Big Mistakes

by Michael Batnick

  But when the air came out of the stock market, they learned the meaning of not confusing brains with a bull market. “The merger that I sought and accomplished not only failed to solve Wellington's problems, it exacerbated them.”13 Ivest, which is one of the reasons they sought TDP&L, lost 55% of its value, compared with a decline of 31% for the S&P 500 over the same time. But the carnage wasn't just limited to Ivest. They had started a few other funds, but they were no better off. When the markets tanked, all of them dropped far below the S&P 500. The Explorer Fund was down 52%, the Morgan Growth Fund slid 47%, and Trustees Equity Fund was down 47%. By 1978, the Trustees Equity Fund had folded and, as Bogle noted, “a speculative fund – Technivest – that we designed to ‘take advantage of technical analysis’ (I'm not kidding) folded even earlier.”14 You read that right, Jack Bogle, the creator of the index fund, was the CEO of a company that ran a strategy based on technical analysis.

  Of all the damage that would be done, the one that cut the deepest was inflicted on their crown jewel, the Wellington Fund. It lost 40%, which was 80% of the decline in the S&P 500. Bogle described this as a “shocking excess relative to Wellington's long history. The loss would not be recouped until 1983, 11 long years later. The ‘strong offense’ proved no ‘defense’ at all.”15 The incredible track record and reputation they had built over the years was in jeopardy. The average balanced fund gained 23% for the decade, while Wellington's total return (including dividends) was just 2%.16

  Bogle looks back on this period of his career with disgust. “I can hardly find words to describe first my regret and then my anger at myself for having made so many bad choices. Associating myself – and the firm whose leadership I had been entrusted – with a group of go‐go managers.”17 The blame for the disastrous performance fell on Bogle. He was fired as CEO of Wellington Management in 1974 but convinced the board to let him stay on as chairman and president of the Wellington Fund.

  Abject failure would give birth to the most important financial innovation the world has ever seen, the index fund. In 2005, at a Boston Security Analysis Society event, the great Paul Samuelson said:

  I rank this Bogle invention along with the invention of the wheel, the alphabet, Gutenberg printing, and wine and cheese: a mutual fund that never made Bogle rich but elevated the long‐term returns of the mutual‐fund owners. Something new under the sun.18

  Bogle had taken all of the lessons he learned and focused his attention into a better way of doing business. By September 1974, he and his team had completed months of research. He was able to bring that to the directors of the funds and convince them to form the Wellington Group, a specialized staff dedicated to Wellington and seven other selected funds. The eight Wellington funds were wholly owned by the funds themselves, “operating on an at‐cost basis‐ a truly mutual mutual funds structure, without precedent in the mutual fund industry. The name I chose for the new firm was The Vanguard Group Inc. On September 24, 1974, Vanguard was born.”19

  After 16 months of trying to convince the board to create an index fund, the First Index Investment Trust was born. Bogle had shown them the evidence, that over the previous three decades, the S&P 500 index averaged 11.3% growth per year, while the funds trying to beat it earned just 9.7%. The rest is history. Well, sort of. Wall Street wasn't ready to embrace the index fund or stocks for that matter. When they launched in August 1976, stocks were just wrapping up a lost decade. They were trading at the same levels as they had 10 years ago and just experienced the worst bear market since the Great Depression. But determined and sure that he was onto something, Bogle pressed on. He knew that the index fund would give investors their best chance at capturing their fair share of market returns over the long‐term.

  The First Index Investment Trust did well in its first decade, growing to $600 million (which represented less than one half of 1% of mutual fund assets). But competition was slow to encroach on their territory. In fact, the second index fund wasn't created until 1984, by Wells Fargo. The Stagecoach Corporate Stock Fund came with a 4.5% sales load and an annual expense ratio of 1%.20 Today, the fund has just $2 billion. I guess there is something to Bogle's saying “ideas are a dime a dozen, but implementation is everything.”

  Success found its way to index funds in the second decade after their creation, when they went from $600 million to $91 billion. In the end, Bogle was vindicated, and then some.

