Author: A.T.

Sorry Greg. If you could beat the market in two hours a day, why wouldn’t the mutual fund managers who spend ALL day on it be able to? [February 4, 1999]

Tom Williams puts it this way: “I wonder if the answer to the question you posed to Greg is that because the mutual fund managers have lots of money invested in a lot of different stocks, they are more subject to the law of averages than the little guy who can target fewer stocks. No doubt the average single investor doesn’t beat the market, but it’s probably true that a few do much better than the market while others do much worse. Which is what everyone has known all along: if you are willing to take more risk, you MIGHT make more money. And Greg might to. He just needs to understand that there is also a good chance that he won’t.”

Yes. And this actually breaks into two questions.

The first is purely about risk. For example, in the short run, stocks are riskier than savings accounts. But if you take more short-run risk, you are very likely — even if you’re just an average Jane or Joe — to do better over the long run than if you had played it safer. (Warning: Not everyone . . . indeed relatively few . . . can afford the long run. If you have a car loan and credit card balances, etc., you should not be in the market. It’s only with money you won’t need to touch for many years even if the roof needs to be replaced that you can invest for the long term.) So, yes: prudent risk — risk thoughtfully and soberly assessed and accepted — yields rewards. (Taking risk-for-risk’s sake, by contrast, can pay off — people do win the lottery — but is generally dumb. You are paying for a thrill, not investing.)

And it’s not magic. One way to look at it is that the market pays you to take risk. Another is that, with stocks, you are investing in actively managed wealth-producing enterprises that, taken as a whole, over the long run, will likely grow and prosper. So it just makes sense that owning a piece of them would do better for you than keeping your money in a savings account. (Or look at it this way. The money you put in the bank or a bond you are, in effect, lending to company that’s pretty sure it can earn a higher return on it — or else why would it be paying you this interest to borrow this money in the first place? So you can lend it at a low rate, or buy a piece of the business, or the bank, that thinks it can earn a higher rate, a little sliver of which, in theory at least, as a tiny co-owner of the business, will be yours.)

One more warning here: With the Dow at nearly 14,000 (yes! I’ll explain tomorrow), there may be more risk in the market and less potential reward, than usual. Risk really does have its ugly side. Look at the investors in Russian stocks in 1916. Or Japanese stocks in 1989. Or Trump Hotels, symbol DJT, the Donald’s initials, at 35 (it’s 4 today).

But the second question is, for any given amount of risk, can you consistently do better than others taking the same level of risk? I.e., if you and someone else both choose the stock market . . . and if, what’s more, you both choose a handful of fairly risky stocks . . . one of you may do much better than the other this year. But is it because one of you was smarter? Or is it, rather, because one of you was luckier? Surely at the roulette table or the slot machines, we credit success mostly or entirely to luck. We don’t assume that the fellow who left the roulette table a winner last night will likely leave it a winner tonight. Yet we do tend to assume that last year’s outstanding stock-market performers will be among next years as well. A little of that assumption is sometimes justified. But not nearly as much as we instinctively think.

Tomorrow: Dow 14,000.

Sorry Greg. If you could beat the market in two hours a day, why wouldn’t the mutual fund managers who spend ALL day on it be able to? [February 4, 1999]

Mike Fitzgerald: “This comment from an investment guy? That would mean you shouldn’t be picking stocks, which I know you do. Seems like I’ve read that 80%-90% of the mutual funds underperform the market (let’s say the S&P 500). Given that, I think the odds are very good on beating the market – even in the long run.”

No, the odds of beating the mutual funds are fairly good — especially those that charge the highest loads and fees. But the odds of beating the index funds, which have almost no drag from sales fees and annual expense charges, are not good. For more on this, see February 9.

“The reason the mutual fund managers have such a hard time beating the market [Mike continues] is that they have such huge amounts of money to invest that they in essence become the market.”

Well, there’s a lot of truth to that. But that would more or less just put them even with the market, not behind it. And there are lots of funds with “only” a few billion to invest — and these days, you could easily spread a few billion over just a handful of stocks if you wanted to, albeit the larger ones. It’s the sales and expense fees that pull mutual fund performance down below the market.

