EMH. This hypothesis is generally credited to the Chicago school of thought, residing in the University of Chicago's department of economics.

Now many people are saying the EMH was terribly wrong, and perhaps even seriously damaging to the economy. The debate is reviewed in an excellent article by Joe Nocera in today's New York Times.

Clear failings have resulted from pushing efficient market concepts too far. For example, Milton Friedman, a Nobelist Chicago-school stalwart, believed that the U.S. FDA (Food and Drug Administration) was not needed to protect the public because rational food and drug corporations would never endanger their market values by taking the risk of selling contaminated food and unsafe drugs. Such theory-bound extremism has now been exposed for what it was.

But as Justin Fox, quoted in Nocera's article, makes clear, the EMH is useful and mostly right. Perhaps it is like Newtonian physics, which works in almost all cases except extreme ones -- for example when you're approaching the speed of light. For that, you need a new theory that encompasses the old: Einstein's theory of relativity.

What will the new theory be? So far it hasn't really gelled. There is much talk about behavioral economics and behavioral finance, but those are mainly sets of experimental results and observations and do not rise to the level of theory.

I believe the answer lies in a maxim I will now coin: Those who forget Heisenberg will be doomed to reinvent him. What do I mean? I mean that the observer is as much a part of the experiment as the observed facts, from which the observer pretends to be removed. (Heisenberg was the physicist who created the Uncertainty Principle, which says you can't accurately observe the position and velocity of a particle at the same time.)

In securities markets, the pretense is that its participants observe the facts of the companies in which they buy and sell securities, making accurate estimates of their values based on those facts. What this ignores is that the participants are also observing each other. They try to guess what others think they are thinking, playing a kind of poker game with them -- who can get out of the game while the value is high before it crashes, who can get in while a bubble is being created then get out in time, who can bluff until others sell out. Should they be doing this? -- after all, it amounts to the demeaned practice of "speculation" -- but that is irrelevant, they will do it. And what they do doesn't only distort the market values of securities, it creates them -- thereby also creating fundamental facts about the underlying companies.

The person who has, at this point, come closest to articulating this new theory is George Soros, whose "theory of reflexivity" is receiving renewed attention. But much more work will be required before a body of thought that really rises to the level of theory is created. Stay tuned.

Bogle on buy and hold

The remarkable John Bogle addressed the Morningstar Advisor conference last week in Chicago.

Robert Huebscher, the CEO and publisher of the online newsletter Advisor Perspectives, was fortunately there to report.

Huebscher begins by saying, "Don’t be surprised if Vanguard founder and index fund pioneer Jack Bogle is not invited to next year’s Morningstar Advisor conference. Bogle had very few positive things to say about the mutual fund industry – the industry from which Morningstar derives the bulk of its revenues."

Bogle just turned 80 and has had a transplanted heart for 13 years. This has not detracted from his crusading energy -- he has long been a beacon of probity and sanity in a sea of cynicism and nonsense.

For example, Huebscher reports that,

Responding to renewed claims that “buy and hold is dead,” Bogle repeated an argument he has made many times before: Divide the S&P index into two sections, and let the “buy and hold” proponents own 50% of every stock, which they won’t trade. The other 50% is held by traders and investors, who trade amongst themselves and pay the “croupiers” for that trading. “At the end of the day, week, month, or any period you choose, the ‘buy and hold’ proponents will capture 100% of the return, while the other group captures at best 50% of the return.”

“If buy and hold is dead, we are all dead in terms of our financial futures,” Bogle said.

Bogle believes that "investing" should be what it has always been intended to be -- providing needed capital to productive businesses. Unfortunately, he believes that much of investing has turned into "speculation" -- trying to beat other investors in the game of greater fool. But the only people who really win are the "croupiers" -- the helpers who claim to be able to help us beat other people in the speculation game. This is not the route either to portfolio wealth accumulation or a healthy economy.