The New Coffeehouse Investor

I’ve had a few bad report cards in my life, including the one I got from Sister Lucida after telling her that I didn’t get much out of her religion class. But I have to say, in my eight years of attending Guardian Angel School, I never had a report card quite as ugly as the report cards of mutual fund managers.

If these report cards were handed out by Sister Lucida, I suspect most mutual fund managers would be stuck in eighth grade.

Investors who decide to invest their hard-earned money with these underperforming stock-picking experts are destined to underperform the stock market average with them.

It’s that simple—and this costly.

The following table shows how much underperforming the stock market average costs someone who invests $500 a month over a thirty-year period.

Not surprisingly, mutual fund managers go to great lengths to hide these bad report cards by drawing our attention away from them and directing it toward performance numbers that have nothing to do with our long-term investment success:

I’M NUMBER ONE!

(for the last three weeks)

I’M NUMBER ONE!

(for risk-adjusted, large-cap mutual funds that begin with the letter x)

I’M NUMBER ONE!

(for Euro-Pacific biotechnology cat food funds)

I’M NUMBER ONE!

(at missing four-foot putts)

Unfortunately, as the report cards reveal, there aren’t too many mutual funds that are number one at consistently beating the stock market average.

This phenomenon of underperformance by mutual fund managers is difficult for many investors to accept because many of us have come to depend on experts in many areas of our lives, including our stock market investments, and the thought that professional stock pickers could collectively do such a lousy job is hard for many investors to comprehend.

For instance, Dale, my dentist, is an expert at taking care of my teeth.

Greg, my mechanic, is an expert at taking care of my car.

Fred, my doctor, is an expert at keeping me healthy.

In a society that finds comfort in experts, it is only natural to want a “stock-picking expert” to pick stocks for us, because investing is a very serious thing, especially when the quality of our retirement depends on it.

I can assure you, if Dale, my dentist, Greg, my mechanic, or Fred, my doctor, had a report card as bad as mutual fund managers’ I would be in the market for a new dentist, mechanic, and doctor; and so would you.

With all due respect to mutual fund managers, who try their hardest and do a very good job at hiding bad report cards, I know of no other industry in which so many self-proclaimed experts try so hard to convince us that they are wildly successful at that at which they so miserably fail—outperforming the stock market average.

The problem is that Wall Street is so successful at drawing our attention away from bad report cards that most investors have come to accept this mediocrity, oblivious to any alternatives.

Guess what. There is an alternative.

Most of you have probably heard of it by now: approximating the stock market average; that is, coming as close to equaling it as possible.

One way to do this is to invest in a stock index mutual fund. As many of you already know, a stock index fund is simply an unmanaged mutual fund that owns a piece of all the companies of a particular stock market index. The good companies and the not-so-good companies combined.

What a brilliant, ingenious, commonsense idea—which I can’t take credit for but can religiously pass along to those of you who want to unclutter your financial lives and own a sophisticated portfolio. And boy, wouldn’t Sister Lucida be proud of me for finally doing something a little religious.

Before we go further, let’s discuss the difference between stocks and mutual funds. (It never hurts to review what you probably already know, so here we go.)

When you invest in a common stock, you become part owner in that company. When you invest in a mutual fund, you indirectly own common stock in many companies. These stocks are all bundled together in one investment called a mutual fund. Managed mutual funds have a person or group of people who call themselves mutual fund managers. Mutual fund managers spend all day trying to make sense out of interest rates, predict future earnings growth, look for undervalued companies, and predict overvalued situations, and they do all this with the goal of providing their investors with a rate of return that is better than a specific stock market index.

At least I hope that’s their goal.

A stock index fund is also a mutual fund, but an unmanaged mutual fund. Because it owns a piece of all the publicly traded companies that make up a particular stock market index, there is no need for any kind of manager to decide what stocks the fund should invest in. Pretty nifty, eh?

History has shown that an investment in the collective creativity of human beings, as represented by a piece of all the publicly traded companies in an unmanaged stock index mutual fund, is much more profitable over time than an investment with a mutual fund manager who tries to “beat” the stock market average, even though mutual fund managers try with all their might to convince us otherwise.

I suppose that with Wall Street saying “I’m number one” in your ear every day of the year, it is only natural for you to think that the secret to being a successful investor is to beat the stock market average with your stock market investments. But by trying to beat the stock market average it is easy for investors to ignore the fact that the stock market average itself has historically provided an excellent investment, and by trying to beat an already good thing you are virtually guaranteed to end up below it.

When building and maintaining an investment portfolio, the first step in breaking this addiction to mutual fund managers is to understand why these stock pickers consistently underperform the stock market average. The first reason mutual fund managers consistently underperform the stock market average is that the stock market is already very efficient. In other words, because there are millions and millions of investors out there, if there is a good deal to be had, more often than not somebody has already grabbed it.

For example, if someone scatters seven thousand-dollar bills next to the Empire State Building, would you call your travel agent and book a flight to New York in the hopes of retrieving a thousand-dollar bill?