“But for us small guys all we need to do is latch onto a couple of extraordinary stocks during our life time and hold for a decent amount of time. If you would have invested a few thousand dollars in Microsoft, Cisco, Amazon, Dell, AOL, etc. at the right time you would be rich in a few years. Yes, you have to be willing to take the risk, but that’s what it’s all about. The risk in investing in a mutual fund is also high (below average returns), so why not try to beat the market? And you don’t have to be a genius and spend all of your time doing so and you don’t have to be stupid either (risking it all on penny stocks). Anyway, I’ll continue to try to beat the pros and I’m confident I will.”

And I hope you do. What are tomorrow’s Microsofts/AOLs/Ciscos? Let us know your list and your reasons for choosing them. The floor is yours.

(But remember, “the market” includes today’s huge winners — indeed, the names you mention account for a huge portion of “the market’s” recent sizzling performance. So “the market” has owned those winners along with the rest, and benefited from them. To beat the market, you need not only be smart enough to own some of the future winners, but to own a disproportionate share of the future winners, and be underweighted with those that fail to pan out. That’s the part of the trick few manage to pull off over the long run. But some do, and you could be one of them.)

Tomorrow, more thoughts on the same theme.

Coming soon: Why These Stupid One-Cent Stamps?

From Paul Langley: “I just wanted to agree with today’s anti-rant. Since you mentioned booksamillion.com a while back, I have ordered from them several times and saved an additional $50 so far in one month over what I would have saved at Barnes & Noble on-line or Amazon.com. (I buy and read a lot of books!) I have no complaints. My last order of 29 books, included some books that were readily available within 24 hours and some more obscure books that were available in 2 to 3 days and/or one week. About a week after my order, 28 of the books were shipped out and I got an e-mail saying that the other one (a remaindered $4 hardcover of a recent Oprah pick) was unavailable. The books arrived (via UPS) about 6 days later in perfect condition. Booksamillion is terrific as far as I’m concerned. However I’ve no doubt that your other reader had problems with them because I’ve had similar problems (worse problems actually) with Music Boulevard — yet all of my friends who use them seem to have no problems with them at all. So go figure.”

In other words, anecdotal evidence ain’t worth much — but Paul did save $50 (and far more than that versus the old-fashioned way, walking through an actual store).

Note that, as mentioned February 5, Paul might have saved even more with www.buy.com.

Tomorrow: Fish-and-Chips So Good We’ll Pay You $1.09 to Eat Them

If you read yesterday’s long column, it may well have left you with this question: Well, what if everybody threw up his hands and decided he couldn’t beat the market and so stopped trying?

The short answer is: it won’t happen, so forget about it. The only slightly longer answer is: well, if that happened, then you could beat the market. In markets that are not efficient — where people are not trying hard to evaluate products and prospects and managements and competitors and regulatory climate and everything else — some companies will be foolishly overvalued and others, foolishly undervalued. (And with hindsight, it will always be clear which group was which.)

I doubt this will ever happen with shares of, say, IBM or Intel — not to say that the crowd of money managers can’t get unreasoningly carried away with even these big stocks in a mass euphoria or panic. But market inefficiencies are more likely to occur in the backwaters, and perhaps in those parts of the market dominated less by sharp-pencil MBAs with their spreadsheets and discounted-cash-flow models than by guys (why is it almost entirely guys? And did you know guys have been documented to do worse at investing than gals, basically because they have more confidence in their ability and thus trade more, racking up more transaction costs?) looking for the next hot one on Internet chat boards.

So, yes, if the entire world simply bought index funds, then you could easily beat the market by investing only in the undervalued stocks and eventually getting rich off their increasing profits and dividends, bought for a song. Better still, perhaps, by shorting the ones you could see were headed for bankruptcy. (Presumably, in bankruptcy, or surely in complete liquidation, the stocks would be eliminated from the index and thus decline in price, suddenly, to zero.) But even when there’s little real chance of beating the market consistently, most investors try (either themselves, or through actively managed mutual funds). So imagine how much harder and eagerly they’d try if a normal bright guy with two hours a day to spare really could expect meaningfully to beat the market! And there you’d be again: millions of people making their best judgments trying to predict the future prospects of companies and earnings and stock prices, and a more or less efficient market that “knows” everything there is to know and that is, thus, hard to beat.

