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Jewish World Review April 24, 2002 / 13 Iyar, 5762

James K. Glassman

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Being there is best revenge

http://www.NewsAndOpinion.com |
Everyone's favorite hi-tech energy company goes bankrupt. Oil prices rise. The Middle East erupts. Housing starts drop. The federal surplus turns to deficit. Skeptics target the world's most valuable corporation. The New York attorney general claims massive fraud by stock analysts. What a mess!

Yet, suddenly on Tuesday, with no warning, the Dow Jones Industrial Average shoots up 208 points, its biggest gain in seven months. The tech-heavy Nasdaq, Japan's Nikkei, Britain's FTSE, Korea's Kospi and practically every other market in the world score handsome increases as well.

Why? Pundits point to a few decent earnings reports ("Better-than-expected results at General Motors and Sprint goosed the blue chips," indelicately wrote Igor Greenwald of SmartMoney.com), apparent Mideast progress and scattered upbeat economic numbers.

But pay no attention to these attempts at explanation. No one can consistently predict the short-term ups and downs of stock prices - and, even at the end of a day like Tuesday, it's rare that anyone can explain why the value of the tens of thousands of companies listed on the world's exchanges rose, on average, by about 2%.

"I never have the faintest idea what the stock market is going to do in the next six months, or the next year, or the next two," the most successful investor of the 20th century wrote in Fortune magazine last December. And if Warren Buffett hasn't the faintest idea, why do you think you do?

Don't despair. The short-term unpredictability of the market dictates a simple and effective strategy for small investors. I call it "Being There." Since, by their nature, stocks are prone to dramatic, unexpected moves, the trick is to stay invested all the time. Jumping in and out of the stock market -- even during periods when you might think shares are overvalued or the world stage is overwrought -- is a sure recipe for poor performance.

The most powerful evidence for Being There is a study called "Quantitative Analysis of Investor Behavior," begun in 1994 and updated every June by Dalbar, Inc., a Boston research firm. Using a sophisticated computer model, the study looks at cash flows into and out of mutual funds and determines the real-life returns achieved by small investors. The study, says the firm, "was the first to investigate how mutual fund investors' behavior affects the returns they actually earn."

The results are heartbreaking.

Between 1984 and 2000 (the most recent figures), stock-fund investors achieved average returns, including dividends, of just 5.3% a year. But investors who simply bought and held the 500 stocks of the Standard & Poor's index, a proxy for the market as a whole, achieved average returns of 16.3% a year. In other words, over the 17-year period, the typical investor's initial $10,000 grew to $24,000 while $10,000 invested in the S&P grew to $140,000.

Why the gigantic difference? Bad market timing, pure and simple.

The problem was not that investors picked the wrong mutual funds but that they jumped in and out of the market - and weren't around when the biggest gains were made. "Investors follow the trend in an intuitive way," Louis Harvey, president of Dalbar, told me. "They start piling their money in when markets are up, and they tend to stop piling it in when things are soft, as they are now."

Actually, said Harvey, the data show that investors are getting better. "As a group, they have become more tolerant" of risk, he said. Still, the results since 1984 are truly abysmal. The average frenetic investor would have done better by simply stashing her money in Treasury bills, which returned 5.8% annually during the period.

Professionals who employ market timing as an investment strategy don't do much better than amateurs. Timer Digest, a newsletter edited by Jim Schmidt, follows the actual buy-and-sell recommendations of newsletters that provide their readers with market-timing advice. For the 10 years ending Dec. 31, 2000, only one newsletter out of the 112 that Schmidt follows managed to beat the S&P 500 benchmark.

That newsletter was the Blue Chip Investor, edited by Steven G. Check of Check Capital Management in Costa Mesa, Calif. But Check, who beat the S&P by only a few tenths of a percentage point annually, is the exception who proves the rule. "We aren't in the business of forecasting the economy or short-term market moves," he writes in his utterly sensible list of seven "Realities and Expectations" for clients. "The future is never clear. We don't buy or sell stocks based on what the market may do."

