William Bernstein has a message for fund investors: The interests of mutual fund companies are highly divergent from yours.
Well, Bernstein, a principal in investment-management firm Efficient Frontier Advisors and the proprietor of the
Efficient Frontier Web site, doesn't think all mutual fund firms are inherently bad. But plenty of firms, in his opinion, are far more interested in maximizing the fees they collect from you and peddling hot products you might want but certainly don't need. Bernstein takes on suspect fund firms, the so-called market expert's opinion and foolish investment advice in his 2002 book,
The Four Pillars of Investing
Bernstein is an index-fund devotee and a firm believer that proper asset allocation is the key to a happy and wealthy retirement. His opinions may not win the hearts of active-fund adherents, but investors should heed the heaps of great insights about investing contained in his information-packed but readable book. In today's
, Bernstein explained his investment philosophy -- why hunting for the next
is a fool's game; why today's best-performing funds often end up tomorrow's losers; and why costs matter.
1. In your book, you write that of the Four Pillars -- Theory, History, Psychology and Business -- investors have the most difficulty with Pillars One and Three, Theory and Psychology. What makes these two facets of the market so difficult for investors?
Well, theory is simply not easy. It's basically statistics. Individuals may have an intuitive grasp of addition, subtraction, multiplication and division, but no one is born with an intuitive grasp of statistics. It's very counterintuitive.
Furthermore, as Francis Bacon noted, people have a tendency to see order in patterns where there, in fact, are none. This is true of many investors who look for tried-and-true patterns in the market.
Psychology trips up investors because we're human beings. You're fighting human nature when you invest. Think about how we evolved. We came down from the trees and lived in a world where every minute our very lives where in danger. A good psychological inclination toward fight or flight, the here-and-now moment, was ingrained into us. That's how we respond to risk. That's exactly the wrong way to look at investing. In investing, the short term really doesn't matter. It's the long term that counts, but we're not programmed to think in the long run.
It goes back to Ben Graham's Mr. Market. You've got this manic-depressive guy who constantly offers to buy and sell shares from you at different prices. And if you become manic or depressed, the game's lost.
2. You mention that one of the quickest ways to get to the poorhouse is to make finding the next Microsoft your primary goal. Should individuals invest in individual stocks at all?
I do occasionally buy individual stocks, purely for my own amusement. Ten years ago, it used to be 5% to 10% of my portfolio; it's now closer to a half-percent.
Did you lose money on your stock investments?
Actually, the dirty little secret is I've done very well with individual stocks. However, I now make very small bets with very dry hands. I'm buying things that I find irresistibly cheap. I only buy about one stock a year. I don't put any significant portion of my portfolio in individuals stocks.
The reason you can't make a living buying one or even 10 stocks is because it's unsystematic risk -- risk above the broad market that you aren't compensated for. You can't put a significant portion of your nest egg in such concentrated holdings. Your chance for getting 20 clunkers is actually very good.
That's the problem with trying to find the next Microsoft among the small-growth stocks. You're basically buying a lottery ticket, and it's easy to get 100 losing lottery tickets in a row. That's why small growth is the worst-performing domestic equity asset class -- everybody is looking for the next Microsoft, so the prices of these small-growth stocks get bid up so hideously.
3. Let's talk about mutual funds. In the book, you write that the interest of most mutual fund companies is highly divergent from yours. Would you explain your sentiments to our readers?
The interest of the mutual fund company is to maximize assets so they can maximize the fees they collect. So they will pander to the investing public. If gold stocks are doing well this year, guess what, they'll advertise their gold funds -- no matter how poor the expected returns are.
The classic example is Internet funds three or four years ago. The public wanted an Internet fund. That's the difference between a
, which caters to public appetites, and a
. Some firms are marketing firms; others are investment firms.
4. You decry the practice of load funds, and you discuss the negative effects on returns extensively in your book. Would you elaborate on your findings?
The book demonstrates that you aren't getting less than nothing in return for the loads, or sales charges, that you pay for these funds.
The returns of load funds in the aggregate are lower -- 0.48% a year less on average. The reason is their expenses are higher. Almost all load funds also carry 12b-1 fees
an additional fee the
allows to pay for advertising. It's simple arithmetic, and those returns don't even take into account the load itself.
5. One of the most damning points you make about actively managed funds in the book is the chart from the indexing firms S&P and DFA that track "five-year winners" over the subsequent five years. What did you find?
The chart examines the 30 best-performing funds in any given five-year period going back 30 years. In the subsequent five-year periods, that group of 30 funds sometimes trailed the average fund, sometimes beat the average fund. But it always trailed the
There are at least three factors at work here. First, the performance of active mutual fund managers is random. People think there are patterns; people think that there is persistence -- there is no persistence, on a statistical basis. It's random.
