"Given Corporate Greed, Fraud and Corruption:
Is the Stock Market Just a Con Game?"
Nicholas Johnson's Question
Responses from Barney Sherman (host), John Spitzer and Larry Swedroe (guests).
"Iowa Talks" Radio Program
May 23, 2002 1000-1100
“Question for any guest.Gentlemen, your answers.
Enron and Anderson were obviously prepared to lie, cheat and steal from investors and employees alike.
Merrill Lynch has just confessed that it deliberately lied to its clients to encourage their investing in companies that it knew to be bad investments, to its benefit in other ways.
Even among the honest financial advisors, 80% apparently do worse than what you would get with an S&P index fund, throwing darts at the stock page or asking a chimpanzee.
Why shouldn’t we ignore the advisors and either buy index funds or skip the market entirely and buy government and corporate bonds?
Isn’t it all just a con game?
Nick, Iowa City."
John Spitzer: Well, I think he’s got in right in terms of going for the index funds and not paying attention to the advisors who are telling you which stocks or what are the hot things to do. Their record has not been very good. Their record has been pretty good in terms of their own returns, but in terms of the advice they give and what that does to the investor, those returns have been generally substandard.
Now, the second part, why don’t we just give up on the stock market and go to something safe like bonds, government bonds. I think bonds have a place in your portfolio.
But there’s a couple of fairly important principles in managing your personal wealth. And one of them is that you have this huge benchmark called “inflation.” You need to outpace inflation. And the things that we’re talking about that you can invest in, bonds, stocks, money market accounts, all of those are markets, so you can’t find home runs there. The markets do work. So the margins are pretty close.
If you go to bonds, the long-term average bond yield is something like 5%, and long-term average inflation is 3%, you’ve got two percent over inflation. For most of us, we just can’t earn enough money and invest enough of it at that 2% premium to have enough to retire on.
Stocks, in contrast, long term, have ups and downs. Long term? Roughly 10%. So 10% minus 3%, 7% on average, roughly, roughly. And that difference between 7% and 2%, that’s a huge difference. So I’m unwilling to—for most people, it just doesn’t work to try to put everything into bonds.
Larry Swedroe: I would add a couple of things here. One is, there is a new instrument called the TIPS, or the Treasury Inflation Protective Security, which is now guaranteeing the real rate of return above inflation of about a little over 3%. So that is a very attractive alternative.
Now also, I would add the historic return of 7% for stocks in real terms is probably too high going forward, and one of the reasons it was so high is, I think, that investors felt much safer investing in stocks, say, starting from 1950’s on as the world became safer for Democracy, the U.S. economic system won, the SEC became better at regulating the markets. And now the world may be a littler riskier. People may perceive the stock market a little more risky than they thought before because of all of these accounting issues, and investors could demand a bigger risk premium. On top of which, stock prices are now very high relative to historic levels. So I think the future expected real return might be expected to be more like 5% rather than 7.
But what I want to add is one last thing. The question confused the issue of financial advice with picking stocks or mutual funds at this time in the market. There are advisors who do that, and I would suggest avoiding them.
There are other advisors who are basically advising people on how to construct a portfolio of passive assets, mutual funds, ETFs or index funds that meet that person’s individual ability and willingness to take risks. And then tax managing it, rebalancing it, helping them with estate and tax planning issues, helping them decide on what mortgage to take out, and integrating that into a total plan, and then keeping them disciplined. That type of financial advisor, I think, can add a tremendous amount of value for most people.
John Spitzer: I would concur with that, and there are two parts to this managing your personal wealth. One is how you actually invest and manage those investments. And the other part is how much money you put in, and that’s the discipline of how much do I save?
Of the levers you have, actually, that second one is the biggest lever, in that you have the most control over it. I have some personal experience with friends who have struggled with that part of managing their own finances for figuring out how much money to put in and actually doing it. The key to their success was going to financial advisor to help them, sort of put in a third party there that casts some tie-breaking votes between the two parties of the couple, and that’s very good service that they can provide.
Larry Swedroe: I would add one other thing, Barney, just as an example. I think many investors are, again, over-confident of their skills. Just because you choose to be an indexer or passive investor, in terms of investing in those funds, does not mean that you will truly be a passive investor. An example I would suggest is, I would venture, I bet that most people who invested in index funds and built a safe, diversified portfolio, I wonder how many of them, for example, were rebalancing their portfolio in ’98 and ’99 to sell, say the S and P or the large-cap growth portion to buy real estate and emerging market and smaller value index funds, and also tax managing the portfolio to take advantage of tax losses there. And now, of course, you have to be doing the reverse.
The evidence is is very clear that investors chase yesterday’s returns, so more likely what they were doing in ’98 and ’99 was selling value in real estate, emerging markets and buying index funds, when in fact they should’ve been doing exactly the opposite.
Barney Sherman: So people tend to buy the things that have been hot and have gone up a lot. To buy high and sell low.
Larry Swedroe: What I call it is they tend to jump on the bandwagon and buy high, and then they abandon ship by selling losers and sell low. That’s called convex investing. What you want to become is a concave investor, where you buy yesterday’s losers low and sell yesterday’s winners high. I try to teach people that they should buy stocks like they buy socks—when they’re on sale, not the other way around.
Barney Sherman: I see. It’s gets complex. Now, one thing that’s implicit in what you said, Larry, is that if a person says, “Okay, I want to do this index fund, passive investing thing,” it isn’t just the S&P 500. There’s indexes for all kinds of different asset classes, and it sounds like, in your opinion, you should have a mix of many different ones.
Larry Swedroe: Well, I don’t believe that there is a “one” right asset allocation for everybody. A lot of it has to do with psychology, and then, of course, it depends upon your ability, willingness and need to take risks. But, in general, I recommend more broad diversification than an S and P 500 Index Fund or a total stock market fund would give you, for a variety of reasons which I describe in my book.
But what I suggest people start off with as a place to think about as a starting point for their portfolios—what I call the coward’s portfolio. And it contains five U.S. asset classes of large growth, large value, small small value and real estate, probably putting 70% of their equity in the U.S.—although there’s not magic to that particular number—and then do something similar including emerging markets in the international side with, say, 30% international and kind of equal weight them. And if you want or need higher returns and are willing to take more risks, own more value and own more small. If you want to be a more conservative investor, and also look more like the market, then own more S and P 500 or total stock market. But at least get some broad exposure to each of those asset classes.
And then very importantly, you should write and sign an investment policy statement, listing your allocations, prepare a rebalancing table that says, “If I’ve got 10% in the S and P 500, I will not let it drop, for example, to less than 7 ½ or let it get above 12 ½. If it gets there, then I will rebalance the portfolio. I call that a rebalancing table, and I think that’s an equally important part of the winning strategy.
Barney Sherman: So that way you sell your winners and buy the things that aren’t doing as well.
Larry Swedroe: It allows you to do that without
making any predictions at all. And what you have to do is avoid the noise
of the market. Stop watching CNBC, except as entertainment. Don’t read
Money magazine, unless you’re using it to tell you where to go on
vacation or what insurance to buy or what car to buy. But don’t listen
to their investment advice, because it’s highly likely to be dangerous
to your health—at least financial health.