The blog ofJonathan Pepin

Notes from The Little Book Of Common Sense Investing [raw]


SUCCESSFUL INVESTING IS ALL about common sense. As Warren Buffett, the Oracle of Omaha, has said, it is simple, but it is not easy.

the winning strategy for investing in stocks is to own all of the nation’s publicly held businesses at very low cost. By doing so you are guaranteed to capture almost the entire return that these businesses generate in the form of dividends and earnings growth.

Buy a fund that holds this all-market portfolio, and hold it forever.

The index fund eliminates the risks of individual stocks, market sectors, and manager selection. Only stock market risk remains.

It is a book about why long-term investing serves you far better than short-term speculation; about the value of diversification; about the powerful role of investment costs; about the perils of relying on a fund’s past performance and ignoring the principle of reversion (or regression) to the mean (RTM) in investing; and about how financial markets work.

As investors seek to outpace their peers, winners’ gains inevitably equal losers’ losses. With all that feverish trading activity, the only sure winner in the costly competition for outperformance is the person who sits in the middle of our financial system.

After the deduction of the costs of investing, beating the stock market is a loser’s game.

Successful investing, then, is about minimizing the share of the returns earned by our corporations that is consumed by Wall Street, and maximizing the share of returns that is delivered to Main Street.

Adding a fourth law to Sir Isaac Newton’s three laws of motion, the inimitable Warren Buffett puts the moral of his story this way: For investors as a whole, returns decrease as motion increases.

profound conflict of interest between those who work in the investment business and those who invest in stocks and bonds.

The higher the level of their investment activity, the greater the cost of financial intermediation and taxes, the less the net return that shareholders—as a group, the owners of our businesses—receive.

“Over time, the aggregate gains made by . . . shareholders must of necessity match the business gains of the company.”

The price/earnings (P/E) ratio measures the number of dollars investors are willing to pay for each dollar of earnings. As investor confidence waxes and wanes, P/E multiples rise and fall.

the reason that annual stock returns are so volatile is largely because of the emotions of investing, reflected in those changing P/E ratios.

I divide stock market returns into two parts: (1) investment return (enterprise), consisting of the initial dividend yield on stocks plus their subsequent earnings growth (together, they form the essence of what we call “intrinsic value”), and (2) speculative return, the impact of changing price/earnings multiples on stock prices.

In the long run, stock returns depend almost entirely on the reality of the investment returns earned by our corporations.

The expectations market is about speculation. The real market is about investing. The stock market, then, is a giant distraction to the business of investing.

Occam’s razor: When there are multiple solutions to a problem, choose the simplest one.

For the past 90 years, the accepted stock market portfolio has been represented by the Standard & Poor’s 500 Index (the S&P 500). It was created in 1926 as the Composite Index, and now lists 500 stocks.

In 1970, an even more comprehensive measure of the U.S. stock market was developed. Originally called the Wilshire 5000, it is now named the Dow Jones Wilshire Total Stock Market Index.3 It now includes some 3,599 stocks, including the 500 stocks in the S&P 500.

Owning the stock market over the long term is a winner’s game, but attempting to beat the stock market is a loser’s game.

A low-cost all-market fund, then, is guaranteed to outpace over time the returns earned by equity investors as a group.

Once you recognize this fact, you can see that the index fund is guaranteed to win not only over time, but every year, and every month and week, even every minute of the day. No matter how long or short the time frame, the gross return in the stock market, minus intermediation costs, equals the net return earned by investors as a group.

On average, an astonishing 90 percent of actively managed mutual funds underperformed their benchmark indexes over the preceding 15 years. The index superiority was consistent and overwhelming.

the returns of investors as a group must, and will, and do fall short of the market return by an amount precisely equal to the aggregate amount of those costs. That is the simple, undeniable reality of investing.

Before costs, beating the market is a zero-sum game. After costs, it is a loser’s game.

Investors pay far too little attention to the costs of investing.

Where returns are concerned, time is your friend. But where costs are concerned, time is your enemy.

Fund performance comes and goes. Costs go on forever.

DIVIDEND YIELDS ARE A vital part of the long-term return generated by the stock market.

The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course.

Fund returns are devastated by costs, adverse fund selections, bad timing, taxes, and inflation.

It’s Wise to Plan on Lower Future Returns in the Stock and Bond Markets.

Both common sense and humble arithmetic tell us that we’re facing an era of subdued returns in the stock market.

three sources of return on stocks: the initial dividend yield and the earnings growth (together, “investment return”), and changes in the P/E multiple (“speculative return”).

