FUNDAMENTALS OF FINANCE
A Guide for Helping Professionals
Adam J. McKee
SECTION 6.5: Stock Funds
What stocks are and how they work may seem like a grand mystery. Most folks that grew up outside of the world of high finance have never been exposed to stocks. Never fear; we’ll delve deeper into what stocks are and how they can make you rich in a later section of this book. For now, we want to look at mutual funds and how they work. For now, we’ll just answer one simple question: Why invest in stocks? The answer, according to Jim Cramer is this: “Because every academic study shows that in any twenty-year period in history, no asset—not gold, not real estate, not bonds, not cash—outperforms high-quality equities that can pay good dividends.”
This stuff isn’t as exciting as making a ton of cash on a great company as it grows from obscurity into a titan of business, but mutual funds are the way that you will build the most wealth over your lifetime. This is because 401k (and similar programs) retirement plans usually only let you invest in mutual funds–there is no option to invest in individual stocks. For most plans, there isn’t even the option to invest in particular sectors of the market. Even if you are self-employed and save for retirement through an IRA that you have a high level of control over, you still want the bulk of your savings in a mutual fund.
Think of a mutual fund as a company that buys stocks in lots of companies. When you buy shares of a mutual fund, you are buying a tiny piece of all the stocks that the mutual fund owns. The reason that these funds are the most important retirement investment vehicle in America today is that they are diversified. Even the grandmaster of stock picking, Jim Cramer, says that you should put your retirement savings into mutual funds to achieve this level of diversification. Diversification is all about risk reduction. If your mutual fund holds 500 companies, then a few of them can go completely bust and you won’t even notice it because roughly an equal number will do extremely well and make up the difference. You need to invest the bulk of your retirement savings in a diversified mutual fund because, when you’re old, you can’t afford to lose value in your portfolio, and you can’t afford to take the risk that your portfolio won’t be worth enough to retire on when you are young.
Managed versus Index Funds
The big idea of an index is to track the overall performance of the market or some sector of the market. Recall that at the macro level, the overall market trends such that individual stocks go up and down together, at least in the short term. A few Titans of Wall Street have demonstrated that a great stock picker can “beat the market.” When investors talk about beating the market, they are talking about beating the return of some benchmark index. The evening news and the average Joe tend to pay a lot of attention to the Dow Jones Industrial Index ($DJI). Most serious traders and financial experts tend to reference the S&P 500 as the ultimate reflection of what the market (overall) is doing at any particular time.
When financial advisors talk about “managed funds” they are talking about a type of mutual fund that is overseen by a stock picker. The idea is that these financial professionals will beat the market for you, and you will realize greater returns than if you had just bought all of the stocks in a particular index. (The difference between an index and a fund’s (or stock’s) performance is referred to as alpha). The problem is that most stock pickers don’t do a very good job and they almost never beat the market. To add insult to injury, they charge fees, so you actually do worse than the market a lot of the time.
The best advice when it comes to choosing a mutual fund is to find a fund that mirrors the S&P 500 and has low fees. Stick all of your money into that, and leave it alone. Some people disagree with this logic because such a strategy isn’t diversified enough–the strategy is “too risky.” Keep in mind that the very nature of an S&P 500 index fund is to expose you to 500 different companies. That’s pretty diverse! It does expose you entirely to stocks. This means when the market goes down, the value of your portfolio will go down in lockstep. Recall that your portfolio (if you are invested in equities) reflects your ownership of stocks, not dollars. Peaks and valleys in the short term charts of the individual companies and the indices are nothing to be concerned about. When you are saving for retirement, you need to think of the long, long-term view.
Since equities were first traded in America (which was before it was the United States of America), the stock market has performed admirably over the long haul. There have been many highs and many lows, but over the long term, the trend line always points up. My take on this is simple. As populations grown and more people participate in the economy, the economy grows (This is why I think restricting immigration is stupid; America needs to grow as fast as our competitors in the East if we are to retain the world’s biggest economy). As technology advances and we produce more per capita, the economy grows. The bottom line is that as long as technology advances and more people are producing more goods and services, the economy can’t help but grow. That growth will be reflected in the stock market given enough time, and the regression line will always have a positive slope.
