Enrich Your Future E-Book

Larry E. Swedroe

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 394

Veröffentlichungsjahr: 2024

Beschreibung

Create a winning portfolio by understanding the realities of modern investing

In Enrich Your Future: The Keys to Successful Investing, prolific author and investor Larry Swedroe shines light on the foundation of modern investing, enabling readers to create winning portfolios through simple yet effective strategies. Through a combination of analogies, personal anecdotes, and empirical evidence from peer reviewed journals, the book clearly explains how to play the winner’s game, instead of simply following the crowd, speculating, and making brokers and fund families wealthy in the process.

The book begins by first explaining how to put your portfolio on the right path, then how to keep a steady course during market uncertainty, when many investors fall victim to human nature, lose perspective, and make incorrect investment decisions based on fear and greed.

In this book, readers will learn:

• How prices of securities are established and why it's so difficult to outperform on a risk-adjusted basis
• How to navigate various key decision points when designing your portfolio
• How to develop a conceptually sound investment strategy and reach your financial goals faster
• How playing the winner’s game in investing will improve the quality of your life as well.

Revealing the true nature of the modern financial market and changing the way readers approach investing in general, Enrich Your Future: The Keys to Successful Investing is an essential guide for individual investors and financial advisors seeking to make more informed and prudent investment decisions.

Leseprobe

Table of Contents

Cover

Table of Contents

Additional Praise for

Enrich Your Future

Title Page

Copyright

Dedication

Also by Larry E. Swedroe

Foreword

Notes

Introductionintroduction

Note

Part One: HOW MARKETS WORK: HOW SECURITY PRICES ARE DETERMINED AND WHY IT'S SO DIFFICULT TO OUTPERFORM

Chapter 1: The Determinants of the Risk and Return of Stocks and Bonds

Implications for Investors

The Moral of the Tale

Notes

Chapter 2: How Markets Set Prices

Point Spreads and Random Errors

Examining the Evidence

An Efficient Market

How Stock Prices Are Set

Battle of the Discount Retailers

The Financial Equivalent of the Point Spread

Individual Investors

Institutional Investors

The Moral of the Tale

Epilogue

Notes

Chapter 3: Persistence of Performance

The Nature of the Competition

Summary

The Moral of the Tale

Notes

Chapter 4: Why Is Persistent Outperformance So Hard to Find?

Successful Active Management Sows the Seeds of Its Own Destruction

The Moral of the Tale

Notes

Chapter 5: Great Companies Do Not Make High‐Return Investments

Small Companies Versus Large Companies

Why Great Earnings Don't Necessarily Translate into Great Investment Returns

The Moral of the Tale

Chapter 6: Market Efficiency and the Case of Pete Rose

The Moral of the Tale

Notes

Chapter 7: The Value of Security Analysis

Buy, Sell, or Hold?

Academic Evidence

The Moral of the Tale

Note

Chapter 8: Be Careful What You Ask For

Historical Evidence

The Moral of the Tale

Notes

Chapter 9: The Fed Model and the Money Illusion

The Fed Model

The Moral of the Tale

Notes

Part Two: STRATEGIC PORTFOLIO DECISIONS

Chapter 10: When Even the Best Aren't Likely to Win the Game

The Moral of the Tale

Note

Chapter 11: The Demon of Chance

Mutual Funds to Drool Over

Coin‐Tossing Gurus?

Those That Don't Know Financial History Are Doomed to Repeat It

The Moral of the Tale

Notes

Chapter 12: Outfoxing the Box

The Moral of the Tale

Notes

Chapter 13: Between a Rock and a Hard Place

The Evidence

The Moral of the Tale

Notes

Chapter 14: Stocks Are Risky No Matter How Long the Horizon

The Moral of the Tale

Notes

Chapter 15: Individual Stocks Are Riskier Than Investors Believe

The Moral of the Tale

Notes

Chapter 16: All Crystal Balls Are Cloudy

The Threat of Sequence Risk

The Moral of the Tale

Notes

Chapter 17: There Is Only One Way to See Things Rightly

Modern Portfolio Theory

The Moral of the Tale

Note

Chapter 18: Black Swans and Fat Tails

The Moral of the Tale

Notes

Chapter 19: Is Gold a Safe Haven Asset?

Safe Haven

The Moral of the Tale

Notes

Chapter 20: A Higher Intelligence

The Moral of the Tale

Note

Part Three: BEHAVIORAL FINANCE: WE HAVE MET THE ENEMY AND HE IS US

Chapter 21: You Can't Handle the Truth

Overconfidence

Possible, Not Likely

The Moral of the Tale

Notes

Chapter 22: Some Risks Are Not Worth Taking

The Moral of the Tale

Note

Chapter 23: Framing the Problem

Indexed Annuities

Monte Carlo Simulations

The Moral of the Tale

Note

Chapter 24: Why Do Smart People Do Dumb Things?

Supporting Evidence

Counterproductive Activity

Why Are Warnings Worthless?

