5.45 - .50.50 - .55.55 - .60.60 - .65.65 - .70.70 - .75.75 - .80Overall
Frequency1.28%3.27%4.78%7.12%15.17%17.97%24.85%14.35%8.63%2.57%100.00%
Annualized Returns Subsequent to Sentiment Readings(January 2, 1970 - June 2, 2006)Three Month18.52%12.24%20.30%15.98%8.61%10.45%-0.39%0.35%12.72%
Six Month15.40%13.79%15.02%13.61%6.75%7.17%0.23%-3.87%10.35%
Nine Month22.79%16.52%13.06%11.10%6.66%7.03%-3.32%-9.17%9.45%
Twelve Month20.74%15.82%13.43%10.21%6.03%6.74%-1.79%-10.18%9.02%
Annualized Returns Subsequent to Sentiment ReadingsThree Month20.43%16.69%30.10%33.39%21.80%12.92%4.65%5.37%10.64%3.03%13.19%
Six Month15.83%18.19%22.52%18.61%17.98%11.61%5.67%5.34%7.04%6.86%11.04%
Nine Month15.51%18.63%20.99%15.25%15.74%11.36%6.91%4.38%6.63%4.51%10.38%
Twelve Month20.66%20.85%21.24%15.24%14.81%11.05%6.25%5.35%6.43%5.02%10.33%
Out-of-Favor Stocks and the Dow 10 StrategyDave: Can you use contrarian strategy to pick individual stocks?IC: Yes. Contrarians believe that the swings of optimism and pessimisminfect individual stocks as well as the overall markets. Therefore, buyingout-of-favor stocks can be a winning strategy.Werner De Bondt and Richard Thaler examined portfolios of bothpast stock winners and losers to see if investors became overly optimistic or pessimistic about future returns from studying the returns ofthe recent past.31 Portfolios of winning and losing stocks were analyzed31Werner F. M. De Bondt and Richard H. Thaler, “Does the Stock Market Overreact?” Journal of Finance, vol. 49, no. 3 (1985), pp. 793–805.
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FIGURE
19–1
Investors Intelligence Sentiment Indicator, 1986 to 20070.900.800.700.600.50October
0.40 MarketCrash
0.300.200.10
AsianCrisis
IraqiInvasion ofBondKuwaitMarketCrash
LTCM/RussiaTerroristAttacks
Bear MarketBottom
Fears of CrashInduced by Decline
1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
over five-year intervals. Portfolios that had been winners in the past fiveyears subsequently lagged the market by 10 percent, while the subsequent returns on the loser portfolio beat the market by 30 percent.One of the explanations for why this strategy works relates to therepresentativeness heuristic we talked about before. People extrapolaterecent trends in stock prices too far in the future. Although there is someevidence that short-term momentum is positive in stock returns, overthe longer term many stocks that have done poorly outperform, andstocks that have done well underperform. Another strategy based onout-of-favor stocks is called the Dogs of the Dow or the Dow 10 strategy.32Dave: There has been so much to absorb from today’s session. It seemslike I fell into almost all of these behavioral traps. The comforting newsis that I’m not alone and that your counseling has helped other investors.32
This strategy is discussed in great detail in Chapter 9.
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IC: Not only have they been helped but they have also prospered. Formany people, success in investing requires a much deeper knowledge ofthemselves than does success in their jobs or even in their personal relationships. There is much truth to an old Wall Street adage, “The stockmarket is a very expensive place to find out who you are.”
