" A Dying Banker's Last Instructions "

Enclosed is a NY Times article dated 26^th November 2010, titled, A Dying Banker’s Last Instructions.

The article is about Gordon Murray-a former salesman at Goldman-who rose to become Managing Director at Lehman and CSFB. As he was diagnosed with brain cancer-he decided to pen a small book The Investment Answer.

The article mentions that Gordon Murray later in his career learnt about the failings of active portfolio management, which had taught him to erroneously believe It’s American to think that if you’re smart or work hard, then you can beat the markets.

Gordon Murray, later on in his career, is influenced by Dimensional-a passive mutual fund company, which teaches him, No one can predict the future with any regularity, so why would you think that active managers can beat their respective indexes over time?

http://www.nytimes.com/2010/11/27/your-money/27money.html

' The market ...it's crazy...but the fact it's crazy doesn't make you a psychiatrist '

Meir Statman of Santa Clara University is a Professor of Finance whose research focuses on behavioural studies.

Despite being a proponent of behavioural finance he believes that ordinary investors cannot get a better risk-adjusted return than they can in low-cost index funds!

Being a behavioural finance proponent he does not believe that markets are efficient-but that does not mean people should not Index, his brief explanation is as under,

Q: You pound the drum for index funds. Is that because you think the markets are efficient and therefore unbeatable over the long-term?

A: The market is not efficient. It's crazy, but the fact that it's crazy doesn't make you a psychiatrist. It's crazy like a wild animal. You wouldn't want to go against a wild lion because it's crazy. It's crazy in ways you cannot understand and cannot forecast.

People in behavioral finance and standard finance come to the same conclusion - don't try to beat the market. Whether it is rational, as people in standard finance say, or crazy, as I say, don't try it.

Practically speaking, individual investors should treat the market as unbeatable and realize that when they try to beat it because it is inefficient, they are likely to injure themselves, rather than gain at the expense of another.

Can professionals beat the market? His answer,

Q: Do you think pros can beat the market?

A: Yes, they can. But it's still a zero-sum game. If some people win, it means that some people lose relative to what they can get by being in an index fund.

My interpretation of the above for Indian investors / advisors,

·        Indian markets are competitive because they comprise of a large number of professional investors who are all attempting to generate alpha, a brief list includes: MF, PMS, insurance, treasury, FII and hedge fund managers, stock pickers, analysts both fundamental and technical and so on and so forth.

·        The constant analysis and activity of the above ensures that Mr Market knows more than individuals and hence it is difficult for individuals to beat it (outguess the market) consistently.

·        Therefore, ‘beating the market’ is a) more of a random outcome b) it is known in hindsight and c) past data is of little predictive value going forward.

·        I am tempted to repeat Meir Statman’s sage advice for Indian investors: People in behavioral finance and standard finance come to the same conclusion - don't try to beat the market. Whether it is rational, as people in standard finance say, or crazy, as I say, don't try it. Practically speaking, individual investors should treat the market as unbeatable...!

Link to the article,

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2010/11/16/BU991GCEF9.DTL&type=printable

' Buy and Hold is still a winner '....Burton Malkiel

Dr Burton Malkiel is the economics professor at Princeton and author of a best-seller A Random Walk Down Wall Street. If my memory serves me right it has run into nine editions till date and remains an all time investment classic.

In a recent WSJ article, titled ‘Buy and Hold is still a winner-’ Professor Malkiel reinforces the timeless wisdom of a buy and hold investment strategy using passive indexing i.e. even during the turbulent first decade of the 21^st century.

The lessons from his analysis, in principle, are applicable to Indian investors also: it is rather difficult to outguess and beat the markets consistently!

Some outstanding words (in italics) from the article,

Many obituaries have been written for the investment strategy of buy and hold. Of course, investors would be better off if they could avoid being in the stock market during periods when it declines. But no one—either professional or amateur—has ever been able to time the market consistently. And when they try, the evidence shows that both individual and institutional investors buy at market tops and sell at market bottoms.

I am reproducing a sample of ‘market timing’ from the article.

Market strategists called for a sharp market decline in late August 2010 as technical indicators were uniformly bearish. The market responded with its best September in decades.

The logic of passive indexing, in brief,

Low-cost passive (index-fund) investing remains an excellent strategy for at least the core of every portfolio. All the stocks in the market must be held by someone. Therefore, if one active portfolio manager is holding the better-performing stocks, then some other active manager must be holding those with below-average returns.

http://online.wsj.com/article/SB10001424052748703848204575608623469465624.html

Pearls of investment wisdom from 'The Little Book of Commonsense Investing'

John C Bogle’s The Little Book of Commonsense Investing is one of my favourites. John C Bogle as we know launched the first index mutual fund in 1976 and it went on to become one of the largest equity funds in the world.

Mr Bogle remains a dyed-in-the-wool indexer and has been a strong advocate of cap-weighted indexing, ever since his senior thesis as a student at Princeton University more than 60 years ago.

Some wisdom from the book-these are quotes from ‘investment giants’ other than Mr Bogle-who also support passive indexing.

I believe that in principle the following words (from the book) have a universal application and hence should be understood by investors and investment advisors everywhere!

‘For the markets in total, the amount of value added, or alpha, must sum to zero. One person’s positive alpha is someone else’s negative alpha. Collectively, for the institutional, mutual fund, and private banking assets, the aggregate alpha return will be zero or negative after transaction costs.’ --Gary P. Brinson, CFA, former president of UBS Investment Management in ‘The Future of Investment Management’, Financial Analyst’s Journal, July / August 2005, Vol.61 No.4

‘A low cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth. In this book, Jack Bogle tells you why’. -- Warren Buffet.

