Most investors spend countless frustrating hours and often rack up big losses attempting to predict and understand exactly how markets work. They attempt to buy and sell the right securities, at the right time. While a select few develop great skill at riding the waves, so to speak, most get battered about and end up mystified by the market’s secrets. Then they look to gurus and “experts” to tell them where to invest, often times to no avail.
“Passive investing is a misnomer. Index investors eschew market timing and stock picking not out of laziness or passivity, but because those activities usually reduce returns and increase risks, a better name for it would be "Intelligent Investing.”
– David M. Blitzer
Chairman of the S&P 500 Index Committee
The radical truth we are here to convey is that investing success does not require that you understand how markets work. All you need to know is that markets work. Markets emerge from the economic activity of all their participants. Buyers and Sellers determine among themselves the price at which they are willing to transact. Prices will always move according to people’s expectations of supply and demand. Sometimes their expectations are based on rational objective criteria, and other times emotions of greed and fear take hold. What is critical to understand is that, in the short term, markets will either under or over estimate the value of any particular security. This is so either because of imperfect information about the true value of the security at any given time, or conditions exist that spur emotional decisions. Over the long term, however, markets will reflect the true value of the underlying securities as information becomes known and the swings caused by transitory emotions cancel each other out. And over the long-term, risk is reduced.
From 1926-2007, more than one in four years have shown losses in the stock market, but there has never been a 15-year period with losses.
Chance of Negative Returns
1-year Holding Period
5-year Holding Period
15-year Holding Period
Source: Morningstar, Inc. & RVW Research
A stock’s price is theoretically equal to the value of the underlying value of the company it represents. There are a large number of fundamental metrics such as price to earnings ratio (P/E), growth rate, and price to sales ratios that are used to evaluate the stock and attempt to ascertain proper pricing at any given time. Since market conditions and expectations of the future color the market’s pricing of an asset, these fundamental metrics are hardly of objective value. The most important thing to know is that as a company grows its earnings, the true value of the company increases. By extension, when the economy grows, the total value of the market increases. Once you understand that, over the long run, an investment in the market is an investment in the overall growth of the economy, you will begin to see the forest from the trees.
“Most investors pick last year’s best managers and funds. That’s like driving a car while looking in the rear-view mirror. Because of style rotation, it’s a sure recipe for disaster.”
– Rip Van Winkle Wisdom
The conventional wisdom suggests that smart people generate good stock picks. Therefore, the more research a person does, the better his investing results will be. Likewise, a person will expect that the best returns will come from hiring the best managers to do the hard work for them. It is true that there are some extremely talented individuals who have done quite well at the stock picking game. That being said, the data is clear, for the vast majority of those attempting to play, stock picking is a loser’s game.
For many years the Wall Street Journal ran a “Dartboard Portfolio” in which, as the name indicates, the stocks were randomly selected by throwing darts at the stock listings. That portfolio regularly outperformed the “experts”.
Literally hundreds of studies have been conducted comparing active managers’ performance over a ten year period against the market’s performance over the same interval. Time and time again, the market beat the managers. In fact, the odds of a particular manager beating the market over the long run are between 2.4% and 2.7%. By contrast, the odds of winning by picking a single number in roulette are 2.6%. Few people would go to
“For short term stock market forecasts we suggest using tarot cards. It’s only in the long run that the noise gets filtered out and the trends emerge”
– Rip Van Winkle Wisdom
The most famous adage in investing is: buy low, sell high. It is obvious to most that doing so is far easier said than done. Nevertheless, there are many who believe that it is possible to determine the optimal time to buy and to sell. Market timing, as it is called, is another art that many claim to have mastered yet few have actually benefited from. In fact there are hundreds of newsletters written by so-called market timing gurus that promise to inform readers of the exact moments of opportunity. It is hard to ignore the fact that if true, the predictions written in such letters should generate enough profits to dissuade the so-called gurus from extending the efforts to write them. The data confirm the skepticism with which savvy investors view these letters.
. The data shows conclusively that over the short term markets move randomly and that when the equity markets move up they tend to do so in significant spurts rather than in straight lines. Missing the best 30 trading days over a 10 year period ending in 2004 will change a significant gain of 160% for those who held on throughout, into a loss of 8%.
According to a
There is no question that these letters are alluring, especially when they tout unbelievable past results. That being said, the statistics don’t lie. Attempting to time the market might be an entertaining pastime but it is no way to invest the bulk of your hard earned capital.
“Investing in indexes is like watching a man walking up the stairs with a yo-yo in his hand. Watch the feet and not the yo-yo.”
– Rip Van Winkle Wisdom
Most people think that selecting the right investments, watching them closely, and being prepared to reposition when necessary, is the best formula for success. Without question, for those gifted with a healthy dose of prescience, this strategy will work quite well. For the rest of us, it is far from a foolproof endeavor.
The first mistake, typical of most investors, is in their initial investment decisions. When selecting a mutual fund, for example, people tend to look at those funds with the greatest track record. Likewise people tend to select stocks that have been top performers. The problem with this approach is that yesterday’s top performers are rarely tomorrow’s. Investors tend to do the equivalent of driving down the street while looking in the rearview mirror. Statistically, this is a big mistake, as over time, hot sectors and strategies will go in and out of fashion. In fact because of what is technically known as style rotation and reversion to the mean the sectors that were hottest in the recent past tend to be the worst performers going forward.