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BUILDING WEALTHTHROUGH STOCKS
Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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FUND PERFORMANCE, INDEXING,AND BEATING THE MARKETI have little confidence even in the ability of analysts, let alone untrained investors, to select common stocks that will give better thanaverage results. Consequently, I feel that the standard portfolioshould be to duplicate, more or less, the DJIA.BENJAMIN GRAHAM1
How can institutional investors hope to outperform the market . . .when, in effect, they are the market?CHARLES D. ELLIS, 19752
There is an old story on Wall Street. Two managers of large equity fundsgo camping in a national park. After setting up camp, the first managermentions to the other that he overheard the park ranger warning thatblack bears had been seen around this campsite. The second managersmiles and says, “I’m not worried; I’m a pretty fast runner.” The first1
Benjamin Graham and Seymour Chatman (ed.), Benjamin Graham: The Memoirs of the Dean of WallStreet, New York: McGraw-Hill, 1996, p. 273.2Charles D. Ellis, “The Loser’s Game,” Financial Analysis Journal, July/August 1975.341Copyright © 2008, 2002, 1998, 1994 by Jeremy J. Siegel. Click here for terms of use.
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manager shakes his head and says, “You can’t outrun black bears;they’ve been known to sprint over 25 miles an hour to capture theirprey!” The second manager responds, “Of course I know that I can’t outrun the bear. The only thing that’s important is that I can outrun you!”In the competitive world of money management, performance ismeasured not by absolute returns but the returns relative to some benchmark. These benchmarks include the S&P 500 Index, the Wilshire 5000,the Russell indexes, and the latest “style” of indexes popular on WallStreet. But there is a crucially important difference about investing compared to virtually any other competitive activity: Most of us have nochance of being as good as the average in a pursuit that others practicefor hours to hone their skills. But anyone can be as good as the average investor in the stock market with no practice at all.The reason for this surprising statement is based on a very simplefact: since the sum of each investor’s holdings must be equal to the market, the performance of the whole market must, by definition, be the average dollar-weighted performance of each and every investor.Therefore, for each investor’s dollar that outperforms the market, theremust be another investor’s dollar that underperforms the market. Byjust matching the performance of the overall market, you are guaranteedto do no worse than average.But how do you match the performance of the whole market? Until1975, this goal would have been virtually impossible for all but the mostaffluent investors. Who can hold shares in each of the thousands of firmslisted on U.S. exchanges?But since the mid-1970s, index mutual funds and then exchangetraded funds (ETFs) have been developed to match the performance ofthese broad stock indexes. Over the last several decades the average investor could match the performance of a wide variety of market indexeswith very low costs and a very modest investment. And, over the last several years, new indexes have been developed, based on the research discussed in Chapter 9, that may allow investors to outperform the averages.
THE PERFORMANCE OF EQUITY MUTUAL FUNDSMany claim that striving for average market performance is not the beststrategy. If there are enough poorly informed traders who consistentlyunderperform the market, then it might be possible for informed investors or professionals to outperform the market.Unfortunately, the past record of the vast majority of such activelymanaged funds does not support this contention. There are two ways to
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measure long-term fund returns. One is to compute the returns of allfunds that have survived over the period examined. But the long-termreturns on these funds suffer from survivorship bias that overestimatesthe returns available to investors. This survivorship bias exists becausepoorly performing funds are often terminated, leaving only the moresuccessful ones with long-term track records to be included in the data.The second, and more accurate, method is to compute, year by year, theaverage performance of all equity mutual funds in existence.Both of these computations are shown in Table 20-1. From January1971 through December 2006, the average equity mutual fund returned10.49 percent annually, 1.06 percentage points behind the Wilshire 5000and 1.04 percentage points behind the S&P 500 Index. Indeed, the survivor funds returned 0.80 percentage points more per year but stilllagged the averages. And all these fund returns exclude sales and redemption fees that would reduce their net returns to investors evenmore.3The underperformance of mutual funds does not happen everyyear. Actively managed equity funds did on average outperform theWilshire 5000 and the S&P 500 indexes during the period from 1975through 1983 when small stocks returned a spectacular 35.32 percent peryear. Equity mutual funds generally do well when small stocks outperform large stocks, as many money managers seek to boost performanceby buying smaller-sized firms.3Fund data provided by the Vanguard Group. See John C. Bogle, Bogle on Mutual Funds, Burr Ridge,Ill.: Irwin Professional Publishing, 1994, for a fuller description of these data.