If Not Past Performance?

The Moral of the Tale

Notes

Chapter 25: Battles Are Won Before They Are Fought

The Historical Evidence

The Anatomy of a “Crisis”

When Risks Show Up

Timing the Market

The Winner's Game

The Moral of the Tale

Notes

Chapter 26: Dollar Cost Averaging

The Lesser of Two Evils

The Moral of the Tale

Notes

Chapter 27: Pascal's Wager and the Making of Prudent Decisions

Asset Allocation

Whether or Not to Buy Life Insurance

Long‐Term Care Insurance

The Impact of Adding Long‐Term Care Insurance

TIPS Versus Nominal Bonds

Active Versus Passive Funds

The Ownership of Company Stock

The Moral of the Tale

Notes

Chapter 28: Buy, Hold, or Sell, and the Endowment Effect

The Moral of the Tale

Chapter 29: The Drivers of Investor Behavior

Ego‐Driven Investments

The Desire to Be Above Average

Framing the Problem

Confirmation Bias

The Moral of the Tale

Notes

Chapter 30: The Economically Irrational Investor Preference for Dividend‐Paying Stocks

Financial Theory

The Math of Cash Dividends Versus Homemade Dividends

The Explanatory Power of Dividends

Taxes Matter

Diversification

Attempting to Explain the Preference for Dividends

The Moral of the Tale

Notes

Chapter 31: The Uncertainty of Investing

The Moral of the Tale

Notes

Part Four: PLAYING THE WINNER'S GAME IN LIFE AND INVESTING

Chapter 32: The 20‐Dollar Bill

The “January Effect”

The Moral of the Tale

Notes

Chapter 33: An Investor's Worst Enemy

The Moral of the Tale

Notes

Chapter 34: Bear Markets

Small Value Stocks

Risk Premiums and Investment Discipline

The Keys to Successful Investing

The Moral of the Tale

Notes

Chapter 35: Mad Money

Other Evidence

The Moral of the Tale

Notes

Chapter 36: Fashions and Investment Folly

The Moral of the Tale

Notes

Chapter 37: Sell in May and Go Away

The Moral of the Tale

Chapter 38: Chasing Spectacular Fund Performance

The Moral of the Tale

Note

Chapter 39: Enough

Needs Versus Desires

The Moral of the Tale

Notes

Chapter 40: The Big Rocks

Don't Sweat the Small Stuff

The Moral of the Tale

Note

Chapter 41: A Tale of Two Strategies

The Moral of the Tale

Notes

Chapter 42: How to Identify an Advisor You Can Trust

The Moral of the Tale

Conclusion

Appendix A: Implementation: Recommended Investment Vehicles

Single‐Style Funds

Note

Acknowledgments

Index

End User License Agreement

Guide

Cover Page

Additional Praise for Enrich Your Future

Title Page

Copyright

Dedication

Also by Larry E. Swedroe

Foreword

Introduction

Table of Contents

Begin Reading

Conclusion

Appendix A Implementation: Recommended Investment Vehicles

Acknowledgments

Index

Wiley End User License Agreement

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Additional Praise for Enrich Your Future

“If the conventional wisdom is, ‘Don't just sit there. Do something,’ Larry shows us that it should be ‘Don't just do something. Sit there.’ Indeed, consistently being long, the ‘Larry factor’ is how investors today can enrich their savings and their quality of life.”

—Ross L. Stevens,founder and CEO, Stone Ridge Holdings Group

“Larry Swedroe shows investors how to protect themselves against their own worst enemies—themselves. He buttresses his valuable advice with citations of the most rigorous quantitative research but explains it all in readily understandable—and highly entertaining—terms. This book is a tour de force!”

—Martin Fridson,publisher, Income Securities Investor

“Classic Larry Swedroe: eminently readable and eminently important for anyone interested in their investments.”

—Andrew L. Berkin,head of research, Bridgeway Capital Management

“Many investors know that diversification, low cost, and tax awareness are the keys to being successful, but most can't resist the urge to chase returns, buy individual stocks, and use complicated and expensive investment products. In Enrich Your Future, esteemed author Larry Swedroe shows you how to construct a long‐term investment portfolio, how to deal with difficult money emotions, and how to play the winner's game in life and investing. A must‐read for all investors.”

—Tom Cock,cohost, Talking Real Money

“Larry entertains as he busts toxic investing myths with illuminating personal stories and market histories: a wise and lively guide for investors to make the most of their resources.”

—Ed Tower,professor of economics, Duke University

“If you want to build wealth, read this book! Larry Swedroe's Enrich Your Future is a well‐written, fabulously researched treasure‐chest of wisdom that will give you the best investment education that you've likely ever had. Swedroe's lessons are worth a million times the price of this book.”

