Read Time: 12 Minutes
“Wall street people learn nothing and forget everything.” – Benjamin Graham
Let’s pretend that you’re the owner and general manager of a major league baseball team. Here’s the rules. If you’re in your twenties, then you have 40 to 50 years to run the team and try to win a world championship. A world championship is defined as saving and investing enough so that you can retire happily without worrying about your money running out. If you’re not in your twenties, then subtract your age from 65 and that’s how many years you have to win.
As a general manager, you have two to ways to fill out your roster.
- Pick all the best players yourself.
- Higher a VP of Scouting who does the work for you. There’s two very different types of VPs on the market.
- Jim Kramer: A high powered baseball guru. Although he’s very expensive, he comes highly recommended and promises results. If not he’ll throw chairs around.
- The Baseball Tron 5000: A simple computer program. The Baseball Tron 5000 doesn’t take into consideration a particular player’s strengths or weaknesses. Instead, it issues a contract with every player available and pays them all a small retainer to be on your team. However, because your team will be so large most of them can only play a few games for you. In that sense no single player will have a huge impact on your overall performance. The program is very inexpensive compared to Jim Kramer.
Let’s say you picked the “Do It Yourself” approach. I’m going to be honest with you, this is a dumb choice. First of all, you don’t know anything about baseball. You don’t know what an ERA or what an RBI means. When you make a trade for another player, you’re probably going to get screwed by more knowledgeable managers. All you know about baseball is that after watching a few games, it’s exciting to see somebody step up to the plate and crack a homerun.
So you know you need a homerun hitter. But he needs to last 40 years. Ideally, you’d like him to hit 60 home runs every year but you know that would be impossible. In some seasons he might be so bad that you want to fire him. If he does, you’ll have lost a huge amount of your capital. That’s a lot of risk to take on a single player.
“What the hell,” you say to yourself. You’re young and you have to be aggressive. You subscribe to Baseball America, which has identified 10 players who did really well last year. You decide to make a substantial investment, 20% of your capital in a couple of these hotshots. It’s risky, but they come highly recommended! The next year, your guys start off good but fall into a slump. Now you have a problem. You’re debating whether or not if you should trade them and take the loss or wait and hope they improve. As you’re debating this, a new copy of Baseball America arrives. It’s touting 10 completely new “Must Own” players. They’re gonna kill it!
In investing, picking a single stock or even a couple of stocks that you think will kill it is like trying to identify a top slugger. There are many great players who do better than expected, but do you really trust YOUR ability to pick the best players when most professionals GM’s can’t do it? You might get lucky and find a Cal Ripken who returns above average results for a long time. But for every unidentified consistent winner, there’s a Sammy Sosa, an overpriced stock everybody loves in the short term. In the long run, these stocks probably won’t be giving you above average returns every year. They’ll return to the mean unless their really special. But even if they are special, you won’t know when they’ll slump or when they’re about to take off, so any investment that depends on when you buy/sell rather than buy/hold will depend on a healthy does of luck.
After learning more about baseball, you realize that it’s a bad idea to concentrate your capital into only a few players. Instead, you realize you need infielders, outfielders, and pitchers. Most people never learn the lesson you just learned. They try to find as much offensive one hit wonders as possible and forget about defense. They load they’re portolio with 5-10 stocks and think they’re “diversified.”
You carefully avoid that trap by filling out 10% of your roster with pitchers who do well when hitters struggle. For a small price, bonds will offset your risk to equities. This is the basic meaning of “hedging,” before hedge funds made the word a catchall for exotic investing.
You can also diversify your offensive. You not only buy U.S players, but also players from China, Costa Rica, Japan and Europe. In investing, this means having pieces of small, medium, and large companies which are both domestic and international. The key takeaway is that after you are diversified, if one sector goes down, it doesn’t drag your entire portfolio with it.
Let’s forget about picking our own players and go back to the second option. You hire a VP of Scouting. The way the VP of scouting does his job is by buying you small shares of every single player available so that you can create a farm system. No single player will have a great impact on your team, but if they all do well, you win. Statistically speaking players get better with time. You can get all these players through a Jim Kramer, who actively manages finding new players, or through the Baseball Tron 5000.
Out of your two VP’s who does a better after 40 years? Is it Jim Kramer, the bald but brilliant, chair throwing, temper tantrum guru? Or is it the silent and emotionless Baseball Tron 5000?
As it turns out, the Baseball Tron 5000 is the winner. That shouldn’t really surprise you if you’ve learned your lesson from trying to pick your own players. The Jim Kramers of the world, the actively managed mutual funds, have numerous fees and expenses that will cut into your profits. Because of these fees, almost all of them fail to beat the market. It would require somebody with an extraordinary amount of skill and information to succeed. Secondly, even though a few of these guys exist, (e.x. Peter Lynch, Warren Buffett) LIKE STOCKS, YOU WILL NOT BE ABLE TO IDENTIFY TOP MANAGERS UNTIL AFTER THEY HAVE SUCCEEDED.
On the other hand, the Baseball Tron 5000 is both cheap and effective. What it lacks in marketing it makes up for in performance. Since we know that as a whole, stocks do better over time than other investments, we know we need to be in the market. But we want to reduce our exposure to egregious fees and unnecessary risks. The best way to do this is by buying the entire market. Passively managed index funds do this for a very cheap price.
Vanguard and Fidelity are two of the most trusted name in the industry as far as passively managed no load funds go. Vanguard’s fees are usually around 0.19%. Fidelity’s Spartan Funds, are even cheaper with a 0.10% fee. They have no other fees or restrictions. Compare these prices to an actively managed fund’s fees of 2.0%. Over time and through the power of compound interest, that’s a HUGE difference. It could mean that you lose nearly 50% of your gains over time if you pick an active fund over a passive fund.
If you want something that you basically “set and forget,” take the time to look into a lifecycle fund. These funds work the same way as an index fund, except that they change their mix of stocks and bonds on their own as you age. If you want diversification and proper asset allocation (which you do!), these funds do it by themselves, although they aren’t perfect.
For example, be wary of the overpriced lifecycle funds that have fees around 0.70% which will cost you quite a bit of money in the long run. Also, make sure that whatever fund you do buy doesn’t concentrate all in one type of sector. There’s so many exotic sector index funds that it basically beats the purpose of indexing if you buy into them. Like any investment, these funds are not guaranteed. They just have less risk and upkeep compared to other ways to investing in the market.
Before you go dumping your 401(k) into one of these funds, make sure that the retirement date matches up to your age. If you’re fifty-five DO NOT buy into a target retirement fund set for 2050. You don’t want to see your entire savings reduced by 40% in one year if you’re just about to retire.
Also, don’t just plunk all your money down at once. That’s like spending all your capital to lock down contracts for every player in one season. It would be much smarter to have capital on hand so that you can renegotiate contracts the next season when prices change. In investing, you do this via dollar cost averaging to deal with the tyranny of the market.
Checkout the 22 year chart below for why you should dollar cost average into the market. It also shows the results between two of the more popular and “successful” actively managed mutual funds versus the Vanguard total market 500.
Here’s the main takeaway from this chart. You’re just gambling if you try to time the market rather than dollar cost average. The past won’t predict the future so the best way to invest is to do it a little bit at a time, over a long period of time.
Extra Credit Reading:
Bloomberg Story: Magellan Shows Peril of Active-Managed Stock Funds as Fees Bite