TABLE
20–1
Equity Mutual Funds and Benchmark Returns: Annual Compound Returns (Excluding Sales andRedemption Fees), January 1971 through December 2006 (Standard Deviations in Parentheses)
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Since 1983, when the small stocks surge ended, the performance ofthe average mutual fund has been worse, falling nearly 11⁄2 percentagepoints per year behind either the Wilshire 5000 or the S&P 500 Index.The percentage of general equity funds that has outperformedthe Wilshire 5000 and the S&P 500 Index each year from 1972 to 2006is displayed in Figure 20-1. During this 35-year period, there wereonly 11 years when a majority of mutual funds beat the Wilshire 5000.All but 2 of these years occurred during a period when small stocksoutperformed large stocks. In the last 25 years there have been only5 years when the average equity mutual fund outperformed the broadmarket.The underperformance of mutual funds did not begin in the 1970s.In 1970, Becker Securities Corporation startled Wall Street by compilingthe track record of managers of corporate pension funds. Becker showedthat the median performance of these managers lagged behind the S&P500 by 1 percentage point and that only one-quarter of them were able toFIGURE
20–1
Yearly Percentage of General Equity Funds That Outperform the S&P 500 and the Wilshire 5000(Excluding Sales and Redemption Fees), 1972 through December 2006
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outperform the market.4 This study followed on the heels of academicarticles, particularly those by William Sharpe and Michael Jensen, thatalso confirmed the underperformance of equity mutual funds.Figure 20-2 displays the distribution of the difference between thereturns of 138 mutual funds that have survived since January 1972 andthe Wilshire 5000.Only 48, or less than 40 percent, of the 138 funds that have survivedover the past 35 years have been able to outperform the Wilshire 5000.Only 30 have been able to outperform the market by more than 1 percentper year, while only 14 have bettered the market by at least 2 percent. Onthe other hand, over 65 percent of the surviving funds underperformedthe market, and almost two-thirds of those underperformed by morethan 1 percent per year. And, as noted above for Table 20-1, the actual returns on these funds are worse since these returns exclude sales and redemption fees.Despite the generally poor performance of equity mutual funds,there are some winners. The best-performing mutual fund over theentire period is Fidelity’s Magellan Fund, whose 16.07 percent annual4
Burton G. Malkiel, A Random Walk Down Wall Street: The Time Tested Strategy for Successful Investing,5th ed., New York: Norton, 1990, p. 362.
FIGURE
20–2
Performance of Surviving Mutual Funds Relative to the Wilshire 5000, January 1972 through December 2006
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return from 1971 through December 2006 beat the market by over 4 percentage points per year. Close behind was Mutual Shares Z, run byFranklin Templeton, with a return of 16.04 percent over the same period. In a virtual tie in third and fourth places are the Columbia AcornFund (previously known as the Liberty Acorn Fund), run by CharlesMcQuaid and Robert Mohn, and the Sequoia Fund, run by the investment firm of Ruane, Cunniff, & Goldfarb that closely follows WarrenBuffett’s philosophy and has a large portion of its holdings in BerkshireHathaway. These two have enjoyed annual returns of 15.57 and 15.54percent, respectively.Despite these sparkling returns, chance may have played a largerole in these outperformers. The probability that a fund would beat theWilshire 5000 by 4 percentage points or more over this period by chancealone is 1 in 12. That means out of the 138 funds examined, one wouldexpect 11 to have done this well.Yet luck could not explain Magellan’s performance from 1977through 1990. During that period, the legendary stock picker PeterLynch ran the Magellan Fund and outperformed the market by an incredible 13 percent per year. Magellan took somewhat greater risks inachieving this return,5 but the probability that Magellan would outperform the Wilshire 5000 by this margin over that 14-year period by luckalone is only 1 in 500,000!