Well, judging from your responses, I seem to have started something with this February 4 comment:

Beating the Market in Two Hours a Day
“I picked up your revised investment guide book. I have to say though that I was a little depressed to read again that you believe that one can’t beat the market over the long haul. I hope that you are talking to the average Joe that spends maybe an hour or two per month thinking about this sort of thing rather than someone like me who spends a couple of hours a day on the subject. If not, then I guess my retirement is a lot farther off than I had hoped (I’m 24).”-Greg King

Sorry Greg. If you could beat the market in two hours a day, why wouldn’t the mutual fund managers who spend ALL day on it be able to?

Joshua Rasiel responds: “Don’t those managers have quotas, and guidelines and official goals and a prospecus that they must follow? Can a mutual fund decide, on a day’s research, to sell everything and go long on Apple? I did. Actually, I’m losing on that one. But I’m going to stick it out a while longer. The point is, mutual funds are not very flexible, are they? And let’s not forget all those overweight jockeys.”

Well, I agree with that latter part about the overweight jockeys.

For those of you new to this space, this refers to the handicap your investment horse has if dragged down by a 100-pound or 150-pound or even 200-pound jockey (a 1% or 1.5% or even 2% annual expense charge on your mutual fund). It’s those jockeys that cause 80% of the funds to trail the dumb old index fund nags, whose managers make no attempt to beat the market at all. They just buy the entire index to mirror it. For this simple chore the annual fee is two-tenths of one percent — a 20-pound jockey.

So Greg wonders whether he can’t “beat the market over the long haul” – which means beating the index funds, with their 20-pound jockeys — and Joshua wonders whether a horse with no jockey at all (well, he’ll be the jockey, but work for free) can’t do better still.

And the answer is . . . well, no. Not often, anyway.

In the first place, actively trying to beat the market, as Joshua is when he sells everything to buy Apple, implies a fair amount of buying and selling. Selling implies taxes. So even though you knock that final 20 pounds off your horse by doing it yourself, you may still have a structural handicap: index funds are tax-efficient. They rarely sell, and thus normally expose you to only modest taxes.

Yes, Joshua and Greg are right, in my view, that they have a reasonable chance of doing a little better than the actively managed funds. If an actively managed fund earns 9% after its 1.5% fees, they might do 10.5%. And that’s nothing to sneeze at. But that extra return comes not from wise stock picking, but from saving the fee.

So why not just use index funds?

Two reasons.

First: it’s no fun. I’m not kidding. That’s why I don’t use them. I do-it-myself because it’s just so darn interesting and stimulating and exciting, and because on some level I think that with all my smarts and experience I really can beat the market. And sometimes I do great (the result of brilliance and insight) and sometimes I do rotten (the result of bad luck or management’s dirty dealing) and when it’s all evened out, I would probably have done better in index funds.

Second, you get to control the tax consequences. (Well you get to control everything. And control is a word many of us know well . . . control, control, control . . . but that goes back to Reason #1.) An index fund is tax-efficient, but it doesn’t give you the flexibility to take specific losses on one or two disasters (up to $3,000 of which serve to lower your taxable ordinary income each year) while letting your profits in the others run. It doesn’t let give your big winners to Alma Mater instead of cash for your 25th reunion gift. (Cash is good, but appreciated securities — stocks that have gone way up that you’ve held more than a year — are the way to make large gifts.)

So there is a case for doing it yourself, now that brokerage commissions at deep discounters are all but trivial. (Note to younger readers: for all of recorded time, until about yesterday, it used to cost the Little Guy a fortune in commissions to buy or sell stocks.) But it is not that you’ll outsmart the pros.

