There are several organizations that track the results of financial newsletter stock picks. The Hulbert Financial Digest is one of them. In its January 2001 edition, the US-based publication revealed it had followed 160 newsletters that it had considered solid. But of the 160 newsletters, only 10 of them had beaten the stock market indexes with their recommendations over the past decade. Based on that statistic, the odds of beating the stock market indexes by following an investment newsletter are less than 7 percent.7
Put another way, how would this advertisement grab you?
You could invest with a total stock market index fund—or you could follow our newsletter picks. Our odds of failure (compared with the index) are 93 percent. Sign up now!
I don’t think the Hulbert Financial Digest was created to be critical. But it’s tough not to be. When investment newsletters fudge the truth, they can profit from new subscribers.
In 2013, Mark Hulbert wrote a story for Barron’s. It was titled, “Newsletter Returns: Be Skeptical.” Hulbert’s firm has been tracking the performance of investment newsletters for years. When newsletters advertise, he says, they often lie.
As an example, Hulbert brought up one of Mark Skousen’s investment newsletters. Skousen’s newsletter claimed, “that for seven years running—through good markets and bad—my recommendations have racked up an annualized return of 145 percent.”8
Hulbert responded to that claim. “My Hulbert Financial Digest performance monitoring service hasn’t found Skousen’s longest-lived newsletter to produce anywhere close to a 145 percent annualized return. . . . Over the last seven years, the time frame that the ad refers to, the HFD [Hulbert Financial Digest] calculates that the newsletter produced a 5.2 percent annualized return.” A US index fund would have beaten it.
High-Yielding Bonds Called “Junk”
At some point, you might fight the temptation to buy a corporate bond that’s paying a high percentage of interest. Ignore such investments. If a company is treading water or sinking, it’s going to have a tough time borrowing money from banks, so it “advertises” a high interest rate to draw riskier investors. But here’s the rub: if the business gets into financial trouble, it won’t be able to pay that interest. What’s worse, you could even lose your initial investment.
Bonds that pay high interest rates (because they have shaky financial backing) are called junk bonds.
I’ve found that being responsibly conservative is better than stretching over a ravine to pluck a pretty flower.
Fast-Growing Markets Can Make Bad Investments
A friend of mine once told me: “My adviser suggested that, because I’m young, I could afford to have all of my money invested in emerging market funds.” His financial planner dreamed of the day when billions of previously poor people in China or India would worship their 500-inch, flat-screen televisions, watching The Biggest Loser while stuffing their faces with burgers, fries, and gallons of Coke. Eyes sparkle at the prospective burgeoning profits made by investing in fattening economic waistlines. But there are a few things to consider.
Historically, the stock market investment returns of fast-growing economies don’t always beat the stock market growth of slow-growing economies. William Bernstein, using data from Morgan Stanley’s capital index and the International Monetary Fund, reported in his book, The Investor’s Manifesto, that fast-growing countries based on gross domestic product (GDP) growth produced lower historical returns than the stock markets in slower growing economies from 1988 to 2008.9
Table 9.2 shows that when we take the fastest growing economy (China’s economy) and compare it with the slowest growing economy (the US) we see that investors in US stock indexes would have made plenty of money from 1993 to 2008. But if investors could have held a Chinese stock market index over the same 15-year period, they would not have made any profits despite China’s GDP growth of 9.61 percent a year over that period.
Table 9.2 Growing Economies Don’t Always Produce Great Stock Market Returns
Country 1988–2008, After Inflation Annualized GDP Growth (in Percentages)
Average Stock Growth (in Percentages)
United States 2.77
8.8
Indonesia 4.78
8.16
Singapore 6.67
7.44
Malaysia 6.52
6.48
Korea 5.59
4.87
Thailand 5.38
4.41
Taiwan 5.39
3.75
China 9.61
3.31 (as of 1993)
Source: The Investor’s Manifesto by William Bernstein
China’s GDP continued to soar from 2008 to 2016. But the country’s stocks suffered. If $10,000 were invested in the iShares China Large-Cap ETF at the beginning of 2008, it would have been worth just $6,971 by October 10, 2016. By comparison, if $10,000 were invested at the same time in Vanguard’s S&P 500 Index, it would have grown to $14,792 by October 10, 2016.10
Yale University’s celebrated institutional investor, David Swensen, also warns endowment fund managers not to fall into the GDP growth trap. In his book written for institutional investors, Pioneering Portfolio Management, he suggests that from 1985 (the earliest date from which the World Bank’s International Finance Corporation began measuring emerging market stock returns) to 2006, the developed countries’ stock markets earned higher stock market returns for investors than emerging market stocks did.11
In Table 9.3, I updated those returns to January 1, 2016. Emerging markets pulled ahead of developed world markets, excluding the United States. But they aren’t the runaway winners that many investors expect.
Table 9.3 Emerging Market Investors Don’t Always Make More Money
Index 1985–2016
$100,000 Invested in Each Index Would Grow to . . .