FINDING SKILLED MONEY MANAGERSIt is easy to determine that Magellan’s performance during the Lynchyears was due to his skill in picking stocks. But for more mortal portfolio managers, it is extremely difficult to determine with any degree ofconfidence whether the superior returns of money managers are due toskill or luck. Table 20-2 computes the probability that managers withbetter-than-average stock-picking ability will outperform the market.6The results are surprising. Even if money managers choose stocksthat have an expected return of 1 percent per year better than the market, there is only a 61.9 percent probability that they will exceed the average market return after 10 years and only a 70.1 percent probability5The standard deviation of the Magellan Fund over Lynch’s period was 21.38 percent, compared to13.88 percent for the Wilshire 5000, while its correlation coefficient with the Wilshire was 0.86.6Money managers are assumed to expose their clients to the same risk as would the market, and themoney managers have a correlation coefficient of 0.88 with market returns, which has been typicalof equity mutual funds since 1971.
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TABLE
347
20–2
Probability of Outperforming the Wilshire 5000, Based on Returns, Risk, and Correlations from 1972through December 2006
that they will exceed the average market return after 30 years. If managers pick stocks that will outperform the market by 2 percent per year,there is still only a 72.8 percent chance that they will outperform themarket after 10 years. This means there is a one-in-four chance that theywill still fall short of the average market performance. The length of timeneeded to be reasonably certain that superior managers will outperformthe market will most certainly outlive their trial period for determiningtheir real worth.Detecting a bad manager is an equally difficult task. In fact, amoney manager would have to underperform the market by 4 percent ayear for almost 15 years before you could be statistically certain (definedto mean being less than 1 chance in 20 of being wrong) that the manageris actually poor and not just having bad luck. By that time, your assetswould have fallen to half of what you would have had by indexing tothe market.Even extreme cases are hard to identify. Surely you would think thata manager who picks stocks that are expected to outperform the marketby an average of 5 percent per year, a feat achieved by no surviving mutual fund since 1970, would quickly stand out. But that is not necessarilyso. After one year there is only a 7-in-10 chance that such a manager willoutperform the market. And the probability rises to only 74.8 percent thatthe manager will outperform the market after two years.Assume you gave a young, undiscovered Peter Lynch—someonewho over the long run will outperform the market with a 5 percent per
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year edge—an ultimatum: that he will be fired if he does not at least matchthe market after two years. Table 20-2 shows that the probability he willbeat the market over two years is only 74.8 percent. This means there is almost a one-in-four chance that he will still underperform the market andyou will fire Lynch, judging him incapable of picking winning stocks!
Persistence of Superior ReturnsDo some money managers have “hot hands,” meaning that if they outperformed the averages in the past, they are likely to do it again in thefuture? The conclusions of numerous studies are not clear-cut. There issome evidence that funds that outperform in one year are more likely tooutperform the next.7 This short-run persistence is probably due to thefact that managers follow a particular “style” of investing and stylesoften stay in favor over several years.But over longer periods, the ability of fund managers to continue tooutperform the market finds less support. Elton, Gruber, and Blakeclaim that outperformance persists over three-year periods,8 but BurtonMalkiel, Jack Bogle, and others disagree.9,10 In any case, performance canchange suddenly and unpredictably. Perhaps Magellan’s underperformance after Peter Lynch left the fund did not surprise some investors.But Bill Miller’s hot hand with Legg Mason’s Value Trust, whichrecorded a record 15 consecutive years of beating the S&P 500 Index,suddenly and unexpectedly turned cold in 2006 and 2007.