Joshua continues: “I may be down right now, but since I started investing last summer, my portfolio is up about 25%, and during that period, the Dow has flim-flammed all over the place. In fact, I bought very close to the July high, just before the huge correction. And I was still able to profit, because I traded a lot, as I thought neccesary. Not all my trades were profitable. But apparently enough of them were, because I came out ahead. I did lots of research and made as logical a decision as I could on my orders, and I am pretty sure that at least for me, sitting back and letting an index fund make me a reasonable profit would have been unacceptable. That’s why I hate the Motley Fool’s Dow dogs approach. It’s good maybe for someone who wants to invest their cash and forget about it for a year. But if you can spare just a little time to learn a thing or two about the market, you could do so much better! How people can sit around and watch their stocks go down when there are far better stocks in which they could be invested, is beyond me. I can’t do it. If my stock is not performing up to my standards, it’s gone! I’ll find a better one and make my money back, and then I’ll make some more!”

That’s the spirit!

But unfortunately, the markets don’t work that way. In the first place, again, there are the taxes. People have calculated that if Warren Buffett, world’s second richest man, had turned over his portfolio once a year instead of patiently buying and holding — and something tells me Joshua turns over his portfolio even more aggressively — the poor fellow would have had barely 12% the fortune he has today. Compound $1 for 34 years at 26% and it grows to $2,585. Clip 30% off that 26% rate for taxes, bringing it down to 18%, and the same dollar grows to $278.

(In addition to taxes, there are the commissions — trivial but not zero. And there are the spreads. If a stock is 12-1/4 bid, 12-3/8 asked, there is a 1/8-of-a-point “spread.” You get clipped for $125 each time you buy-and-then-sell 1,000 shares.)

And in the second place, the markets are relatively “efficient.” At any given time, so this argument goes, all the available information is “in” the market. Yes, there will be some idiots buying and selling brainlessly, but they more or less cancel each other out (goes the theory). So only if you truly know something important that no one else does — only if, that is, you possess inside information and are willing to risk prison to trade on it — can you beat the market.

This is called the “random walk” theory of price movements, and I commend you to Burton Malkiel’s classic book, A Random Walk Down Wall Street. I don’t totally buy the theory — and neither does Malkiel. He describes himself as “a random walker with a crutch.”

But I believe, as he does, that it’s largely true.

Joshua concludes: “You probably think I must be one arrogant guy.”

No, you sound like a terrific guy. But young, and I don’t want to see you get burned. Or addicted. “A couple of hours a day” is a lot of your life. Are you sure this is how you want to spend it? The answer need not necessarily be “no.” But the question should be asked.

Tomorrow: One final point on this topic.

I think I have solved the Y2K problem, at least in part.

Like most of my clever ideas, this one came from one of you. I would attribute it, but it just came in passing a while back and I only recently realized its value. (So thanks, whoever you were.)

Namely, we get a day’s warning. That is, we should have some sense nearly a full day before the stroke of midnight December 31 just what we might be up against. Because, as you know, it is already tomorrow in Australia. So if the CNN correspondents I expect to be swarming Australia for this very reason show you pictures of the lights on in Sidney . . . and if you can reach your old pal in Melbourne by phone (or the new e-pals you might make for this purpose) . . . then at least you’ll know that the fundamental life-and-civilization-sustaining force — electricity — is likely to be with you on New Year’s day, 2000, in America.

Not for certain, I suppose, and not to the exclusion of all other potential problems. But this is the key one – electricity. And Australia (and Asia) will give us at least a little warning.

Just what to do with that warning if you live in a be-icicled Chicago high-rise I’m not certain. In my own case, I plan to be no more than a tank or two of gas away from warmth. If there’s no answer from Down Under, Charles and I will be heading south on Interstate 95.

But my hunch – or maybe it’s just my native optimism – is that Australians will find their New Year’s Eve boisterous but uneventful, as will we a day later.

I’m very happy to report that you have stuck with this column through the address change. Without you, I’d be making all kinds of reckless and inaccurate pronouncements without benefit of your correction. For example:

DELL’S MARKET CAP

Harold J. Ries: “Since when is Dell the first company to be worth 100 billion and have a PE of 100? How about Cisco Systems?”

