Short-take: Index funds are inexpensive but they are riskier than they appear, and individuals tend to dump them during panics because they don’t know what they own. Superior after-tax returns are achieved by working with an investment advisor to create a diversified “conglomerate” of stocks you actually understand. Hang on as long as they are doing well; sell the losers not the winners.
The Trouble with Index Funds
The Wall Street Journal carried a sad story about how active portfolio managers are losing share to passively managed funds, which are cheaper. It is actually a big mistake for individual investors to flock to index funds, for two reasons.
Index funds are less “passive” than they appear. An S&P 500 Fund is risky because the index is managed to be “representative” of the market, which means S&P adds stocks in excessively popular sectors that may eventually crash. Between 1990 and 2003 the number of tech stocks increased from 44 to 83; in the late 1990s S&P added many “hot” tech stocks after they had soared in price. So investors got the downside but not the upside. Similarly, because of numerous mergers and new names being added, the financial sector’s weight soared from 7% of market cap in 1990 to 21% in 2004, making index investors highly vulnerable to the financial crisis.
Second, index fund investors tend to think of their holdings as a single asset class, rather than individual enterprises that pay dividends every quarter and can deal with adversity. When the whole world is bearish at the bottom of bear markets, individuals tend to sell, and fail to get back in until stocks have recovered. Consequently they vastly under-perform the market averages, as Dalbar has demonstrated through extensive research into the returns of mutual fund holders. For example, ICI data shows that individuals were aggressively selling, not buying, equity mutual funds during the huge bull market of the past four years.
So in the real world index funds are a very expensive way to save on fees. Individuals are likely to achieve superior long-term after-tax returns if they team up with a knowledgeable investment advisor to assemble a group of companies they understand. To channel New York Yankee catcher Yogi Berra (“Ninety percent of this game is half-mental.”), 80% of investing is 100% mental; the other 20% is emotion. If you know what you own you are less likely to panic at the bottom. Think of your stocks not as a “portfolio” to be traded, but rather as divisions of a “conglomerate.” Buy shares of 20-40 strong, high quality companies with good growth prospects. They should be “leaders in their field” but usually not “hot stocks” that everyone is talking about. Most of them should pay decent dividends, but include a few smaller growth stocks without payouts. It is important to diversify across the major sectors (consumer, tech, healthcare, energy, industrials, utilities / telecom), finance) because:
- Diversification cuts risk. Most stock market debacles involve overexposure in one sector – think glamour growth stocks in 1972, energy in 1980, tech in 1999, financials in 2007.
- You get a better feel for the stock market and the economy if you have exposure to all sectors.
- At least part of your portfolio will always be doing relatively well, so you’re less likely to become frustrated and dump stocks because “nothing is working.”
Here Are A Few Do’s…
Keep the winners, even if the stocks become a bit expensive, and sell the losers.
Try to get exposure to potent long-term themes, such as the fracking revolution; rise of the Asian Middle Class; and rising income inequality.
Keep turnover low to reduce tax expense. The media pays amazingly little attention to after-tax returns; performance figures are never after-tax. Long-term investors get two benefits—a lower tax rate and tax deferral until gains are taken. Consider two investors, Long-term Jim and Short-term Bill, who invest $100,000. Both get pre-tax returns of 10%, but Jim pays a 20% tax after 20 years while Bill pays a 30% tax every year. At the end of 20 years, Jim has $558,200 and Bill has $386,968 or 31% less.
In monitoring your stocks, don’t just focus on stock price. Sit down with your advisor to track growth of EPS, revenue, and dividends; companies’ strategies and M&A Activity; and PE ratios. If EPS rises, so will stock price, eventually. Again, if you know your companies you are less likely to dump stocks during a panic.
…and Don’ts
Don’t try to time the market. Equity prices are a function of GDP, profits, interest rates, investor psychology, and “exogenous shocks” (think 9/11 or Pearl Harbor)–none of which are forecastable.
Don’t do short-term trades in individual stocks. Do you really think you have better insight into XYZ’s prospects than the hedge fund managers in Greenwich who just got calls from the Wall Street analyst who just finished a meeting with the CFO to discuss the analyst’s new 180-line earnings model?
Forget about fancy asset allocation strategies. It’s just market timing in drag, with clear thinking subverted by preconceived “benchmark” allocations. Example: a celebrated private bank might tell clients it is bullish and “overweight equities,” which means an allocation of 47% bonds / 33% equities / 20% other stuff. Sorry guys; that ain’t bullish on equities.
Don’t try to buy just a few great stocks. Way too risky; as a public investor you don’t know enough about companies to own just a few. Even the bluest blue chips can stink and sink; look at GE, Lucent, Sun Micro and Digital Equipment.
Don’t average down by buying stocks that decline more than the market. Mr. Market is smart and probably knows something you don’t.
The CNBC dEffect
The media is no help. I have a high regard for the folks at CNBC and Bloomberg and I do extract useful insights and information from their programming. But for the investor much of it is disinformation:
- Hours and hours of macro hand-wringing about “Fed tapering,” “Abenomics,” and the latest Euro-disaster;
- Over-hyping market moves.
- Breathless updates on un-investable stocks such as Zynga, Groupon and J.C. Penney.
- Silly chatter about short-term “trading opportunities.”
Remarkably absent is smart discussion of good companies with strong business franchises, benefiting from potent long-term trends, that can make investors rich over time. I guess it’s too boring.
For more on this topic, see earlier posts dated July 23, 2012, Nov. 19, 2012, and Nov. 21, 2012
Copyright 2013 Thomas Doerflinger. All Rights Reserved.
