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Ü Book
On Investment |
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Index Funds: The 12-Step Program
for Active Investors "Active Investors Annonymous"
Click
here to obtain a free download of this book, or you
can order a printed copy. This book is a complete investor
education program and the treatment-of-choice for active
investors. After you have completed the program, you will
be prepared to invest and relax.
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4
Market Randomness and Active Management:
Markets are moved by news. News is
unpredictable and random by definition. Therefore, the
markets movements are unpredictable and random. However,
this market randomness does have a positive average
of about 10%/year because capitalism
works. Active managers who have claimed to outperform
a market average or index have also implied that they
have the power to predict tomorrow’s news. But since it is impossible to
consistently predict the future, the results of active
managers are unpredictable and random. This concept
is known as the Random Walk Theory and it was first
discussed in The
Theory of Speculation, a paper written in 1900 by
Louis Bachelier. In 1964, MIT Professor Paul Cootner
published a 500 page collection of research papers on
the randomness of the market titled, The Random
Character of Stock Market Prices. In 1965,
Nobel Laureate in Economics and MIT Professor Paul Samuelson
wrote his now famous paper, Proof
That Properly Anticipated Prices Move Randomly.
Also in 1965, University of Chicago Professor, Eugene
Fama wrote his highly regarded papers, Random
Walks in Stock Market Prices, and The Behavior
of Stock Market Prices. After carefully reading
this extensive collection of peer-reviewed research,
you will be convinced of the randomness of stock market
prices.
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4
Skill or Luck
:
The average actively managed investment must underperform
the indexed investment, when all costs are deducted.
[source] Those actively managed investments that beat the
indexed investments fail to consistently beat the index
in the future. The reason for market beating performance
in a random market is simply due to luck and not due to a skill that is repeatable. Research shows that only
about 3% of active managers beat an appropriate index
over a 10 year or longer period. Needless to say, it
is nearly impossible to predict those winners in advance.
Lucky investors are well advised not to expect a continuation
of their good fortune. [see 1, 2, 3, 4, 5,
6,
7,
8]
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4
Index Portfolios
Best Capture Risk and Return :
Actively managing your money will create higher risk
and lower returns than a globally diversified, tax-managed,
and small value tilted portfolio of index funds. Due
to commissions, management fees, margin costs, taxes,
stock randomness, and market efficiencies, you will
slowly transfer your money into the pockets of stock
brokers, mutual fund managers, hedge
fund managers, and the many other individuals profiting
from your numerous transactions and your lack of understanding
of free market principles. Active management is hazardous
to your wealth. A recent study by Brad Barber of the University of California,
Davis, showed that 82% of the 925,000 active traders
on one stock exchange lost $8.2 Billion/year from 1995
to 1999. Dalbar Research stated in their 2004 report
on Investor Behavior that the average equity investor earned
a paltry 3.51% annually for the last 20 years, compared
to 3.05% inflation and 12.98% for the S&P 500 over
that same period. The gap between the average active
investor and the market is 9.47%/yr. The global equity
total market value is $ 25
Trillion as of 12/31/04, so 9.47% of that is $2.4 Trillion! |
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4
Returns from
the Risk of Capitalism Rank Highest:
Capitalism is a great idea that has worked for centuries.
It has provided an annualized return of about 10%/year
since 1926 and has the highest rate of return of all
investments tracked over periods of 50 years or more.
That rate of return is explained by the difference
between the low risk of capital and the high risk
of capitalism. It is not the result of speculating
in short term price changes. There is no additional
expected return from speculation above the average
return. The gains from speculation are offset by the
losses in any random situation, leaving the average,
or the index, as the most likely return. This concept
is known as a zero sum game. Investors earn
returns from consistant exposure to the right
risk factors, not from gambling
on tomorrow’s news.
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4
Market Efficiency
Is Why Capitalism Works Better:
The world’s stock exchanges facilitate a free
market system that is the cornerstone of capitalism.