Financial advisors are trained to tell their clients that they should have a “diversified portfolio.” They bristle at a portfolio composed entirely of equities. After all, conservative investors need a balanced portfolio of bonds, annuities, perhaps some real estate—only a fraction of these selections should be stocks. I am no financial advisor, but I disagree wholeheartedly. I suggest you put everything into the maximum yield you can get with an adequate margin of safety. To my view, this means put it all in an S&P 500 index fund with the lowest cost possible. Unless interest rates top 10%, bonds, CDs, and savings accounts are an “old man’s game.” If you go with a “really safe” retirement account asset allocation, you’ll retire poor. It really is that simple. This is another reason that you really need to understand all of this stuff: Being “conservative” and “preserving capital” sound like very good things to those who don’t know any better!
This is a good place for a note about “financial advisors.” For the most part, these are good folks that are trying to make a good living for their families. Very few of them have degrees in finance (especially graduate degrees), and most of what they know they learned from their company. The question you must ask yourself is, “how does my financial advisor get paid?” Often, they get paid on a commission. It’s all about how much money they can bring under management. Often, it is also about how much money they can bring under management in the “investment products” that their companies sell.
My father was in insurance sales for a long time, and he was very good at it. He went to trainings where the company gurus taught him all about the amazing annuity products he could sell and make big bonuses. He had a lot of faith in those products and sold them with conviction. He felt good that he was helping people secure their future. A lot of his customers were poor blue collar folks from Mississippi, so in a way he was right. They often didn’t have a 401k and wouldn’t have saved anything for retirement any other way had he not intervened. He genuinely cared about his customers; they were members of the community and his friends. The company he worked for was a huge, publicly traded concern that cared far more about their bottom line than their customers’ savings. Those customers did save money, and they even made a little. They probably even hedged inflation. We are smarter than those folks, and we can do much, much better.
About ten years from retirement, you need to start changing the way you think about your retirement account. At this point, you will want to start looking for points where your index fund is doing really, really well. Each time the S&P 500 (or whatever index your funds follow) hits a new high, you want to move a couple of percent of your portfolio into “conservative” investments that guarantee your capital. I suggest about 2.5% per year during this ten year period if you want to take on a little risk and maximize the value of your portfolio on retirement, and about 5% if you are really, really conservative.
Some people feel like their retirement date is the date by which they should have all of their money in “safe” investments. Keep in mind that your retirement account should be designed to last you from the time you retire until the time that you ultimately die. My wish for you is that this is nice, long time and you really get to enjoy the fruits of your lifetime’s labor and your grandchildren. If you retire at 65 and live to be 85 years old, you will be retired for 20 years. Why, then, would you pull your money completely out of the market and let it waste away because of inflation? Having 25% (or 50% if you have an anxious personality type) of your funds in bonds and other guaranteed income producers will get you through any market downturns. The idea that the S&P 500 could tank and stay at rock bottom for 20 years is possible, but I’d put that up there with the same likelihood as a new black plague killing half the Earth’s population, a catastrophic meteor strike, or a zombie apocalypse.
Developing a Trading Strategy
As this section on investing draws to a close, we are preparing to move into some specific types of investing that you may or may not want to consider. The average person will have reached the useful end of this book at this point. Most people simply don’t have the time or the drive to master the art of trading, and that is a prerequisite for moving forward with more advanced strategies. The old adage “she knows just enough to be dangerous” definitely applies to this situation. I only provide a basic overview of the process of market investing. This will provide you with just enough information (as the saying goes) to be dangerous to your wealth.
