I RECEIVED A CALL last week from a college student who’d started a successful business. His school, he said, didn’t offer any practical courses in personal finance, so he asked my advice on investing.
We walked through nine key questions. I would offer the same advice to investors of any age.
1. Why should I expect stocks to go up? One way to answer this question would be to invoke the oft-quoted phrase that “history doesn’t repeat itself but it often rhymes.” Stocks have delivered roughly 10% returns per year since reliable recordkeeping began in the 1920s. You could extrapolate that long-term average into the future. But that still wouldn’t address why we should expect stock prices to rise.
To answer that question, the best resource is Stocks for the Long Run by University of Pennsylvania finance professor Jeremy Siegel. The book includes a useful mix of market history and finance theory. If I were teaching an investments 101 class, this is the book I’d use.
Notably, Siegel was able to piece together market data going all the way back to 1802. His finding: Market returns in the 1800s weren’t all that different from our more recent experience. He goes on to explain why returns have been so consistent over time. The short version: Stock prices tend to follow corporate profits. This, of course, isn’t true every day. But over long periods, share prices do tend to mirror corporate earnings.
2. Should investors have confidence that profits will continue to grow? I think so—because the same economic principles that applied in 1800 and 1900 still apply today. Companies are always working to develop new products, to expand the market for those products and to manufacture them more efficiently. Taken together, these three factors are the universal drivers of economic growth, and thus of stock prices.
3. Why is active management destined to underperform? In recent years, investors have been moving money from actively managed mutual funds—that is, funds run by traditional stock-pickers—to index funds, which for the most part simply buy and hold a particular list of investments. That shift has been driven by a growing body of data showing that active managers, on average, underperform. But why is that? Is it because stock-pickers aren’t good at what they do?
In some cases, that’s the explanation. But there’s a more fundamental reason: cost. Actively managed funds are, on average, much more expensive than their passively managed peers. Of course, active managers will argue that cost isn’t the most important thing. Instead, they’ll argue that the only thing that matters is bottom-line performance. Indeed, if an active manager is able to beat his benchmark by more than his fee, then an investor in that fund would come out ahead.
That sounds logical. But William Sharpe, a recipient of the Nobel Memorial Prize in Economics, dismantled that argument in a 1991 essay titled “The Arithmetic of Active Management.” The essay is short, which is good because it usually requires reading a few times to understand what Sharpe is saying. But once you follow the logic, I think you’ll agree that Sharpe’s argument really is airtight. Active management is an uphill battle, at best.
4. What evidence is there that Sharpe is right about active management? Twice a year, S&P Dow Jones Indices compiles a study called SPIVA, short for S&P Index vs. Active. The study compares the performance of U.S. actively managed funds in various categories to their respective benchmarks. The results confirm exactly what Sharpe postulated. For example, over the 10 years through year-end 2021, just 17% of large-cap stock funds were able to beat the S&P 500. The results are similar in other categories.
5. If the only issue is cost, can’t individuals managing their own money beat the market? There’s some logic to this. But unfortunately, cost isn’t the only factor. It turns out that picking winning stocks is very difficult.
Brad Barber and Terrance Odean, both professors at the University of California, have been studying this for decades. In 2000, they published “Trading Is Hazardous to Your Wealth,” which examined the connection between trading frequency and performance. In 2007, they published “All That Glitters,” which looked at the trap presented by popular stocks. More recently, they’ve examined the Robinhood phenomenon and studied some of the paradoxes exhibited by the trading results of individual investors.
6. Lots of people have made money in obvious winners like Apple, Amazon and Google. Doesn’t that contradict Barber and Odean’s research? A paper titled “Selling Fast and Buying Slow,” published last year, helps explain the apparent contradiction. Professional investors actually do a pretty good job of spotting winners. The problem is on the other end. When it comes to selling, investors do a poor job—so poor, in fact, that it offsets the advantage gained by their timely purchases.
7. What about people like Warren Buffett, Seth Klarman and James Simons? There’s no denying their success. Indeed, all of the data I’ve cited here should be taken with this caveat: This is what the data say, on average, about most people, most of the time. There are always exceptions.
8. If actively managed funds underperform and I shouldn’t pick stocks myself, what about private investment funds instead? Major universities and pension funds often invest in private equity funds and hedge funds. That might lead an investor to conclude that these funds are the way to go, especially if traditional mutual funds have such a poor track record. But this turns out to be a dubious idea, for two reasons.
First, according to a study by McKinsey, there’s wide dispersion in the performance of private funds—much wider than among publicly traded funds. This means that it’s especially important to choose the very best from among the universe of private funds. But that presents a problem. If you or I were a billion-dollar endowment, the best funds would be happy to have us. But these funds aren’t interested in everyday investors. They’re not even interested in everyday millionaires. Andy Rachleff, a founder of Benchmark Capital, explained this, in colorful terms, in an interview a while back.
The second reason private funds are a problem: Because they’re more lightly regulated, private funds are fertile ground for unscrupulous operators. Everyone knows about Bernie Madoff’s misdeeds, but he’s hardly the only one. There was Jan Lewan, the “king of polka.” There was Elliot Smerling, who specialized in forgery. And there was Marcos Tamayo, the airport baggage handler. The list is long.
And those are just the more notable cases. According to the SEC, fee billing issues are widespread. In a speech, an SEC examiner had this to say: “When we have examined how fees and expenses are handled by advisors to private equity funds, we have identified what we believe are violations of law or material weaknesses in controls over 50% of the time.” Private funds are a minefield.
9. What about other alternative investments? So far this year, both stocks and bonds have declined, so you might wonder about alternatives to these standard portfolio building blocks. Gold, for example, has declined just 7% in 2022, much better than the 20% decline in the S&P 500. Indeed, a recent report by the research firm Morningstar indicates that certain types of alternative strategies have fared well over time, delivering low—or even negative—correlations with stocks.
Trouble is, these relationships aren’t stable. In 2018, when the market dropped 20% toward the end of the year, Morningstar found that alternative investments were of little help. On top of that, correlation isn’t the only metric that matters. Cash has a theoretically attractive zero correlation with stocks. But its return is terrible. If you’re considering alternative investments, you need to consider both their diversification benefit and the potential contribution to returns. On that score, the data aren’t compelling.