Oops! I could hardly have been more wrong on this one – CSCO’s market cap is $175 billion and its p/e, 119P.

And even when I’m not out-and-out wrong, you frequently go me one better. For example:

BUY.COM

From my pal Jim Halperin (author of The Truth Machine and The First Immortal): “Overall, the best deal I’ve found on books and videos is at www.buy.com. Their prices are guaranteed lowest (they use spiders to check out competitors prices, and automatically beat the lowest), the site is fast, convenient and intuitive, all their acknowledgement systems seem to work fine, and their shipping charges, at least on large orders, are much lower than Amazon’s. I believe they actually sell most of their products at cost, and hope to make a profit selling ads on the site. Disadvantages: buy.com may take a day or two longer to deliver some products, their selection isn’t as all-inclusive, and of course there is a lot less information on the product. I believe Amazon is still the best shopping ‘experience’ on the Web, but if you spend a LOT of money on books, tapes and/or, I assume, software, computer stuff, games and music, and know what you want, buy.com absolutely the best deal out there.”

Boy, is Jim right. (Annoyingly, Jim is almost always right.) I just went and bought 10 copies of each of two of my own books (somebody’s got to) and buy.com charged $239.40 plus $7.43 shipping. Total: $246.83. Then I went and priced the same thing at Amazon: $301.30. So I saved $54.47 or 18%. On a single book, of course, the saving would be small, and I agree with Jim that Amazon does a terrific job. But I’ve added www.buy.com to my “Favorite Links.”

And then there’s the joy of your great questions (examples of which I will leave to future columns) and your occasionally wack-o ideas. For example:

THE PERSONAL IPO

From Russell Turpin: “Have you thought about creating an IPO for yourself as a ‘very popular Internet content provider’?”

Hmm. Well, I have no earnings and there’s a “dot com” at the end of my name. Maybe this isn’t so wack-o after all. (You read the Skewpoint spoof of Sea.net? An old Scottish company that makes fishing nets . . . four old guys sitting around sewing these things . . . whose stock is now worth a $2.5 billion? Skewpoint — at www.bobsfridge.com — did it better, but that was the idea.)

So I’m very pleased you are still here. Me, too. Monday: a (partial) Y2K solution.

“I picked up your revised investment guide book. I have to say though that I was a little depressed to read again that you believe that one can’t beat the market over the long haul. I hope that you are talking to the average Joe that spends maybe an hour or two per month thinking about this sort of thing rather than someone like me who spends a couple of hours a day on the subject. If not, then I guess my retirement is a lot farther off than I had hoped (I’m 24).” — Greg King

Sorry Greg. If you could beat the market in two hours a day, why wouldn’t the mutual fund managers who spend ALL day on it be able to?

#

THANKSAMILLION

From Ralphe: “This is an anti-rant. Since your article, I have used www.booksamillion.com a number of times with GREAT results. Not only have I saved lots of money, but (almost) every time they have shipped an order, UPS has sent an email with the tracking code. Since I live in a city and have my mail delivered to a commercial mailbox, I never have trouble with delivery. The only problem — booksamillion keeps including these mouse pads with the order.”

Writes a pal frustrated by logic:

“Dell is the first company in history to be worth over $100 billion and have a 100+ PE.
Is there no end in sight? Will Dell be worth more than GE and MSFT combined?????”

Maybe not, but if you click on my SCALE, you will see that — as of this writing, anyway (Tuesday morning) — Dell is now worth more than General Motors, Ford and United Airlines combined.

I’m told one reason for Dell’s latest surge is that it may split its stock. As faithful reader Wayne Arczynski explains, with respect to another high flyer:

“Microsoft announced a 2 for 1 stock split, Oh boy! Oh boy!!! I get 2 nickels for every dime… Yay!!!!! What I like best is that my stock surges on the news. I’d like to talk more, but I’m heading down to the bank to change a fifty. Normally I’d just get a couple 20’s and a 10, but today I feel rich — 10 five’s for this kid. What’s great is that even my five’s are divisible. Is this a great country or what?”

It is a great country indeed. Maybe we should split it.