If you find that you become both intrigued and excited about the prospect, perhaps your personality will allow you to pursue trading as a second vocation. I strongly advise that if you do decide on this path that you dedicate the time and energy to really learn how markets work and how to profit from within them. All too often, people get excited about making big money based more on a sense of euphoria than a workable plan. Anyone with a few thousand dollars and an internet connection can trade, but very few people have what it takes to be a profitable trader.
By “have what it takes” I don’t mean superior intelligence or preternatural skills. I mean a fierce dedication to mastery. Beyond having the “grit” to dedicate yourself to lifelong learning with mastery as your goal, you must develop the intellectual discipline to develop a detailed trading plan and the emotional discipline to stick to the plan. Many people don’t have the stomach for trading because markets don’t work according to neat, linear functions. Markets are multivariate and highly probabilistic. The problem with probabilistic phenomena is that they cannot be predicted with perfect accuracy. Individual trades will fail. To win this game, you have to step into the mind of the gambler yet never gamble.
As you may have surmised by reading all that came before the current discussion, I believe that there is a distinct difference between an investor and a trader. The only path suitable for the vast majority of people is investing. I also believe that there is a distinct and critical difference between a trader and a gambler. Gamblers are defined by a penchant for risk, and will frequently make bets when they do not have an edge in the hope of realizing oversized gains. The waters become murky because so many people are dishonest with themselves about this distinction. When it comes to casinos, the lottery, and racetracks, most people will tell you that they are gambling. For some reason, people doing their gambling within a brokerage account almost always call themselves “investors.” You are an investor when you seek to profit from economic growth, and such growth only happens over protracted timeframes. Profits are circumscribed for even the world’s best investors, and the magic of compounding is the investor’s edge.
The trader, on the other hand, has not such perfect edge. Traders, no matter how skilled, have an imperfect edge. Successful traders must master the art of assessing the probabilities associated with particular outcomes while also mastering the art of safe capital allocation (sizing bets). Probability assessment sounds rather technical, and many successful traders would say that they don’t know what you are talking about. Traders often assess risk intuitively and use strategies that have high probabilities of success.
We could develop a long list of strategies and tactics that attempt to develop high probability trades without ever using the term “probability.” If a trader says that “I am a momentum” trader, they are attempting to profit from the fact that trends have a high probability of continuation in the short term. They may not think of the way that they trade in those terms, however. A technical trader may enter a trade because an oscillator crossed over a threshold. She may not be able to articulate the precise probability of a change in direction associated with that crossover, but she intuitively understands that when such as event occurs that the probabilities shift such that she has an edge.
The reasons that some people fail to become profitable traders even when they use a probability-based strategy is that they are using a univariate model to predict a multivariate outcome. Many traders recognize this problem intuitively (they likely do not think in terms of probability and variables) and they develop systems that have many steps, each aimed at assessing and tweaking probability levels. Often, they end up measuring the same thing in several different ways (a problem researchers call collinearity) and fail to meaningfully improve their prediction models. A trading system that actually works will use several indicators (e.g., buy signals and sell signals) that provide a unique contribution to the probability assessment equation.
Occam’s Razor is a problem-solving principle attributed to the English theologian and philosopher William of Occam. Also known as the “law of parsimony,” the principle states that when all thing are equal, the simplest solution is the best one. When it comes to applying the principle to a trading plan, it means that we want to include anything that provides a substantial advantage in terms of accuracy (as evidenced by it generating profitable trades). We want to exclude everything that doesn’t improve our chance of success. This is accomplished by eliminating indicators that don’t have much predictive power and ones that provide redundant information. Many stock “signals,” for example, get at the same thing in slightly different ways.
Perhaps the rarest breed of trader is the scientifically minded individual that seeks to empirically determine actual probabilities of success. This is usually impossible in the day to day reality of executing trades for the retail trader because of the time involved. Smart Money traders can accomplish this feat because they have vast resources such as mathematicians to develop the algorithms, programmers to set them up within supercomputers, and blazing fast network connections to execute high probability trades in a matter of nanoseconds.