REASONS FOR UNDERPERFORMANCE OF MANAGED MONEYThe generally poor performance of funds relative to the market is not dueto the fact that managers of these funds pick losing stocks. Their performance lags the benchmarks largely because funds impose fees and tradingcosts that are often as high as 2 percent or more per year. First, in seekingsuperior returns, a manager buys and sells stocks, which involves brokerage commissions and paying the bid-ask spread, or the difference be-
7Darryll Hendricks, Jayendu Patel, and Richard Zeckhauser, “Hot Hands in Mutual Funds: ShortRun Persistence of Relative Performance, 1974–1988,” Journal of Finance, vol. 48, no. 1 (March 1993),pp. 93–130.8Edwin J. Elton, Martin J. Gruber, and Christopher R. Blake, “The Persistence of Risk-Adjusted Mutual Fund Performance,” Journal of Business, vol. 69, no. 2 (April 1996), pp. 133–157.9Burton G. Malkiel, A Random Walk Down Wall Street, 8th ed., New York: Norton, 2003, pp. 372–274.10John C. Bogle, The Little Book of Common Sense Investing, Hoboken, N.J.: Wiley, 2007, Chap. 9.
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tween the buying and the selling price of shares. Second, investors paymanagement fees (and possibly sales, or “load,” fees) to the organizationsand individuals that sell these funds. Finally, managers are often competing with other managers with equal or superior skills at choosing stocks.As noted earlier, it is a mathematical impossibility for everyone to do better than the market—for every dollar that outperforms the average, someother investor’s dollar must underperform the average.
A LITTLE LEARNING IS A DANGEROUS THINGIt is interesting that an investor who has some knowledge of the principles of equity valuations often performs worse than someone with noknowledge who decides to index his portfolio. For example, take thenovice—an investor who is just learning about stock valuation. This isthe investor to whom most of the books entitled How to Beat the Marketare sold. A novice might note that the stock has just reported very goodearnings but its price is not rising as much as he believes is justified bythis good news and so he buys the stock.Yet informed investors know that special circumstances caused theearnings to increase and that these circumstances will not likely be repeated in the future. Informed investors are therefore more than happyto sell the stock to novices, realizing that the rise in the price of the stockis not justified. Informed investors make a return on their special knowledge. They make their return from novices who believe they have founda bargain. Uninformed indexed investors, who do not even know whatthe earnings of the company are, often do better than the investor who isjust beginning to learn about equities.The saying “a little learning is a dangerous thing” proves itself to bequite apt in financial markets. Many seeming anomalies or discrepanciesin the prices of stocks (or most other financial assets, for that matter) aredue to the trading of informed investors with special information that isnot easily processed by others. When a stock looks too cheap or too dear,the easy explanation—that emotional or ignorant traders have incorrectly priced the stock—is usually wrong. Most often there is a good reason why stocks are priced as they are. This is why beginners who buyindividual stocks on the basis of their own research often do quite badly.
PROFITING FROM INFORMED TRADINGAs novices become more informed, they will no doubt find some stocksthat are genuinely undervalued or overvalued. Trading these stocks will
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begin to offset their transactions costs and their poorly informed, losingtrades. At some point, a trader might become well enough informed toovercome the transactions costs and match, or perhaps exceed, the marketreturn. The key word here is might because the number of investors whohave consistently been able to outperform the market is small indeed. Andfor individuals who do not devote much time to analyzing stocks, the possibility of consistently outperforming the averages is remote.Yet the apparent simplicity of picking winners and avoiding loserslures many investors into active trading. We learned in Chapter 19 thatthere is an inherent tendency of individuals to view themselves and theirperformance as above average. The investment game draws some of thebest minds in the world. Many investors are wrongly convinced that theyare smarter than the next guy who is playing the same investing game.But even being just as smart as the next investor is not good enough. Forbeing average at the game of finding market winners will result in underperforming the market as transactions costs diminish returns.In 1975, Charles D. Ellis, a managing partner at Greenwood Associates, wrote an influential article called “The Loser’s Game.” In it heshowed that, with transactions costs taken into account, average moneymanagers must outperform the market by margins that are not possiblegiven that they themselves are the major market players. Ellis concludes:“Contrary to their oft articulated goal of outperforming the market averages, investment managers are not beating the market; the market isbeating them.”11
HOW COSTS AFFECT RETURNSTrading and managerial costs of 2 or 3 percent a year might seem smallcompared to the year-to-year volatility of the market and to investorswho are gunning for 20 or 30 percent annual returns. But such costs areextremely detrimental to long-term wealth accumulation. Investing$1,000 at a compound return of 11 percent per year, the average nominalreturn on stocks since World War II, will accumulate $23,000 over 30years. A 1 percent annual fee will reduce the final accumulation by almost a third. With a 3 percent annual fee, the accumulation amounts tojust over $10,000, less than half the market return. Every extra percentage point of annual costs requires investors aged 25 to retire two yearslater than they would have in the absence of such costs.
