Recipes for Investment Success
The best way to minimize the risk of getting clobbered by the market is to simply capture the market’s return via a low-cost, tax-efficient index fund. It was perhaps with this understanding that the creators of Google seized the opportunity to educate their employees on what is important in investing. As described in a well-written San Francisco Magazine article18, Google founders Page and Brin facilitated a series of investment lectures to their legion of employees prior to Google’s historic 2004 public stock offering. With the usual sharks of Wall Street circling—hoping to sink their teeth into the hundreds of soon-to-be multimillionaires—the Google founders instead brought in the most revered names of financial academia to teach the company’s brilliant engineers, programmers and web-geeks the art and science of personal investing.
First to arrive was 1990 Nobel Laureate Bill Sharpe. Rather than dazzle the crowd with the finer points of portfolio optimization or his Capital Asset Pricing Model, Sharpe instead offered a simple recipe for a lifetime of investment success: Don’t try to beat the market. Instead, put your savings in a few diversified index funds and let capitalism and the efficient market work for you. The following week’s lesson was taught by Burton Malkiel, finance professor at Princeton and author of A Random Walk Down Wall Street: Don’t try to beat the market, he said, and don’t believe anyone who says they can—not a friend, a broker with a hot stock tip, or the latest magazine touting the most recent outperforming fund.
Now, to a group of some of the world’s brightest “Brokers exist for one reason and one reason only: to take your money through high fees and transaction costs.” 20-year olds—most of whom grew up watching tech stocks double overnight—this somewhat sobering advice came as a surprise. But one week later, the message was the same. This time the wise sage at the podium was Jack Bogle, founder of Vanguard. Wall Street, he said, is more about salesmanship than stewardship. The brokers hovering at the door are here for one reason and one reason only: to take your money through high fees and transaction costs, the majority of which are hidden from your view. Ignore them all and invest in an index fund.
When the brokers of Wall Street were finally allowed to enter the walls of Google, they were surprised at—and discouraged by—their reception. They were peppered with questions about low-cost investing using index funds and pressed to explain the high fees and costs associated with the get-rich schemes they were offering. Founders Page and Brin and Google President Eric Schmidt felt they had done a good job at helping to prepare their employees. By offering them a free education from the brightest minds in economic finance, they spared them the large “tuition bills” typically paid by those who choose, instead, to learn at the hands of Wall Street’s croupiers.
The Lesson from Google
It should come as no surprise, but rather be expected, that the brilliant minds who brought the world Google also preach the virtues of index funds. After all, the technology which has fueled Google’s success is based on the concept of collective wisdom and the idea that markets work.
By utilizing index funds, the educated investors at Google, Inc. allow the intelligence of the market to work for them. At the same time, they avoid the fees, expenses and risks associated with trying to outguess the crowd. By following Google’s example, everyday investors may also find the investment success for which they’ve long been searching.
Vista Capital Partners, Inc. is a fee-only investment advisor based in Portland, Oregon. We specialize in managing globally-diversified portfolios of low-cost, tax-efficient index funds for individual clients with more than $1 million to invest. Call us at 503-772-9500 or visit www.vistacp.com
REFERENCES
1. www.searchenginewatch.com, July 2006
2. Wolfers, Justin and Zitzewitz, Eric. “Prediction Markets.” Journal of Economic Perspectives, Spring 2004.
3. The results of prediction markets are one way to test the accuracy of market-based decisions. Prediction markets are markets in which participants trade contracts, the payoffs of which are tied to the outcome of future events. Prices in these markets can be interpreted as market-aggregated forecasts. Their results suggest that market forecasts are as good, if not better, than the predictions made by individual experts. For example, The Iowa Electronic Markets, which allow traders to buy and sell futures contracts based on political election results, have yielded predictions which have outperformed large-scale polling organizations. The contracts traded on Intrade in 2006 predicted (accurately) that Democrats would take over control of the Senate even while the “experts” on major TV stations were predicting Republicans would retain control. An internal prediction market at Hewlett-Packard produced more accurate forecasts of printer sales than the firm’s internal experts. Google has also experimented with internal prediction markets to forecast product launch dates.
4. This example, and others in this paragraph, are taken from James Surowiecki’s The Wisdom of Crowds. New York: Random House, 2004.
5. Surowiecki, James.
6. Gibson, George. The Stock Exchanges of London, Paris and New York. New York: G.P. Putnam’s Sons, 1889.
7. Bernstein, Peter. Capital Ideas. New Jersey: John Wiley & Sons, 2005.
8. An index fund is simply a basket (portfolio) of stocks—hundreds, if not thousands, of stocks. By owning all the stocks in a particular market or market sector, an index fund mimics the performance of the market (or sector). A well-known example of an index fund is the Vanguard S&P 500 Index Fund, which tracks the performance of the S&P 500 Index, comprised of the 500 largest publicly-traded companies in the United States. In the management of an index fund, no attempt is made to pick "attractive" over "unattractive" securities or to time the market. The goal is to earn the collective return of all 500 stocks. By minimizing costs (low expense ratios) and managing tax-efficiently (infrequent trading) index funds are able to consistently deliver the returns of the market.
9. Malkiel, Burton. “The Efficient Market Hypothesis and Its Critics.” CEPS Working Paper No. 91. Princeton University, 2003.
10. Morningstar Principia and Vista Capital Partners.
Performance of all 98 diversified large cap U.S. stock funds, with more than $10m in assets, over fifteen years ended January 31, 2008.
11. Morningstar Principia and Vista Capital Partners.
Performance of all 125 intermediate-term U.S. bond funds, with more than $10m in assets, over fifteen years ended January 31, 2008
12. Malkiel, Burton and Saha, Atanu. “Hedge Funds: Risk and Return.” Financial Analysts Journal, November/December 2005.
13. Dimensional Fund Advisors, Basic 60/40 Balanced Strategy vs. Company Plans 1987-2003. FutureMetrics, 2004.
14. Bill Miller’s employer, Legg Mason Capital Management, claims the Legg Mason Value Trust to be the only mutual fund to have outperformed the S&P 500 for 15 consecutive calendar years. Assuming active management is a zero-sum game and that in any given year half of all active managers outperform the market and half underperform, the odds of Bill Miller beating the market in 15 out of 15 years are 1: 32,768. When his streak ended, however, Miller had managed the Legg Mason Value Trust for 24 years. The odds of a fund beating the market for 15 consecutive years in any 24-year period are 1:5,000. In the U.S. alone, there were over 4,500 stock mutual funds at the end of 2006 (and more than 60,000 funds worldwide). The odds tell us we should probably expect a Bill Miller every 24 years. Legg Mason says there has never been another Bill Miller in the history of mutual funds. Investors would be better served asking not “Who is the next Bill Miller,” but rather “Why haven’t we seen more Bill Miller’s?”
15. Bogle, John C. The Little Book of Common Sense Investing. New Jersey: John Wiley & Sons, 2007.
16. Lipper Analytical Service; Top 20 U.S. equity funds 1983-1993 and subsequent 10 yr performance.
17. Ellis, Charles. Winning the Loser’s Game. New York: McGraw-Hill, 2002.
18. Dowie, Mark. “The best investment advice you’ll never get,” San Francisco, December 2006.
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