‘By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb…’--Warren Buffett

‘Market cap based indexing will never be driven from its deserved perch as core and deserved king of the investment world. It is what we should all own in theory and it has delivered low-cost equity returns to a great mass of investors…the now and forever king-of-the-hill’. --Clifford A. Asness-hedge fund manager, of AQR Capital Management in an unpublished paper called, ‘Capitalization vs. Fundamentally Weighted Indices’.

‘Toss a coin, heads and the manager will make $10,000 over a year, tails and he will lose $10,000. We run (the contest) for the first year (for 10,000 managers). At the end of the year, we expect 5000 managers to be up $10,000 each and 5000 to be down $10,000. Now we run the game a second year. Again, we can expect 2500 managers to be up two years in a row; another year 1250; a fourth one, 625; a fifth, 313 managers who made money for five years in a row. (And in 10 years, just 10 out of the original 10,000 managers). Out of pure luck…. A population entirely composed of bad managers will produce a small amount of great track records…. The number of managers with great track records in a given market depends far more on the number of people who started in the investment business (in place of going to dental school), rather than on their ability to produce profits’. --Nassim Nicholas Taleb, Fooled By Randomness, (NY, Texere, 2001)

‘Buying funds based purely on their past performance is one of the stupidest things an investor can do.’ --Jason Zweig, columnist Money magazine.

‘As a dyed in the wool indexer, of course, I believe the classic index fund must be at the core of that winning strategy. But even I would never have the temerity to say what Dr. Paul Samuelson of MIT said in a speech to the Boston Society of Security Analysts in the autumn of 2005: ‘The creation of the first index fund by John Bogle was the equivalent of the invention of the wheel and the alphabet’. Those two essentials of our existence that we take for granted every day have stood the test of time. So will the classic index fund.’ --John C Bogle

‘Well, Jack, we are wrong. You win. Settling for average is good enough, at least for a substantial portion of most investors’ stock and bond portfolios. In fact, more often than not, aiming for benchmark-matching returns through index funds assures unit holders of a better-than-average chance of outperforming the typical managed stock or bond portfolio. It’s the paradox of fund investing today: Gunning for average is your best shot at finishing above average. We’ve come around to agreeing with the sometimes prickly, always provocative, fund executive known to admirers and detractors alike as Saint Jack (Bogle): Indexing should form the core of most investors’ fund portfolios. So here’s to you, Jack. You have a right to call it, as you recently did in a booklet you wrote, The Triumph of Indexing.’ Tyler Mathisen ‘In Your Interest’ Money magazine August 1995.

" Investment Club " is an oxymoron !

Another terrific write-up by Dan Solin, titled “Investment Club” is an Oxymoron...his analysis conceptually, is also applicable to Indian investors because the fundamental logic of passive investing is valid for all geographies!

The success of active management is typically known in hindsight, is not predictable from past performance and is associated with randomness-as a result of market efficiency.

Dan Solin writes,

I was recently invited to debate active vs. passive management at an investment club. The club members, a group of wealthy retired men, refer to themselves as investment "gurus." They are absolutely convinced of the merits of active management (defined as the ability to pick stocks or mutual funds that will beat designated benchmarks).

Read the entire article, the link is as under,

http://www.huffingtonpost.com/dan-solin/investment-club-is-an-oxy_b_779933.html

Dan Solin has written a wonderful book The Smartest Investment Book You’ll Ever Read and is a financial columnist with The Huffington Post

" Why I Index?"-Commonsense observations !

Something that I had read on passive indexing a couple of years back...these happen to be " Why I Index? " kind of general observations from a fee-only financial advisor based in America.

According to me the following " Why I Index? " are typical issues that are applicable in principle to all geographies. They should be kept in mind by investors / advisors while deciding their strategic asset allocation.

I index because I grew tired of being disappointed by active funds that delivered wonderful returns right up until the day I invested.

I index because for years I only discovered funds that I should have owned, not that I should own.

I index because I enjoy my free time and have not seen any overall gain from the hours spent analyzing active funds.

I index because it occurred to me that those who argue the strongest for active funds tend to be the same people who benefit the most if I buy active funds.

I index because I trust indexes more than active managers. Indexes do not get bored, get overconfident, quit, die, or defect to other firms.

I index because indexes are transparent. I know what my money is invested in and why.

I index to eliminate risk without sacrificing return. The high probability that an active fund will not keep up with its benchmark adds uncompensated risk.

I index because as my assets grow I prefer simplicity to complexity.

I index because as I get older cost matters more to me.

I index because I now realize that all I need is the return of index funds to achieve my financial objectives. And that is what really matters.

Fund Manager turnover...wise advice from John Bogle !

John C Bogle is the founder and former CEO of Vanguard-he launched the first index mutual fund way back in 1976.  Till this day he remains one of the most vocal proponents of passive indexing.

I am reproducing an interesting extract from his interview that appeared in ‘Investment Advisor’ issue of May 2010.

This is what he said...although it is in the American context; a quintessential Indian investor who is investing in equities in order to benefit from the long-term India growth story should take note of Mr Bogle advice,

“...the index fund simply gives you the returns earned by American business and those returns are very similar to the growth of earnings in corporate America and are very similar, and this shouldn't surprise anybody, to the growth of our GDP, the growth of the American economy.

So in fact you're getting a share in American business or a share in America when you buy an index fund. You can hold it forever. You don't have to worry about the portfolio manager changing. This is a world where the portfolio manager changes every five years for mutual funds.

So if you're investing for a lifetime, and it's very important to get this idea out there, and you have four mutual funds, that means you have four managers in five years, eight managers in 10 years, 16 managers in 20 years and 32 managers in 40 years.

Anybody seriously put forth the proposition that you can beat the market when you have 40 managers in 50 years.”

Link to the entire interview,

http://www.advisorone.com/article/30-30-interviews-john-bogle