  From 1976 to 2012, the Vanguard 500 returned 10.4%, compared to the 9.2% return of the average large‐cap blend funds. The 1.2% difference is nearly identical to the one Bogle presented to his board 40 years earlier. That decades‐long track record illustrates the consistent returns that index funds can offer – their primary benefit over other types of investments. Today, index funds represent around 30% of all assets held in mutual funds.

  Perhaps most remarkable of all, in 2016, the $289 billion net flows into Vanguard exceeded the other 4,000 global fund providers in Morningstar's database, combined.21

  Jack Bogle didn't create the index fund until he was 47 years old. So if you've yet to find a method of investing that you're comfortable with, it's not too late! Maybe you've been going back and forth between picking stocks, buying options, or timing the market, all with little to show for it. That's fine, you're still on the path to discovery. I know all about it.

  It took me around five years and nearly $20,000 in commissions to realize that I was not destined to be the next Paul Tudor Jones. I was too emotional to be a successful trader, which led me into the arms of Bogle's index funds. Not everybody can buy and hold an index fund – it can be grueling and difficult, rife with drawdowns and potentially decades with nothing to show for it. But warts and all, for me, this is the best way. Not everybody comes to this conclusion and that's okay. The important part is finding a methodology that you are comfortable with. But a methodology means something that is repeatable. It means having a process. The stock market throws far too many curve balls for you to wing it.

  With people living longer than ever, we need to expect and be prepared to fund a long retirement. In order to do this, you, like Bogle, need to find what works for you! Hopefully, after reading how a giant like Bogle was dealt a few blows, you'll realize that investing is a lifelong journey of self‐discovery. If you're still on your journey, keep searching.

  Notes

  1. Credit Suisse, “Looking for Easy Games,” January 4, 2017.

  2. Morningstar, “Recommendations for Fund Companies Not Named Vanguard,” December 27, 2016.

  3. John C. Bogle, “The Professor, the Student, and the Index Fund,” johncbogle.com, September 4, 2011.

  4. Vanguard, “Reflections on Wellington Fund's 75th Birthday,” 2006.

  5. Ibid.

  6. Adam Smith, Supermoney, foreword by John C. Bogle (Hoboken, NJ: Wiley, 2007).

  7. John C. Bogle, The Clash of the Cultures (Hoboken, NJ: Wiley, 2012).

  8. Institutional Investor, “The Whiz Kids Take Over,” January 1968.

  9. Bogle, The Clash of the Cultures, 262.

  10. Michael Regan, “Q&A with Jack Bogle: ‘We're in the Middle of a Revolution,’” Bloomberg.com, November 23, 2016.

  11. John Brooks, The Go‐Go Years (Hoboken, NJ: Wiley, 1999), 128.

  12. Bogle, The Clash of the Cultures, 272.

  13. Smith, Supermoney.

  14. Ibid.

  15. Bogle, The Clash of the Cultures, 272.

  16. Smith.

  17. Ibid.

  18. Quoted in John C. Bogle, “Lightning Strikes,” Institutional Investor 40, no. 5 (Special 40th Anniversary Issue, 2014): 42–59.

  19. Bogle, The Clash of the Cultures, 278.

  20. Ibid.

  21. Ali Masarwah. “Indexing, Vanguard Drove Global Fund Flows,” Morningstar.com, February 4, 2017.

  CHAPTER 6

  Michael Steinhardt

  Stay in Your Lane

  Investors who confine themselves to what they know, as difficult as that may be, have a considerable advanta
ge over everyone else.

  —Seth Klarman

  Making money in the markets is challenging even when you have a deep understanding of what it is that you're doing. Consider specialized professional financial analysts, for example, who have expertise in one particular industry. Even they often have a difficult time separating the winners from the losers.

  With the proliferation of exchange‐traded funds (ETFs) and exchange‐traded notes (ETNs), different parts of the market have become more accessible than ever. But just because we can trade commodities, currencies, volatility, stocks, and bonds doesn't mean we should. Wandering outside of your comfort zone can be a very expensive journey. You don't see lawyers performing oral surgery or accountants drawing blueprints. Similarly, it is your job as an investor to define your circle of competence and stay within that circle.