The second great mistake active investors make is the failure to account for fees and taxes. As far as individual stocks go, sales commissions have become far more affordable with the proliferation of discount brokerages. Mutual funds, on the other hand, are among the worst offenders at bilking investor capital. Some mutual funds charge an upfront fee, called a sales load, that can be as high as 4%-8% of invested capital. Thus moving in and out of these funds can be prohibitively expensive, Moreover, mutual funds also charge annual fees to cover the expenses incurred in the management of the fund. These “expense ratios” can be as much as 1-3% annually.
Even if transaction fees are minimized, taxes are another enormous drain. Whenever a stock is bought or sold for a profit, a tax is incurred on the difference between the sales price and the initial purchase price. If the stock was held for over a year it will be taxed at the long term capital gains rate that is lower than the short term rate. Either way, taxable events will erode long term returns. Many active managers turn over their portfolios every year or two, ensuring that what gains they have been able to generate are taxed, often at the highest ordinary tax rates.
Mutual funds are also great offenders on the tax efficiency front, even when they are held for longer periods of times. Since the average mutual fund trades the dollar equivalent of its entire holdings every year, passive fund investors are often hit with large tax bills at the end of each year. It is not unheard of for investors to have tax bills that exceed the fund’s total return for the same period. Most index funds charge minimal fees and have virtually no tax impact until you liquidate, at which time you will probably be paying tax at the lowest tax rates. The growth thus takes place in a “financial hothouse” unimpeded by the drag of compounding costs and taxes.
When one looks at the big picture of sector rotation, fees, taxes and the improbability of predicting the future, there is but one conclusion to be drawn. The best strategy is one that gains the broadest exposure to all industries and has the smallest possible fees and tax implications. The one strategy that fits this description best is long term index investing.
“You can get your diversity and beat almost every single mutual fund manager simply by buying a stock index fund.”
– Jim Cramer, CNBC television personality
One of the greatest challenges faced by investors is portfolio construction. Everybody knows that one should never put all their eggs in one basket. The question remains: how many eggs in how many baskets? Diversification is the spreading of risk among multiple assets, and works well to decrease the likelihood of risk in a portfolio to any particular factor. Nevertheless, wise portfolio construction requires a real understanding of the risks versus reward of each particular investment and the relationship between the investments. A properly constructed portfolio will include elements that move in opposite directions (negatively correlated) or independently of each other (uncorrelated).
In recent years, so called “Alternative” investments such as hedge funds, private equity funds, and real estate funds have become the rage of wealthy investors seeking huge returns. Unfortunately for many, the allure of large profits usually comes with significant risks. For those drawn to such investments, there is a real need to take a sober look at the contribution such investments make to the investor’s overall risk-return profile.
Probably the simplest, and certainly the wisest approach to this quandary is the “Core & Satellite” model of investing. The investor should identify what portion of his portfolio he can afford to lose and what portion is necessary for his long term financial survival. The “core” portion should be invested in long-term conservative strategies and the “Satellite” portion can be used for a group of more aggressive, shorter term and opportunistic investing, especially if the satellite elements are independent from and unrelated to the core and to each other..
It goes without saying that the larger an investor’s core, the smaller the impact of the satellite portion of the portfolio. Divorced from the powerful allure of getting rich quick, any rational investor should be willing to embrace smaller investments in risky gambles in exchange for the peace of mind that a conservatively invested core safety net provides.
“There are two times when a man shouldn’t speculate: when he can’t afford it, and when he can.”
– Mark Twain, Following the Equator, Pudd’nhead
The final, and perhaps most essential, principle of Rip Van Winkle investing is to go to sleep. Although it sounds like the simplest, it is likely the most difficult principle to apply. In fact, it is completely counterintuitive and contradictory to everything we know about life and human nature. The key element is learning to overcome to impulse to react. You will likely be facing regular bouts of either greed or fear – and your task is to ignore them both. It takes discipline and serious belief in the voracity of the conclusions of countless objective studies.
Any successful person knows that professional success depends, in most cases, on hard work. Scientists sift through data to prove their convictions. Many entrepreneurs rely on highly refined instincts and inspiration to make bold business moves. Soldiers are well trained to react and respond to danger immediately. Even animals in the jungle instinctively respond to threats with either fight or flight.
These deeply ingrained attitudes and behaviors are actually counterproductive when investing. For example, investors tend to sell stocks after a big drop, when the pain is no longer bearable. Generally speaking they are destined to sell at the worst times, right before an upward price reversal. On the other hand, investors will often buy once they see a stock shoot up, not wanting to miss out on the upside, only do catch the ensuing downward correction. Analysts will pour over mountains of data and make a determination that is outdated by changing circumstances as quickly it is publicized. Simply put, the cards are stacked against us and we are hard wired to do the wrong things at the wrong time.
RVW investing is scientific and disciplined. RVW investing is a highly disciplined and there is no room for reacting to gut feelings or intuition Rip Van Winkle investors, transcend the feebleness of all-to-human investing behavior. They know from the outset that their investment will go up and down over time. They understand clearly that the stock market is like a man walking up stairs while playing with a yoyo. Over the long term, it is completely irrelevant if the yoyo goes up and down, because his feet are always climbing and the key is to watch the feet and not the yoyo. The RVW approach is so simple, so straight forward and so validated by the empirical evidence that all a rational investor ever need to do is invest right, then sleep tight.