I doubt it.

Why not?

You wouldn’t waste your time and money because you would logically conclude that somebody would beat you to the seven thousand-dollar bills. In picking stocks, as with finding thousand-dollar bills, once in a while there is a lucky person, but with millions of stock pickers out there, most of the time someone will have beaten a mutual fund manager—or you—to that next underpriced stock.

(For those of you who are caught up in the world of Wall Street things and think it is possible for mutual fund managers to consistently find underpriced stocks in a marketplace filled with millions of investors, and think that the example of the thousand-dollar bill at the Empire State Building is a little silly, the 86 percent of fund managers who were unable to beat the stock market average in each of the last three-, ten-, and fifteen-year periods have done a wonderful job of proving my point.)

The second reason why mutual fund managers consistently underperform the stock market average is that the money they manage is subject to extremely high annual expenses, which reduce your total return.

Quite simply, a $350 plane ticket to New York is too much to pay on the off chance you may find a thousand-dollar bill.

Mutual fund expenses, buried deep in the middle of every mutual fund prospectus, may seem like a few cents here and a few cents there. Unfortunately, these expenses end up costing investors (yes, even smaller investors) hundreds of thousand of dollars over time, as we will find out in chapter 7. Managed mutual funds have a vested interest in keeping Wall Street’s best-kept secret a secret by trying to convince us that picking the good stocks and avoiding the bad stocks is a sophisticated science better left in the hands of a stock market expert.

Nothing could be further from the truth.

Even so, I have found that many investors are a little wary at first when introduced to this brilliant, ingenious, commonsense concept of investing in the entire stock market average as represented by an unmanaged stock index mutual fund. Maybe we should see whether there are any other investors out there who embrace this unconventional approach of investing in the entire stock market instead of specific stocks, industries, trends, and mutual funds.

Let’s check in with some of the largest and most sophisticated investors in our country—the administrators of state pension funds. These people invest billions of dollars and have a fiduciary responsibility to do the right thing for the thousands of state employees who are counting on their state’s pension fund when they retire. First we’ll call my home state of Washington and find out how much of its stock market money is indexed in the collective creativity of our country.

What? 100 percent?

No. No. No.

We don’t want to know the chance of rain in Seattle on the Fourth of July. We want to know how much of the state pension fund’s domestic stock market money is indexed to approximate the stock market average.

100 percent?

No kidding?

Let’s check in with the state of California. What? You index 85 percent?

Okay; I admit, out here in the Wild West we tend to be a little off the wall. Let’s head east and see what other state pension funds are doing.

Kentucky? What? You index 67 percent of your portfolio?

Florida? What? You index 60 percent of your portfolio?

New York? What? You index 75 percent of your portfolio?

Connecticut? What? You index 84 percent of your portfolio? ²

Hmm. When talking with state administrators, my favorite response was from the administrator of a very large state pension fund of a state that shall remain anonymous (though we Mariner baseball fans don’t much care for the pinstriped uniforms of one of its baseball teams), who said that for long-term investors, “not only is it unreasonable to think they can beat the stock market average, it’s probably not doable.”

To be honest with you, I can’t quite picture the administrator of a state’s public pension portfolio going home at night, stopping at the grocery store to pick up some eggs, milk, and fruit, and then casually throwing into his shopping basket the latest mutual fund magazine from the magazine rack to browse through after dinner in the hopes of picking up a few hot mutual fund ideas for his state’s pension fund.

But what the heck, let’s say he did.

In February 1994, one of the top mutual fund magazines ran this cover story: “Where to Make Money in ’94—The Best Funds to Buy!” and listed the top eight domestic stock mutual funds to own. Four years later, each of these eight mutual funds had underperformed the stock market average, and collectively they underperformed it by an average of 25 percent annually.

If a state administrator stuck my retirement money in a mutual fund portfolio that underperformed the stock market average by 25 percent annually, I would call him immediately and politely ask him to switch his after-dinner magazine reading material to National Geographic. This is advice our common stock portfolio can do without, unless of course you have an uncontrollable urge to underperform the stock market average by 25 percent annually.

Unfortunately, that’s how many individual investors make their investment decisions—looking for mutual funds that tout good track records, because track records would seem to be the most logical way to choose a fund, even though it has been shown again and again that past mutual fund performance has little to do with future mutual fund performance. In fact, using past performance numbers as a method for choosing mutual funds is such a lousy idea that mutual fund companies are required by law to tell you it is a lousy idea by listing the following disclaimer in their prospectuses:

Past performance is no indication of future performance.

Maybe investors are attracted to past performance numbers because past performance numbers work so well when selecting things like dishwashers.

When it comes our turn to buy a dishwasher, do we go to the appliance store, plunk down a chunk of change, blindly point to a dishwasher in the corner, and say, “I’ll take that lonely one over there”? No. We do a little research, like maybe asking our friends and neighbors which ones they’ve liked, and then combine that information with research from something like Consumer Reports to find out which dishwasher has performed best in the past, and then buy it.