  Warren Buffett is an example of an investor who was deeply intimate with the limitations of his abilities. As the tech bubble inflated in the late 1990s, he was one of the few high‐profile investors who never bought into the hype. He knew nothing about semiconductors and even less about the Internet – and he wasn't afraid to admit it. So while shares in his company, Berkshire Hathaway, were cut in half, he stayed true to himself. Buffett never stopped attempting to buy companies that did business in areas he understood. But perhaps more importantly, he never tried to buy a company he couldn't understand, and, as a result, he never paid a ridiculously inflated price.

  In July 1999 while at the Sun Valley Conference in Idaho, Buffett got on stage and poured cold water on the current investing landscape. What made this interesting was not that he spoke about the overall market, which he rarely does, but rather whom he was speaking to. Sitting in the audience were Bill Gates, Andy Grove, and other newly minted tech‐made millionaires. To them, Buffett's shade looked like nothing more than sour grapes from an old man who couldn't adjust to the times. Over the prior 12 months, Berkshire Hathaway lost 12% of its value, while the NASDAQ 100, a tech‐heavy index, rose 74%. Individual tech stocks performed even better over that time; Cisco gained 110%, Yahoo! gained 350%, and Qualcomm gained 408%.

  The late nineties were a rough period for value investors. The Internet bubble temporarily changed the way that businesses were valued. For example, eToys Inc. rose 325% on the day of its IPO. At the time, Toys“R”Us was generating 150 times as much revenue and earned $132 million over the previous 12 months, while eToys had lost $73 million. Despite this, eToys was valued at $7.7 billion, while the brick‐and‐mortar retailer was worth just $5.7 billion.

  Stocks like Coca‐Cola, Gillette, and the Washington Post (Berkshire holdings) were left in the dust as investors dumped value and piled into growth stocks. From peak to trough (June 1998 through March 2000), Warren Buffett's Berkshire Hathaway fell 51% in value! During this time, I estimated that Buffett's net worth fell by more than $10 billion. How much Berkshire did Buffett sell? How much Cisco did he buy? Zero point zero. Not tempted by tech stocks, Buffett remained committed to value investing, and it paid off.1

  One of the keys to successfully managing your money is to accept, like Buffett did, that there will be times when your style is out of favor or when your portfolio hits a rough patch. It's when you start to reach for opportunities that you can do serious damage to your financial well‐being. Michael Steinhardt and his investors learned this lesson in 1994.

  Michael Steinhardt is one of those people who was born to pick stocks. There are many mythical stories about investors starting young but Steinhardt actually began investing with his bar mitzvah money. His father bought him shares of Penn Dixie Cement and Columbia Gas System. In his autobiography, No Bull, he talks about how his interest in stock investing began when he was 13 years old. His entire education and career had been focused on US stocks.2 Steinhardt's love affair with the stock market would only intensify with the passage of time. He went through his portfolio six times every day, and his obsession paid off, filling his clients' pockets.3

  Steinhardt was an early pioneer in the hedge fund business and, along with George Soros and Julian Robertson, was one of the big three of the industry. Steinhardt, Fine, Berkowitz & Company opened their doors on July 10, 1967, with $7.7 million. From its inception until he retired in 1995, they returned an average of 24.5% annually, even after taking 20% of the profits. One dollar invested in the fund in 1967 would have been worth $481 on the day he closed the firm in 1995. To underscore how impressive his firm's performance was consider that $1 invested in the S&P 500 would have been worth $19 over the same time period. Stated differently, $10,000 invested with Steinhardt in 1967 would have been worth $4.8 million in 1995 versus the $190,000 it would be worth if it had been invested in the index. These incredible performance numbers are not just abstract. There are a lot of managers with a great, long‐term track record that were not able to keep their clients invested through the ups and downs.