Legg Mason Value Trust
manager Bill Miller is a very smart guy, but the fact still remains that on a coin-flipping basis, one of them is going to beat the S&P for 11 years running, as Miller has. It's the luck of the draw.
Second, when you buy a winner for the past five years, you're buying a hot asset class. Asset classes tend to revert. It's a losing strategy. You're buying the best-performing classes for the past five years, which tend to underperform for the next five years.
Number three, you've got asset bloat. It gets harder to reposition the portfolio. Returns are going to suffer. If you want to sell a billion dollars of
, you're going to take it in the shorts.
6. Let's talk about index fund investing. While you are an index fund adherent, you also mention that the S&P 500 has gotten "too popular." Would you discuss the potential pitfalls of investing in 500 index funds?
I don't want to put the S&P 500 down as a vehicle in someone's investment policy. I think it's a good proxy for large-cap U.S. stocks. I think it should be the core of most investors' portfolio.
The practical problem is that it's still the most overvalued of all the broad indexes.You're still getting a dividend yield of 1.6%, if you're lucky. That's not great.
The reason is, it's market-cap weighted. It becomes over-represented in terms of overvalued stocks.
Having said that, I'll refer to Jack Bogle, Vanguard's founder, who notes that you could point out all the flaws of a bumblebee, and say it shouldn't fly. But fly it does. (Laughs.) The S&P 500 over the past 15 years has still beaten the majority of actively managed funds.
7. You discuss the difference between investment firms and marketing firms in the fund world. Are there any active-management firms you do like?
First of all, there are the quasi-actively managed funds -- Vanguard and DFA. Vanguard's actively managed funds are good funds because they adhere to the low-expenses, low-turnover discipline.
There are other actively managed groups I admire:
has done a good job.
does an excellent job, but their expenses are a bit high.
T. Rowe Price
is a decent fund family. It comes down to corporate culture and ethics; all these firms have those.
And God save me, even the
American Funds Group
. They're a load-fund group, but they are low-key; they stick to their discipline; they are appropriately fiduciary.
Oh, I also think
is wonderful and I think
Chief Investment Officer Martin Leibowitz should be canonized.
8. Your long-term expectations for the market are below historical rates of return -- and certainly below what a lot of pension funds are expecting. Would you explain your outlook going forward? What do you make of the latest market rally?
I don't make anything of the latest market rally. I don't know, and no one knows.
As I see it, The long term is much more important than the short term. Six months to three years is irrelevant. How well you and I and your readers are going to do depends on what's going to happen over the next 30 years.
You can make an educated guess about that -- measure growth in dividends and earnings plus the dividend yield itself. Optimistically, that projects 3.5% real returns, after adjusting for inflation.
You're discussing large-cap stocks here, correct?
Yes, for large-cap. But the trouble for pensions is they can't go the Fama-French route because they're too big. Individuals can invest in small-cap stocks and emerging market stocks if they want to take that gamble and get higher returns. But pension plans are too big. Small investors might be able to get 5% real returns 30 years out if they diversify.
9. How can investors build a diversified portfolio that will put them in good stead for the next decade or so?
Overall, the person should decide four steps:
Number one: What are your risk-tolerance and return needs?
60 to 40 is a good place to start. Three years ago, people didn't know their risk tolerance. Now they do. (Laughs.) The one real advantage of a horrible bear market is learning this lesson. For a young person, this is a great experience you learned and you can buy all these stocks cheaper than you did three years ago.
Number two: You have to decide your domestic/foreign split.
I think 75% domestic-25% foreign is reasonable.
Number three: Decide whether you want a value bias or not?
Remember, you get higher rates of return with value over the long haul, but you also get higher tracking errors. You'll have longer periods of time, like the late-90s, when your Janus-investing, beer-swilling neighbor is going to be trouncing you.
That's an interesting connection to make -- beer and Janus.
(Laughs.) It's a more general way of saying the average Janus investor isn't as informed as the average Vanguard investor. I think it's safe to make that assumption.
Number four: What goes into sheltered and what goes into nonsheltered investments?
The new tax law just reinforces why tax-efficient assets like the S&P 500 or Vanguard's foreign stock index fund should all go in the taxable part of your portfolio. The sheltered part gets things that should be sheltered from taxes: REITs, junk bonds and most of your bonds, really.
10. What's the one most important thing investors need to learn -- the one thing you want to impart for folks who might not go out and read your book?
Costs matter. Index matters.