Earlier this week, I received a call from a college student who had started a successful business. His school, he said, doesn’t offer any practical courses in personal finance so he asked my advice on investing. We walked through the following key questions. I would offer this same advice to investors at any age.
Why should I expect stocks to go up? One way to answer this question would be to invoke the oft-quoted phrase that “history doesn’t repeat itself but it often rhymes.” Stocks have delivered roughly 10% returns per year since reliable recordkeeping began in the 1920s. You could extrapolate that long-term average into the future. But that still wouldn’t address why we should expect stock prices to rise.
To answer that question, the best resource is Stocks for the Long Run by Jeremy Siegel, a professor at the University of Pennsylvania. It includes a useful mix of market history and finance theory. If I were teaching an Investments 101 class, this is the book I would use.
Notably, Siegel was able to piece together market data going all the way back to 1802. His finding: Market returns in the 1800s weren’t all that different from our more recent experience. He goes on to explain why returns have been so consistent over time. In short, stock prices tend to follow corporate profits. When a company’s profits go up, its stock goes up, and vice versa. This, of course, isn’t true every day, but over long periods, stock prices do tend to mirror corporate profits.
Should investors have confidence that profits will continue to grow, as they have in the past? I think so–because the same set of economic principles that applied in 1800 and in 1900 still applies today. Companies are always working to develop new products, to expand the market for those products and to manufacture them more efficiently. Taken together, these three factors are the universal drivers of economic growth, and thus of stock prices.
Why is active management destined to underperform? In recent years, investors have been moving more of their investments from actively-managed mutual funds—that is, funds run by traditional stock-pickers—to index funds, which for the most part simply buy and hold a particular list of investments. That shift has been driven by a growing body of data showing that active managers, on average, underperform. But why is that? Is it because stock-pickers aren’t good at what they do?
In some cases, that is the explanation. But there is a more fundamental reason: cost. Actively-managed funds are, on average, much more expensive than their passively-managed peers. Of course, active managers will argue that cost isn’t the most important thing. Instead, they’ll argue, the only thing that matters is bottom-line performance. Indeed, if an active manager is able to beat his benchmark by more than his fee, then an investor in that fund would come out ahead.
That sounds logical. But William Sharpe, a professor at Stanford and a recipient of the Nobel Prize, dismantled that argument in a 1991 essay titled “The Arithmetic of Active Management.” The essay is short, which is good because it usually requires reading a few times to understand. But once you follow the logic, I think you’ll agree that Sharpe’s argument really is airtight. Active management is an uphill battle, at best.
What evidence is there that Sharpe was right about active management? Twice each year, Standard & Poor’s compiles a study called SPIVA, short for S&P Index vs. Active. They compare the performance of actively-managed funds in various categories to their respective benchmarks. The results confirm exactly what Sharpe postulated. For example, over the past 10 years, through the end of 2021, just 17% of large-cap stock funds were able to beat the S&P 500. It’s not even close. The results are similar in other categories. Another great resource is The Evidence-Based Investor.
If the only issue is cost, then can’t individual investors managing their own money beat the market? There is some logic to this. Unfortunately, cost isn’t the only factor. It turns out that picking stocks is just very difficult. Brad Barber and Terrance Odean, both professors at the University of California, have been studying this for decades. In 2000, they published “Trading Is Hazardous to Your Wealth,” which examined the connection between trading frequency and performance. In 2007, they published “All That Glitters,” which looked at the trap presented by popular stocks. In 2001, Odean looked at the Robinhood phenomenon. And most recently, he has been examining some of the paradoxes exhibited by the trading results of individual investors.
Lots of people have made money on Apple and Amazon and Google. Those companies were pretty obvious winners. Doesn’t that contradict Odean’s research? A paper titled “Selling Fast and Buying Slow,” published last year, helps explain the apparent contradiction. Investors actually do a good job spotting winners. The problem is on the other end. When it comes to selling, investors do a poor job–so poor, in fact, that it offsets the advantage gained in buying right.
What about people like Warren Buffett, Seth Klarman or James Simons? There’s no denying their success. Indeed, all of the data I’ve cited here should be taken with this caveat: This is what the data says, on average, for most people, most of the time. There are always exceptions.
If actively-managed funds underperform, and I shouldn’t pick stocks myself, then what about investing in a private fund? Major universities and pension funds often invest in private equity and hedge funds. That might lead an investor to conclude that these funds are the way to go–especially if traditional mutual funds have such a poor track record. This turns out not to be a great idea, for two reasons.
First, according to a study by McKinsey, there is broad dispersion among private funds–much broader than among traditional, publicly-traded funds. This means that it’s especially important to choose the very best from among the universe of private funds. But that presents a problem. If you or I were a billion-dollar endowment, the best funds would be happy to have us. But they’re not interested in everyday investors. They’re not even interested in everyday millionaires. Andy Rachleff, a founder of Benchmark Capital, explained this, in colorful terms, in an interview a while back.
The second reason private funds are a problem: Because they are more lightly regulated, private funds are fertile ground for unscrupulous operators. Everyone knows Madoff, but he has hardly been the only one. There was Jan Lewan, the “king of polka.” There was Elliot Smerling, who specialized in forgery. And there was Marcos Tamayo, the airport baggage handler. The list is long.
And those are just the more notable cases. According to the SEC, fee billing issues are widespread. In a speech, an SEC examiner had this to say: “When we have examined how fees and expenses are handled by advisers to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time.” Private funds are a minefield.
What about other “alternative” investments? So far this year, both stocks and bonds have declined. In an environment like this, you might wonder about alternatives to these standard building blocks. Gold, for example, has declined just 7% this year–much better than the 20% decline in the S&P 500. And a recent report by the research firm Morningstar indicates that certain types of alternative strategies have fared well over time, delivering low, or even negative, correlations to stocks.
Trouble is, these relationships are not stable. In 2018, when the market dropped 20% near the end of the year, Morningstar found that alternative investments were of little help. And further, correlation isn’t the only metric that matters. Indeed, cash has a theoretically attractive zero correlation to stocks. But its return is terrible. If you’re considering alternative investments, you need to consider both their diversification benefit and their potential contribution to returns. On that score, the data is not compelling.