  Steinhardt once told a story about an early investor who stayed with him through thick and thin and that commitment earned the steadfast client a fortune. The man's name was Richard Cooper, and he first started working with Steinhardt around 1967. His initial investment of $500,000 was worth more than $100 million by the time the firm closed.4

  Despite his steady performance, Steinhardt was an aggressive trader with unbridled emotions. He recounts the story of learning that one of his firm's portfolios, the only one that was supposed to be low risk, contained bonds that were mismarked. In dressing down the portfolio manager, Steinhardt let loose. He writes, “My rage was uncontrollable. The shouting emanating from my office reached a new decibel level. When the portfolio manager finally had the courage to mutter a few words back to me, he said, ‘All I want to do is kill myself.’ I replied coolly, ‘Can I watch?’”5 Steinhardt was aware of his tyrannical behavior, but he didn't do much to change it. On top of his temper, he could also be incredibly arrogant, especially when things were going well.

  His fiery passion for the stock market enabled him to thrive in almost all market environments throughout his three‐decade career, even if his peers were not. In May 1971, Fortune ran an article titled “Hedge Fund Miseries” that referenced an SEC study of the destruction that occurred in these funds when the go‐go years of the late 1960s came to a screeching halt. Once the bull market slowed, many hedge funds had trouble beating market averages. According to Fortune, “The [SEC] study shows that assets of the twenty‐eight largest hedge funds – which accounted for 82 percent of the total in 1968 – declined by a whopping 70 percent, or by about $750 million between the end of 1968 and September 30, 1970…. At least one fund showed portfolio gains for the period. Not surprisingly, it emerged as the largest on the SEC's 1970 list. That fund is Steinhardt, Fine, Berkowitz & Co.”6

  Despite Michael Steinhardt's amazing performance record, he, like every single person who has ever put a dollar into the market, experienced agonizing periods. The fund got annihilated in the crash of 1987, and he compounded his problems by buying more S&P index futures on the morning of October 19, 1987. It was a big loss but not a big deal. Most people didn't see the crash coming, although Steinhardt claims he did, but stayed invested anyway. But under his leadership, the firm made it through. What happened next offers investors the most important lesson they can learn from Michael Steinhardt.

  In the mid‐1990s, hedge fund popularity exploded and investors were knocking down managers' doors to get them to take their money. Steinhardt described the times in No Bull:

  It seemed that every “sophisticated” investor wanted to participate in hedge funds, perhaps because their cachet denoted a peculiar exclusivity. Hedge funds became a buzz word. Our firm was bombarded by potential investors who were begging us to let them invest. I could not attend a social event without being besieged with requests to take money from potential investors.7

  While easy money was available, Steinhardt started his fourth fund (his second offshore) in 1993, the Steinhardt Overseas Fund. They were managing just shy of $5 billion, which
was an enormous amount of money back then and still is now. But this big capital base did not come without a cost. He was now responsible for more than 200 times the amount of money he started with, even after adjusting for inflation. It was getting more and more difficult for small and midcap stocks, his bread and butter, to move the needle. So he did something very foolish. He started globetrotting like he was George Soros, and he entered, what was for him, uncharted territory.

  Steinhardt was used to the rapid‐fire trading of US stocks, but his newfound size became the enemy of performance. It forced him to venture off into areas where he had no expertise. French bonds have as much in common with General Electric stock as an iPhone does with a squirrel. Much of Steinhardt's success had come from his deep understanding of the markets he was trading. Now, he was tempted by potential up‐and‐comers in emerging markets where he knew little about the business environment and political system. In his memoir he recalls, “Unfortunately, we walked forward unafraid.”8

  Foreign stocks are a few miles outside his circle of competence, but now he was about to travel to the moon. The fund was using swaps and making directional bets on the debt of Europe, Australia, and Japan. Thanks to a barrage of currency cross‐trades, the fund's daily profit‐and‐loss statement had reached 30 pages and was practically indecipherable.

  Steinhardt was feeling more brazen about his investing acumen, and his investors would pay for his hubris. Charlie Munger once said, “If you play games where other people have the aptitudes and you don't, you're going to lose.” Steinhardt was playing a game that was destined for failure. He had built his success on equity block trading and, as his reputation developed, so did his relationships with the brokers. The sheer size of his firm gave him an edge. As a VIP client, he could always get in touch with someone if he needed to buy or sell quickly. But in Europe, Steinhardt didn't have close, long‐term relationships with brokers, so he wasn't at the top of their list when things got hairy. And they were about to get hairy.