These capital markets simultaneously price the cost
of capital and the expected return from the risk of
capitalism. Free markets perform this highly important
task in the most effective and efficient manner because
the knowledge of all investors exceeds the knowledge
of any individual. Due to the millions of intelligent
and highly competitive investors, it is unlikely that
any individual investor will consistently profit at
the expense of all other investors. From this we can
conclude that free markets work and that current prices
reflect the knowledge and expectations of all investors
at all times.This concept is known as the Efficient
Market Theory. If free markets were not more
efficient than controlled markets, like those in communist
countries such as North Korea or Cuba, then the communists
would be more prosperous than the capitalists.
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4
Cost of Capital
and Expected Return for Capitalists:
The expected return for a capitalist,
equity buyer, or investor is equal to the cost of
capital of the equity seller. An intelligent capitalist
will estimate the expected return based on the risk
of the equity, which is tied to the risk of the company.
The higher the risk of the company, the higher their
cost of capital, and the higher the expected return
for the capitalist. The lower the risk of the company,
the lower their cost of capital, and the lower the
expected return for the capitalist. Those investors
who carefully match their risk capacity with their
risk exposure have the best chance of obtaining the
long-term historical returns of the global markets.
A buy, hold, and rebalanced risk
exposure strategy is the best method to capture those
returns.
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4
Small Value
versus Large Growth Companies:
Public companies
that are unglamorous, small, and relatively cheap
(small value) are riskier and have higher costs of
capital than those that are glamorous, large and relatively
expensive (large growth.) As a result, a dollar invested
in a Fama/French Index of small value companies in
1927 grew to $40,095 by the end of 2004 (14.6% annualized
return), and a dollar invested in a Fama/French Index
of large growth companies grew to only $1,154 over
the same period (9.6% annualized return.)
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4
Diversify, Diversify,
Diversify:
Diversification is the investor’s best friend because
it reduces the uncertainty of expected returns, otherwise
known as risk, without changing the expected return.
Concentrating investments only adds risk, and does
not increase expected return. For example, any one
stock in the S&P 500 has an expected return of
about 10% per year, plus or minus about 50% two thirds
of the years. However, the S&P 500 Index has the
same 10% expected return, but it only has a risk of
plus or minus 20% two thirds of the years. So 10%
plus or minus 20% is far superior to 10% plus or minus
50%. Highly efficient portfolios of index funds have
had returns of 14.3%/year with risks of 15.6% over
the last 34 years, after fees (see Index Portfolio
100, which includes about 15,000 companies
from 35 countries.) This is why buying the whole haystack
(index) is better than looking for the needle (a stock)
in the haystack. What is the risk and expected return
of your portfolio, based on the same investment strategy
over the last 34 years?
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4
Selecting Index
Funds:
Dimensional Fund Advisors is the premier
commercial provider of capital markets research, historical
risk, return and correlation data, investment advisor
education, and mutual fund products that reflect the
leading academic research. Their complete product
line of index mutual funds are based on the efficiency
of capital markets. They have constructed unique rules
of ownership for their funds that allow investors
to better capture the right risk factors and engineer
portfolios with greater precision and efficiency.
At the heart of their fund eligibility rules is the
Fama and French three-factor model, which has become
the gold standard among academic researchers for risk-adjusted
returns. The three-factor model on average explains
more than ninety percent of the performance of diversified
portfolios of stocks.
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4
Peace of Mind:
Don’t let your retirement years be tainted by the
discomfort of poverty. Reliance on family members
or government programs for your financial well-being
will be a source of unhappiness, insecurity, and low
self-esteem. The sooner you start saving and planning
for your retirement, the better. A prudent
and intelligently managed investment portfolio of
index funds has the highest probability of providing
security and peace of mind in the years when it will
be needed the most.
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 Risk
Capacity Survey |
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 Determine
how much risk is right for you.
Take the Risk Capacity Survey. It will match you to one of
twenty portfolios of index funds. |
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| Book
On Index Mutual Funds |
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