Don’t Look for the Needle—Buy the Haystack.

Sounds easy, but selecting winning funds in advance is more difficult than it looks.

But easy as it is to identify past winners, there is little evidence that such performance persists in the future.

The odds against success are terrible: Only two out of 355 funds have delivered truly superior performance.

IN SELECTING MUTUAL FUNDS, too many fund investors seem to rely less on sustained performance over the very long term (with all of its own profound weaknesses) than on superior performance over the short term.

According to a 2014 study by the Wall Street Journal, only 14 percent of five-star funds in 2004 still held that rating a decade later.

Reversion to the mean (RTM) is reaffirmed in comprehensive fund industry data.

There is remarkably little persistence in returns among the top and bottom funds alike.

The message is clear: reversion to the mean (RTM)—the tendency of funds whose records substantially exceed industry norms to return toward the average or below—is alive and well in the mutual fund industry.

Average annual return of funds recommended by advisers: 2.9 percent. For equity funds purchased directly: 6.6 percent.

factor dominates the returns earned by investors in the bond market: the prevailing level of interest rates.

Why would an intelligent investor hold bonds?

reducing the volatility of your portfolio can give you downside protection during large market declines,

the current yield on bonds (3.1 percent) still exceeds the dividend yield on stocks (2 percent).

(Long-dated bonds—with, say, 30-year maturities—are much more volatile than short-term bonds—say, two years—but usually provide higher yields.)

Like stock funds, actively managed bond funds lag their benchmarks. Why? The arithmetic of costs.

Simply put, the ETF is an index fund designed to facilitate trading in its shares, dressed in the guise of the traditional index fund.

If you are making a single large initial purchase of either of those two versions of classic indexing—the Vanguard 500 ETF or the Spider 500 ETF—at a low commission rate and holding the shares for the long term, you’ll profit from the broad diversification and the low expense ratios that both offer.

But if you trade these two ETFs, you’re defying the relentless rules of humble arithmetic that are the key to successful investing. And if you like the idea of sector ETFs, invest in the appropriate ones, and don’t trade them.

In short, the ETF is a trader to the cause of the TIF. I urge intelligent investors to stay the course with the proven index strategy. While I can’t assure you that traditional index investing is the best strategy ever devised, I can assure you that the number of strategies that are worse is infinite.

“The greatest enemy of a good plan is the dream of a perfect plan.” Stick to the good plan.

Investors should be satisfied with the reasonably good return obtainable from a defensive portfolio.

The real money in investment will have to be made—as most of it has been made in the past—not out of buying and selling but of owning and holding securities, receiving interest and dividends and benefitting from their long-term increase in value.

Ninety-four percent of the differences in portfolio returns is explained by asset allocation.

your first investment decision should be how to allocate your investment assets:

My recommendations for investors in the accumulation phase of their lives, working to build their wealth, focused on a stock/bond mix of 80/20 for younger investors and 70/30 for older investors. For investors starting the postretirement distribution phase, 60/40 for younger investors, 50/50 for older investors.

There are two fundamental factors that determine how you should allocate your portfolio between stocks and bonds: (1) your ability to take risk and (2) your willingness to take risk.

Your ability to take risk depends on a combination of factors, including your financial position;

Your willingness to take risk, on the other hand, is purely a matter of preference.

Low costs enable lower-risk portfolios to provide higher returns than higher-risk portfolios.

your bond position should equal your age, with the remainder in stocks.

Yes, the market value of our capital is important. But frequent peeking at the value of our investments is not only unproductive, but counterproductive. What we really seek is retirement income that is steady and, if possible, grows with inflation.

About half of the balanced portfolio’s income comes from interest on bonds, and the other half from dividends, mostly from large-cap stocks.

A combination of Social Security payments and dividends from index funds1 (supplemented as necessary with withdrawals of capital) are likely to be an effective means of enjoying regular monthly income from your retirement assets.

When determining their asset allocations, most investors need to take Social Security into consideration as a bond-like asset. The value of Social Security in your portfolio is significant.

the income produced by your retirement portfolio is apt to fall well short of your retirement spending needs. A rule of thumb suggests that an annual withdrawal rate of 4 percent (including income and capital) of the year-end value of your initial retirement capital, adjusted annually for inflation, is likely—but by no means guaranteed—to be sustainable throughout your retirement years.

while such an index-driven strategy may not be the best investment strategy ever devised, the number of investment strategies that are worse is infinite.

The way to wealth, I repeat one final time, is not only to capitalize on the magic of long-term compounding of returns, but to avoid the tyranny of long-term compounding of costs.