Unfortunately, there is one small problem with using the dishwasher method to select mutual funds.

It doesn’t work.

And investors who continue to use the dishwasher method of selecting mutual funds based on past performance numbers are destined to be washing dishes when it comes time to retire.

History has shown it is not such a good idea to invest in mutual funds that have a track record of outperforming the stock market average.

The following ten-year track records suggest you are better off investing at a horse track than in a mutual fund that has at one time or another been a top dog (horse?).

The top twenty-five mutual funds from 1988 to 1998 dropped on average to 1,851 out of 3,021 funds during the next ten years, collectively underperforming the stock market average during the later period.

Mutual funds in the top quartile from 1988 to 1998 collectively underperformed that period’s bottom quartile during the next ten-year period.³

With track records like the ones above, how should an investor choose a superior mutual fund? You might be surprised at how easy your choice is. Let’s play a quick game called “Outfox the Box.”

You are the contestant. There are ten boxes. Each box has some money in it, from $1,000 to $10,000, and you know much is in each box. You get to choose a box, and these are your choices:

(Remember, you know how much is in each box.)

Drumroll, please . . .

The crowd is screaming.

Your heart is pounding.

Which one will you choose?

This is not a trick question. The answer is obvious. Anyone would choose the $10,000 box. Your decision to choose a mutual fund is just as easy. This time we will change the rules a little. This time, we are going to hide the amounts in the boxes. Except for one box. For this box we reveal that it contains $8,000.

The choices look like this.

Now, which box will you choose?

This answer is also obvious.

You would choose the $8,000 box, because the chance of increasing your winnings is just not worth the risk of choosing an amount substantially less—unless, of course, you are a gambler.

This is not a book on gambling.

This is a book on investing.

There is a big difference.

With the stock market average consistently outperforming 75 percent to 85 percent of all managed mutual funds, it is a tribute to the massive marketing machine of Wall Street that so many investors spend so much time and effort trying to select the top mutual funds instead of following the lead of state pension fund administrators who have a vested interest in choosing the $8,000 box instead of gambling.

It’s important to keep this silly little game in mind when dealing with Wall Street, because Wall Street loves to criticize the concept of indexing as a boring approach to investing in which you forego all opportunity to beat the stock market.

What Wall Street is really saying is,

“Ignore the $8,000 box and give us your money and we will gladly choose another box for you, because we are the self-proclaimed experts at ‘outfoxing the box,’ and even though the odds are long and the chances are slim that we will succeed, let’s give it a try because we love you and your fees.”

Sometimes it takes a silly little game called “Outfox the Box” to break this addiction of always trying to beat the stock market average. It is a hard addiction to break, because the concept of having a superior mutual fund by investing in a mutual fund that reflects the stock market average is a difficult concept to grasp, especially when thousands of mutual fund managers and thousands of investment advisers and glossy mutual fund magazines are telling you that investing in the stock market average is a mediocre approach to investing in the stock market. Indexing is a case of average being superior, and at first it seems illogical, but, in reality, it’s not illogical at all. It’s simply common sense.

I frequently encounter this addiction to trying to “Outfox the Box” in friends and investors who tell me they have switched mutual funds several times in the last few years and are still searching for a top-notch mutual fund.

First, I explain to my friends the concept of indexing, which means investing in the entire stock market.

Second, I point out that most mutual funds underperform the stock market average over time.

Next, we review why track records are meaningless when trying to choose a top mutual fund, because the top mutual funds of today tend to underperform the stock market average in the future. And finally, we play a silly little game called “Outfox the Box.”

However, most investors are so addicted to relying on past performance numbers, not to mention stock market experts, that I have to start all over.

First, I explain to my friends the concept of indexing, which means investing in the entire stock market.

Second, I point out that most mutual funds underperform the stock market average over time.

My favorite response was from a friend of mine who is an environmental scientist and restores parks in San Francisco. For many years, she had been switching from fund to fund, searching for funds that were best for her. One day she called me, looking for a consistent long-term mutual fund for her portfolio.

First, I explained to her the concept of indexing, which means investing in the entire stock market. Second, I pointed out that most mutual funds underperform the stock market average over time. Next, we reviewed why track records are meaningless when trying to choose a top mutual fund, because the top funds of today tend to underperform the stock market average in the future.

Her response to me was, “I know you like those index funds, but besides that, what is a good fund to invest in?”

So we started all over.

Suddenly, a lightbulb went on. Her exact reply to me was, “Why would anyone consider anything but indexing?”

At that moment, my friend from San Francisco freed herself from the clutter of Wall Street, which is a big load off her shoulders because she is one person who would rather spend her time restoring parks in San Francisco than sorting through fifteen thousand mutual funds and seven thousand stocks every other year in an effort to build and maintain her common-stock portfolio.

Oh, by the way, I hope you enjoy the parks the next time you are in San Francisco.