“[L]ast week’s stomach-turning ride on the stock market — including the first time in the 115-year history of the Dow Jones Industrial Average that it moved more than 400 points for four consecutive days — was more like a terror ride on an out-of-control Big Dipper.” (Gregory Zuckerman, “Market Madness: What Happened, What’s Next“, Wall Street Journal, August 14th, 2011)
This quote, from the Money section of today’s Wall Street Journal on-line, typifies the reporting on market fluctuations during the past couple of weeks. There seems to be no limit to the superlatives to boost viewership and readership for the financial media. Unfortunately, the combination of market gyrations and the reporting of those ups and downs may, according to a study published in this month’s Journal of Finance, be part of a self-fulfilling prophesy. The authors, Thierry Foucault, David Sraer and David J. Thesmar describe, in “Individual Investors and Volatility,” how individual investor trading in stocks may in fact contribute to market volatility. In their study, which they caution was limited in scope, with conclusions that therefore should be taken with myriad caveats, they find that “…retail trading contributes to about 23% of the volatility of stock returns…” (p.1372, Vol.66, No.4, Journal of Finance, August 2011)
The suggestion of studies such as these—caveats notwithstanding–is that, as we observe market fluctuations driven by macroeconomic factors such as economic growth (or lack thereof), insipid political debates that test the boundaries of our faith in the credit of the U.S., and the guessing game in Europe as to which of the big banks there is next to fall victim to its own risk-taking, and bring the European Union to the brink, we in turn chip in and increase market volatility by trading in and out of our stocks and funds. The increased volatility resulting from these macro- and micro-economic forces offers traders the opportunity to buy and sell at prices attractive to them based on their models, which drives further share-price volatility. The process is as unending as it is unpredictable, and despite what your broker tells you, it is infinitely unpredictable.
Most troubling about the potential that our wounds may be in part self-inflicted, as suggested by Foucault, Sraer and Thesmar’s article is that our track record in calling the ups and downs of the markets is questionable at best. In his 2011 book, Don’t Count On It!, John Bogle, the founder of Vanguard, now the largest mutual fund company, demonstrates the degree to which we reduce our long-term returns by trying to time the market and pick the next winners. On page 332, pointing to twenty five years of mutual fund data (a topic about which he knows a thing or two), he offers the sobering conclusion:
“Begin with the fact that during the 25-year period 1980-2005, when the S&P 500 index rose at a 12.3 percent annual rate, the return of the average fund averaged 10.0 percent annually…but the returns actually earned by their shareholders—was just 2.4 percent, only 25 percent of the annual return reported by the fund[s] themselves.”
Set aside for another time the reasons why the average fund falls short of the market—more puzzling, perhaps – why an estimated 100 million investors pay active mutual fund managers to, as a group, underperform the market long-term, and set aside the investment math involved in making the distinction between the statutorily required time-weighted returns reported by mutual funds and the dollar-weighted returns reflecting our personal returns. Further still, set aside for the moment the fact that the return of 2.4 percent per year mentioned is before taxes and inflation. Focus instead on the fact that our attempts to time the market and pick the next winning mutual fund yields for us, as a group, just 25% of the annual return offered by the funds in which we invest long-term. And that is if we are prudent enough to stay clear of individual stocks and instead buy mutual funds.
As mentioned in last week’s message, I have found, through my own experience investing over the past dozen years, after having read much of what John Bogle—among others of the “fight for the little guy ilk”—had written, limited tools by which the ordinary investor can survive the markets long-term and secure our own financial future. The fundamental tool is the index fund, a staple of the institutional investor and portfolio manager. Over the years we have built our own “pension-fund”-like portfolio, and this week our approach was put to the test.
As the markets gyrated, we stuck to our discipline, exchanging, on down-days, from our fixed-income holdings to our equity funds, only those amounts that enabled us to maintain our long-term target asset allocation. No trading. No speculating. By ensuring that we maintain our pre-set exposure to the market, we end up buying as shares are falling and selling as shares are rising. Indeed, the fixed-income shares we are selling are rising; in fact, the sole cost of our rebalancing (we pay no fees to Vanguard for our exchanges, and our expense ratio of 0.14% is below the Vanguard average, which in turn is lower than the industry average by an estimated factor of six) is the small amount of capital gains tax we will owe for exchanging out of our municipal bond funds (which the experts were predicting – wrongly — would collapse while we were rebalancing toward them).
The results of this approach over the past ten years have been rewarding to say the least. Year-to-date, the market, as measured by the S&P 500 Index, including dividends, is down 5.1%. Our portfolio, over the same period, is up 0.7%. While the year-to-date measure is too short-term to enable us to shut off the lights and move to Ravello, Italy (where we honeymooned), the fact that our portfolio is up on a 5-year basis by an amount that exceeds the market’s increase over that time period (through July 31), while taking less than half the market risk, is a source of comfort as we sleep each night in the “city that never sleeps.”
Fearing that my attempts to relate current events to relics of history such as the trial and death of Socrates will leave you convinced that I have “lost it,” I thought I would close this week with something a bit more contemporary. In his 2,700+ year-old epic, The Odyssey, Homer describes the method by which Odysseus manages to navigate his crew past the Sirens, upon whose rocky shores every prior ship had met its fate, in pursuit of those maiden’s enticements. In Book 12: The Cattle of the Sun (as translated by Robert Fagles, Penguin Books, 1996, p.276), Odysseus, having been warned by reliable sources about the fatal attraction of the Sirens, has his crew tie him the mast of his ship, and instructs them to ignore his pleas while passing the singing Sirens, to approach them. Before he climbs the mast, though, he hedges the risk of their own impulses by doing the following:
“Now with a sharp sword I sliced an ample wheel of beeswax
down into pieces, kneaded them in my two strong hands
and the wax soon grew soft, worked by my strength
and Helios’ burning rays, the sun at high noon,
and I stopped the ears of my comrades one by one.”
My wish for you—my wish for us—is that we enjoy the peace of mind of “an ample wheel of beeswax” during times like these. Such determination and will is among the few means by which we can navigate past the rocky—and potentially devastating—shores of the Sirens singing their entreaties to us each day.