11
Charles D. Ellis, “The Loser’s Game,” Financial Analysts Journal, July/August 1975, p. 19.
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THE INCREASED POPULARITY OF PASSIVE INVESTINGMany investors have realized that the poor performance of activelymanaged funds relative to benchmark indexes strongly implies that theywould do very well to just equal the market return of one of the broadbased indexes. Thus, the 1990s witnessed an enormous increase in passive investing, the placement of funds whose sole purpose was to matchthe performance of an index.The oldest and most popular of the index funds is the Vanguard 500Index Fund.12 The fund, started by visionary John Bogle, raised only$11.4 million when it debuted in 1976, and few thought the conceptwould survive. But slowly and surely indexing gathered momentum,and the fund’s assets reached $17 billion at the end of 1995.In the latter stages of the 1990s bull market, the popularity of indexing soared. By March 2000, when the S&P 500 Index reached its alltime high, the fund claimed the title of the world’s largest equity fundwith assets over $100 billion. Indexing became so popular that in thefirst six months of 1999 nearly 70 percent of the money that was investedwent into index funds.13 By 2007, all Vanguard 500 Index funds had attracted over $200 billion in assets, but the largest single equity mutualfund is the American Growth Fund with assets of $185 billion.14One of the attractions of index funds is their extremely low cost. Thetotal annual cost in the Vanguard 500 Index Fund is only 0.18 percent ofmarket value (and as low as 2 basis points for large institutional investors).Because of proprietary trading techniques and interest income from loaning securities, Vanguard S&P 500 Index funds for individual investors havefallen only 9 basis points behind the index over the last 10 years, and its institutional index funds have actually outperformed the index.15
THE PITFALLS OF CAPITALIZATION-WEIGHTED INDEXINGDespite their past success, the popularity of indexing, especially thosefunds linked to the S&P 500 Index, may cause problems for index12
Five years before the Vanguard 500 Index Fund, Wells Fargo created an equally weighted indexfund called “Samsonite,” but its assets remained relatively small.13Heather Bell, “Vanguard 500 Turns 25, Legacy in Passive Investing,” Journal of Index Issues, FourthQuarter 2001, pp. 8–10.14Vanguard’s number includes assets of its 500 Index Fund open to both individuals and institutions.15The Vanguard Institutional Index Fund Plus shares, with a minimum investment of $200 million,have outperformed the S&P 500 Index by 7 basis points in the 10 years following the fund’s inception on July 7, 1997.
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investors in the future. The reason is simple. If a firm’s mere entry intothe S&P 500 causes the price of its stock to rise, index investors will ultimately hold overpriced stocks that will depress future returns.An extreme example of overpricing occurred when Yahoo!, thewell-known firm, was added to the S&P 500 Index in December 1999.Yahoo!’s price during this period is graphically depicted in Figure 20-3.Standard & Poor’s announced after the close of trading on November 30that Yahoo! would be added to the index on December 8. The next morning, Yahoo! opened up almost $9 per share at $115 and continued upward to close at $174 a share on December 7, when index funds had tobuy the shares in order to match the index. In just 5 trading days between the announcement of Yahoo!’s inclusion in the index until it formally became a member, the stock surged 64 percent. Volume duringthose 5 days averaged 37 million shares, more than three times the average on the previous 30 days. On December 7, when index funds had toFIGURE
20–3
Price of Yahoo! around Its Admission to the S&P 500190
Entry into S&P at12/7 Close of 174,Up 63.6% from11/30 Close
170
Close
160
Open
600
5