US Index 11.3% annual gain
$2,744,193
Developed Stock Market Index (England, France, Canada, Australia) 8.9% annual gain
$1,401,378
Emerging Market Index (Brazil, China, Thailand, Malaysia) 9.2% annual gain
$1,529,888
Source: Pioneering Portfolio Management by David Swensen
Emerging markets might be exciting—because they rise like rockets, crash like meteorites, then rise like rockets again. But if you don’t need that kind of excitement, you might prefer a total international stock market index fund instead of adding a large emerging-market component.
Whether the emerging markets prove to be future winners is anyone’s guess. They might. But it’s best to remain diversified and keep such exposure low.
Gold Isn’t an Investment
Gold is a horrible long-term investment. But few people know that. Do you want proof? Try this on the streets.
Walk up to an educated person and ask them to imagine that one of their forefathers bought $1 worth of gold in 1801. Then ask what they think it would be worth in 2016.
Their eyes might widen at the thought of the great things they could buy today if they sold that gold. They might imagine buying a yacht or Gulfstream jet or their own island in the South China Sea.
Then break their bubble. Selling that gold wouldn’t give them enough money to fill the gas tank of a minivan.
One dollar invested in gold in 1801 would only be worth about $54 by 2016.
How about $1 invested in the US stock market?
Now you can start thinking about your yacht.
One dollar invested in the US stock market in 1801 would be worth $16.24 million by 2016.12
Gold is for hoarders who expect to trade glittering bars for stale bread after a financial Armageddon. Or it’s for people trying to “time” gold’s movements by purchasing it on an upward bounce, with the hopes of selling before it drops. That’s not investing. It’s speculating. Gold has jumped up and down like an excited kid on a pogo stick for more than 200 years. But after inflation, it hasn’t gained any long-term elevation.
I prefer the Tropical Beach approac
h:
Buy assets that have proven to run circles around gold (rebalanced stock and bond indexes would do).
Lay in a hammock on a tropical beach.
Soak in the sun and patiently enjoy the long-term profits.
What You Need to Know about Investment Magazines
If investment magazines were created to help you achieve wealth, you’d have the same cover story during every issue: Buy Index Funds Today.
But nobody would buy the magazines. It wouldn’t be newsworthy. Plus, magazines don’t make much money from subscriptions. They make most of their money from ads. Pick up a finance magazine and see who’s advertising. The financial services industry, selling mutual funds and brokerage services, is the biggest source of advertisement revenue.
Advertisers pay the bills for financial magazines. That’s why you see magazine covers suggesting “Hot Mutual Funds to Buy Now!”
In 2005, I wrote an article for MoneySense magazine titled, “How I Got Rich on a Middle Class Salary,” and I mentioned the millionaire mechanic, Russ Perry (who I introduced in Chapter 1). I quoted Russ’s opinion on buying new cars—that it wasn’t a good idea, and that people should buy used cars instead.
Based on a conversation I had with Ian McGugan, the magazine’s editor, I learned that one of America’s largest automobile manufacturers called McGugan on the phone and threatened to pull its advertisements if it saw anything like that in MoneySense again. Financial magazines can’t afford to educate because advertisers pay their bills.
I had the April 2009 issue of SmartMoney magazine on my desk as I wrote this book’s first edition. The magazine was published one month earlier when the stock market was reeling from the financial crisis. Instead of shouting out: “Buy stocks now at a great discount!” the magazine was giving people what they wanted: A front cover showing a stack of $100 bills secured by a chain and padlock with the screaming headlines: “Protect Your Money!” “Five Strong Bond Funds,” “Where to Put Your Cash,” and “How to Buy Gold Now!”
Such headlines are silly when stocks are on sale. But if the general public is scared stiff of the stock market’s drop, they’ll want high doses of chicken soup for their knee-jerking souls. They’ll want to know how to escape from the stock market, not embrace it. Giving the public what it pines for when they’re scared might sell magazines. But you can’t make money being fearful when others are fearful.
I don’t mean to pick on SmartMoney magazine. I can only imagine the dilemma it faced when putting that issue together. Its writers are smart people. They know—especially for long-term investors—that buying into the stock market when it’s on sale is a powerful wealth-building strategy. But a falling stock market, for most people, is scarier than a rectal examination. Touting bond funds and gold was an easier sell.
Let’s have a look at the kind of money you would have made if you followed that April 2009 edition of SmartMoney.
It suggested placing your investment in the following bond funds: the Osterweis Strategic Income Fund, the T. Rowe Price Tax-Free Income Fund, the Janus High-Yield Fund, the Templeton Global Bond Fund, and the Dodge & Cox Income Fund.
Table 9.4 shows that with reinvesting the interest, SmartMoney’s recommended bond funds would have returned an average of 58 percent from April 2009 to January 2016.