For the retail trader, the best method of developing a high probability strategy involves considering an adequate number of indicators and establishing an action plan based on the specific conditions of those indicators that suggest the trader has an edge. The strategy can be tested (and backtested) using historical data and paper trades to assess the strategy, adjust the strategy, and reevaluate the strategy. The key to success always boils down to identifying, entering, and exiting trades in such a way that realized profits exceed realized losses. If you enter trades without such a system in place, you are a gambler and not a trader.
The average person can build wealth with a supremely simple strategy as long as the trading plan is geared toward the long term. This is what I strongly suggest (and earlier advocated) that you do with your retirement account. Your health and well-being in retirement are just too important to accept any probability of success less than 100%. With your “mad money,” you can afford to accept some risk. The key to this strategy is to define that risk. Part of that is learning techniques to limit losses and insure against them.
The other side of that coin is to have a system where you only enter into a trade when you have a probability of winning that is acceptably high. To meet this criterion, the probability of success has to be known. This can be accomplished by using a constellation of indicators that provide the requisite edge, albeit in an imprecise way. You will be able to make profits in a more predictable and consistent way if you can translate imprecise statements of probability (.e.g., “highly likely”) into precise statements such as “a 70% chance” of making a profit. Such specificity is difficult to achieve with most investments. The mysterious world of options trading provides traders with a relatively easy way to accomplish this profitable task.
Risk v. Reward
When we talk about “high probability” strategies, the novice will often conclude that we should always search for trades with very, very high probabilities such as 100% (these don’t exist outside of fixed income investments) or 95%. The problem with this strategy is that there is no free lunch on Wall Street. Other traders are willing to pay you money, but they will only do it in exchange for you taking risks. If you are only willing to make bets that are very nearly “sure things,” then just invest in government bonds and hope they hedge inflation. The ultimate task of traders is to balance risk with reward. The payoffs for very high probability bets are so small that most traders consider them not worth doing. For you to make substantial profits, you must take risks that at least some other traders are unwilling to take.
The other extreme is taking on so much risk that your losses outweigh your wins. This is the sort of losing strategy that wipes out so many novice traders before they ever get a chance to develop a trading system that actually works. This means that to be a profitable trader, you must consider how much capital you are putting at risk and what kind of reward that will generate for each trade you consider. If you just guess, your likelihood of underestimating risk and overestimating reward is quite high. It is worth the time to track your trades and understand this objectively. The most common objective measure is the risk-reward ratio (RRR). There is some confusion about RRRs because sometimes traders are referring to their personal average of all trades over time, and some traders are talking about a particular trade.
Ultimately, we are trying to answer the following question: what is the potential loss compared to the potential gain? We can express that as a fraction, such as ½. This requires that we have actual numbers for both the maximum loss and the maximum (or expected) gain. Stock traders can use trading tools such as stop-loss orders to set a numerical limit on losses. Gains will often be forward-looking and must be estimated. With stocks, traders will often use a price target. If this is the case, then the estimation of the RRR will only be as accurate as the price target. Obviously, this method has a wide margin of error. Still, such a computation will prove more accurate than a mere optimistic guess. A major advantage of risk defined options strategies is that since profit is numerically defined, precise RRRs can easily be calculated.
When examining the risk profile of individual trades, it is important to realize that the RRR is closely linked to the probability of success of the trade. Over many trades, a trader can take higher levels of risk with correspondingly higher chances of winning. Writings on probabilistic trade strategies often use games of chance analogies to explain the concepts of risk, reward, and probability. Analogies are a fine teaching tool, but gambling analogies have a weakness in that they usually don’t explicitly consider that the probability of profit with market trades varies greatly from trade to trade. Games of chance tend to follow identical rules from game to game and thus the win rate is a secondary consideration to the massive gains that come with a win despite the fact that a win is extremely unlikely. We must remember that casinos remain solvent year after year because gamblers are willing to consistently defy the odds. Obviously, traders cannot afford this fallacy.