Does Check sound like a certain sage from Omaha? It's no coincidence. According to its website (www.checkcapital.com), "Check Capital manages your assets under an investment philosophy like that of investment giant Warren Buffett." In fact, Check is not really a market timer at all, which means that the final score is, Market 111, Timers 0.

O.K. If the Being There strategy is so effective, then shouldn't all investors just buy a bunch of index mutual funds, instruct their banks to feed new money into those funds every month or quarter, and then just relax and rake in the profits?

Well, yes.

Another choice is buying exchange-traded funds, which are portfolios that are bought and sold just like individual stocks on major exchanges. Each ETF tracks an index. For example, Standard & Poor's Depositary Receipts (which trade on the American Stock Exchange under the symbol SPY and are nicknamed "Spiders") track the S&P 500, as do iShares S&P 500 (symbol:IVV). Diamonds (DIA) mimic the 30 stocks of the Dow Jones Industrial Average and trade at 1% of the price of the Dow (when the Dow is 10,300, a share of DIA costs about $103). There are ETFs that track the small-cap Russell 2000 index (IWM) and ETFs that track the S&P Europe 350 (IEV) or the global MSCI EAFE index (EFA).

A major appeal of these ETFs - as well as of many index mutual funds - is their low expense ratios. They charge investors an average of about 0.2%, or 20 basis points - compared with 140 basis points for the average fund managed by a real human being.

That's a huge difference for long-term investors. The Securities and Exchange Commission offers a handy calculator on its website that figures total mutual-fund expenses over time. For example, I assumed an investor started with $10,000 and got returns of 11% annually (the historic average) for 10 years. With yearly expenses of 1.4%, the $10,000 grew to $24,660, but with expenses of 0.2%, it grew to $27,831 - or 13% more.

Don't forget, however, that you have to pay your broker a commission to buy an EFT while you can go directly to a firm like Vanguard to purchase an S&P 500 index fund with a low expense ratio. (Both Spiders and Vanguard Index 500 charge 18 basis points in expenses.)

Also, be aware that, while ETFs and index funds are attractive, they will never beat the indexes - which is a feat that good mutual fund managers can accomplish. After accounting for expenses, over the five years ending March 31, the Vanguard Index 500 fund returned an annual average of 10.1%, but such core funds as Torray (14.1%), Janus (10.3%), Legg Mason Value Trust (15.1%), Fidelity Growth (12.7%), T.Rowe Price Capital Appreciation (13.7%) and Vanguard's own Growth & Income (11%) did even better.

The third choice is your own portfolio of stocks. The trouble is that you need to buy at least 30 different companies, spread across a dozen or more sectors, to get safety through adequate diversification. For most small investors, that's far too many. My advice is to do what I do: own about a dozen stocks plus a few EFTs or index funds plus managed funds.

But mind these two rules:

  1. Invest in stocks, EFTs and stock funds only if you can keep your money in the market for at least five years. Equities are too volatile for periods that are shorter.


  2. Stay invested the entire time. Yes, you should sell a stock if the underlying business has deteriorated. But quickly replace it with another stock. The times you are out of the market are far more dangerous to your wealth than the times you are in it.

Just last week, I received a newsletter from Franklin Templeton Investments that underlined, once more, the importance of Being There. Over the 10 years ending Dec. 31, 2001, the S&P returned an annual average of more than 12%. But an investor who missed merely the 10 best days out of the approximately 2,500 trading days during this period would have achieved returns of just 8%. An investor who missed the 20 best days, about 4%; the 30 best days, less than 2%.

No one can tell in advance which days these will be, so the best strategy is to own a diversified portfolio of stocks during each and every one of them.


JWR contributor James K. Glassman is the host of Tech Central Station. Comment by clicking here.

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