Table 9.4 Percentages of Growth (April 2009–January 2016)
SmartMoney’s Recommended Bond Funds
Osterweis Strategic Income Fund (OSTIX) +60%
T. Rowe Price Tax-Free Income Fund (PATAX) +45%
Janus High-Yield Fund (JHYAX) +84%
Templeton Global Bond Fund (FBNRX) +51%
Dodge & Cox Income Fund (DODIX) +48%
SmartMoney’s Recommended Fund Average Return +58%
US Stock Market Index Return +198%
International Stock Market Index Return +86%
Global Stock Market Index Return +131%
Source: Morningstar13
How about gold, which was also recommended by that edition of SmartMoney? It would have gained 13.8 percent during the same period.
So far, it looks like the magazine’s recommendations weren’t too bad, until you look at what they didn’t headline. Stock prices were cheaper, relative to business earnings, than they had been in decades. The magazine headlines should have read: “Buy Stocks Now!”
Because they didn’t, as demonstrated by Table 9.4, SmartMoney readers missed out on some huge gains. Stocks easily beat bonds and gold from April 2009 to January 2016.
The US stock market (as measured by Vanguard’s US stock market index) increased 198 percent. Vanguard’s international stock market index rose by 86 percent, and Vanguard’s total world index rose by 131 percent during the same period.
The comparative results punctuate how tough predictions can be, while emphasizing that magazines cater to their advertisers and their reader’s emotions.
Hedge Funds—The Rich Stealing from the Rich
Some wealthy people turn their noses up at index funds, figuring that if they pay more money for professional financial management, they’ll reap higher rewards in the end. Take hedge funds, for example. As the investment vehicle for many wealthy, accredited investors (those deemed rich enough to afford taking large financial gambles), hedge funds capture headlines and tickle greed buttons around the world, despite their hefty fees.
But by now, it probably comes as no surprise that, statistically, investing with index funds is a better option. Hedge funds can be risky, and the downside of owning them outweighs the upside.
First the Upside
With no regulations to speak of (other than keeping middle-class wage earnings on the sidelines), hedge funds can bet against currencies or bet against the stock market. If the market falls, a hedge fund could potentially make plenty of money if the fund manager “shorts” the market by placing bets that the markets will fall and then collecting on these bets if the markets crash. With the gift of having accredited (supposedly sophisticated) investors only, hedge fund managers can choose to invest heavily in a few individual stocks—or any other investment product—while a regular mutual fund has regulatory guidelines with a maximum number of eggs they’re allowed to put into any one basket. If a hedge fund manager’s big bets pay off, investors reap the rewards.
Now for the Downside
The typical hedge fund charges 2 percent of the investors’ assets annually as an expense ratio. That’s one-third more expensive than the expense ratio of the average US mutual fund. Then the hedge fund’s management takes 20 percent of their investors’ profits as an additional fee. It’s a license to print money off the backs of others.
Hedge funds voluntarily report their results, which is the first phase of mist over the industry.
When Princeton University’s Burton Malkiel and Yale School of Management’s Robert Ibbotson conducted an eight-year study of hedge funds from 1996 to 2004, they reported that fewer than 25 percent of funds lasted the full eight years.14 Would you want to pick from a group of funds with a 75 percent mortality? I wouldn’t.
When looking at reported average hedge fund returns, you only see the results of the surviving funds. Dead funds aren’t factored into the averages. It’s a bit like a coach entering 20 high school kids in a district championship cross-country race. Seventeen drop out before they finish. But your three remaining runners take the top three spots. You report, in the school newspaper, that your average runner finished second. Bizarre? Of course, but in the fantasy world of hedge fund data crunchers, it’s still “accurate.”
As a result of such twilight-zone reporting, Malkiel and Ibbotson found that the average returns reported in databases were overstated by 7.3 percent annually.
These results include survivorship bias (not counting those funds that don’t finish the race) and something called “backfill bias.” Imagine 1,000 little hedge funds that are just starting out. As soon as they “open shop” they start selling to accredited investors. But they aren’t big eno
ugh or successful enough to add their performance figures to the hedge fund data crunchers—yet.
After 10 years, assume that 75 percent of them go out of business, which is in line with Malkiel and Ibbotson’s findings. For them, the dream is gone. And it’s really gone for the people who invested with them.
Of those (the 250) that remain, half have results of which they’re proud, allowing them to grow and to boast of their successful track records. So out of 1,000 new hedge funds, 250 remain after 10 years, and 125 of them grow large enough (based on marketing and success) to report their 10-year historical gains to the data crunchers that compile hedge fund returns. The substandard or bankrupt funds don’t get number crunched. Ignoring the weaker funds and highlighting only the strongest ones is called a “backfill bias.”
Doing so ignores the mortality of the dead funds and it ignores the funds that weren’t successfully able to grow large enough for database recognition. Malkiel and Ibbotson’s study found that this bizarre selectiveness spuriously inflated hedge fund returns by 7.3 percent annually over the period of their study.15
According to hedgefundresearch.com, during the 13 years ending August 31, 2015, the average reported hedge fund averaged a compound annual return of less than 1 percent.16
But averages aren’t chic. Let’s look at the most popular hedge funds, based on size. They’re large for a reason. Whispers of their greatness likely swept through country clubs like a billionaire’s affair. That’s when the rich poured in money—swelling the funds in size.
Millionaire Teacher Page 23