Contrarian Investing Bogle Style
The movement of stock prices up and down tends to freak people out, especially when they have a lot of money on the line, such as when they are close to retirement and have been saving for decades. This big question an investor must ask about risk concerns timeframes. If you are going to be invested for 30 years, why do you care what the stock market does on a day to day basis?
In contrast to Modern Portfolio Theory (MPT) is the idea of index investing. The idea of index investing is to put your savings into mutual funds that are not actively managed, but that passively track an index such as the S&P 500. We have already considered how America’s consumer culture can lead you to make financial decisions that are not in your best interest. The same can be said of commercially available investment products. If you see a commercial for an investment in television, how do you suppose the company that runs the fund paid for the television commercial? The answer is fees. The big fund manager salaries, television commercials, and other trappings of the consumer-driven financial world are all funded by fees that are charged to the investor. Remember, that when we are investing, the returns that we receive are a function of the rate of return that we receive and the amount of time that we are invested. We can’t do much about how old we are and how long it is until we reach retirement age, but we have a choice in which funds to invest. Every basis point that is taken out of our contributions in the form of fees is lost to us forever.
This is even more alarming when we consider that this stolen money isn’t subjected to the magic of compounding interest. A fee structure just under 2% doesn’t sound like much, and that is how they get you! A basis point is one one-hundredth of one percent. This is the yardstick that professional investors use when evaluating an investment. Very small increments in returns make a huge difference in our final portfolio balance over 30 or 40 years of investing. It makes sense, then, that we would want to achieve the highest returns possible by investing in the absolute cheapest mutual funds we can find.
When we examine how index funds work, there aren’t many management fees because there isn’t a lot for a manager to do. They have to deal with stock splits and index changes and things of that sort, but they are not actively picking stocks and changing out the portfolio every day that the market is open. The fact that index funds don’t do a lot of buying and selling is advantageous for the investor; activity costs money on Wall Street. The more you do nothing, the more you are saving in fees over time.
Surprisingly, some of the most successful investors of all time suggest that you can’t beat the Wall Street professionals and that your best chance to meet your retirement goals is to become an index investor. John C. Bogle, the founder of the Index Fund is a very vocal advocate of index investing. Warren Buffett, the most successful investor of all time says that the average person should use index investing as a way to achieve retirement savings goals. David Swensen, the investing genius who oversaw a $25+ billion increase in Yale’s endowment, makes the same recommendation.
If we examine the history of the S&P 500 index, every decline is followed by a new high. In other words, there will be ups and downs, but you will always make money invested in the stock market. The problem is, many people freak out when there is a big downturn, and they sell at the bottom and don’t wait for prices to go back up. If you can simply ignore the day to day moves of the market, then history teaches us that you will make money. You need to think in terms of decades to invest this way, and it may not be appropriate when you are within a few years of retirement. There are, however, bond index funds that have all of the safety and risks that bonds entail. Mr. Bogle recommends a mix of 60% broad market index funds and 40% bonds. There is even a Vanguard mutual fund that has this mix already, so you can just buy some of that one fund every month until you retire. If you feel that such a strategy is too old school and that you’d rather use complex computer models to generate a low volatility portfolio, be aware that Monte Carlo simulations suggest that the highest potential returns (without taking on a lot of sector risk) will come to those that simply buy and hold the index.
The hardest part of putting this little book together was deciding what to leave out. I had a specific length target in mind, and I managed to go over that target by a couple of dozen pages. If you are more interested in market investing and how Modern Portfolio Theory works versus index fund investing, I encourage you to read my other book in this series, Fundamentals of Market Investing.
As for the other topics in this book, there are some great writers and speakers out there that have dedicated a lifetime to helping others win their financial freedom. Don’t think for a second that I attempted to include all of the useful information about personal finance in this slim little volume. My goal was to cover the fundamentals—the bare bones basics—of personal finance. In a monograph of this length, I hope I’ve managed to give you a starting point for a deeper dive into this fascinating and important world.