—Andrew Hallam,author of Millionaire Teacher, Millionaire Expat, and Balance

“Swedroe has nailed his revolutionary theses to the door of conventional finance wisdom. From the relationship of risk and return, randomness and behavioral finance, the book reveals state‐of‐the‐art theory and grounds it in practical advice. Another rigorous work by the foremost investment researcher and writer working today.”

—Tobias Carlisle,managing director, Acquirers Funds®

Enrich Your Future

The Keys to Successful Investing

Larry E. Swedroe

Copyright © 2024 by Larry E. Swedroe. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per‐copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750‐8400, fax (978) 750‐4470, or on the web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748‐6011, fax (201) 748‐6008, or online at http://www.wiley.com/go/permission.

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Library of Congress Cataloging‐in‐Publication Data Is Available:

ISBN 9781394245444 (Cloth)

ISBN 9781394245468 (ePDF)

ISBN 9781394245451 (ePub)

Cover Design: Wiley

Cover Image: © DKosig/Getty Images

Author Photo: Courtesy of the Author

This book is dedicated to my grandchildren, Jonathan, Sophie, and Gracie Rosen; Ruby, Eloise, and Witt Morris; and William and Rosie Brennan, who bring joy into my life each and every day.

Also by Larry E. Swedroe

The Only Guide to a Winning Investment Strategy You'll Ever Need

(first edition 1998, second edition 2005)

What Wall Street Doesn't Want You to Know

Rational Investing in Irrational Times

The Successful Investor Today: 14 Simple Truths You Must Know When You Invest

The Only Guide to a Winning Bond Strategy You'll Ever Need

(coauthor Joe Hempen)

Wise Investing Made Simple: Larry Swedroe's Tales to Enrich Your Future

Wise Investing Made Simpler: Larry Swedroe's Tales to Enrich Your Future

The Only Guide to Alternative Investments You'll Ever Need: The Good, the Bad, the Flawed, and the Ugly

(coauthor Jared Kizer)

The Only Guide You'll Ever Need for the Right Financial Plan: Managing Your Wealth, Risk, and Investments

(coauthors Kevin Grogan and Tiya Lim)

Think, Act, and Invest Like Warren Buffett: The Winning Strategy to Help You Achieve Your Financial and Life Goals

Investment Mistakes Even Smart People Make and How to Avoid Them

(coauthor R. C. Balaban)

The Quest for Alpha

Reducing the Risk of Black Swans: Using the Science of Investing to Capture Returns with Less Volatility

(coauthor Kevin Grogan; first edition 2014, second edition 2018)

The Incredible Shrinking Alpha

(coauthor Andrew Berkin; first edition 2015, second edition 2020)

Your Complete Guide to Factor‐Based Investing

(coauthor Andrew Berkin)

Your Complete Guide to a Successful and Secure Retirement

(coauthor Kevin Grogan; first edition 2019, second edition 2021)

Your Essential Guide to Sustainable Investing

(coauthor Sam Adams)

Quantitative Hedge Fund Investing

(coauthor Marat Molyboga)

If you tell me a fact, I learn; tell me a truth and I'll believe; but tell me a good story and it will live in my heart forever.

—Anonymous

Foreword

You will learn much about investing at the feet of Mr. Larry Swedroe while reading this fine book. Here are a few of the things he will teach you. First, intelligent, hard‐working individual investors can reliably beat the stock market through stock picking and market timing. If you somehow disagree with that, then he will convince you that at least very‐well‐paid, overeducated professional money managers can consistently outperform. Okay, maybe you don't believe that's true, either. But Larry will convincingly argue that at least the subset who've reliably beaten the market in the past will again do so going forward. Okay, if you don't believe him about that, then at least believe him that sophisticated institutional investors, like pension funds and the investment committees of endowments and foundations, can make money manager hire‐and‐fire decisions that add a lot of value over the long term. Okay, enough about all the different ways Larry will show you how the pros can beat the market for you. Larry also teaches a lot of other important things about investing. For instance, he shows us that stocks become riskless but only if you hold them long enough. He clearly demonstrates that if you've built up a large nest egg by keeping your money in the stock of the company you work for, then continuing to do that going forward, provided that you really and truly love the company, is a prudent and low‐risk strategy. He notes that dollar cost averaging is the real secret to investing success, and that owning gold hedges away your inflation risk, and how the stock market would be a paradise without bear markets. I could go on (and Larry does!). All vital pearls of wisdom.

Okay, in truth, this might actually be a somewhat painful (though important!) book to read for investors new to Mr. Larry Swedroe.1 Many sacred oxen are gored (mixing my bovine aphorisms). Specifically, the book you are about to read will show you (quite persuasively) that everything I just listed in the previous paragraph is false. Larry teaches you the opposite of what I said, and that believing otherwise can be very damaging to your long‐term financial health.

You can find this all out on your own.2 All you have to do is read and understand a few hundred academic and practitioner research papers, some of them (unnecessarily?) mathematically difficult. Or you can come here and get it all in a few hours with some entertainment thrown in gratis. The math you'll find in Larry's book consists mainly of reporting average results, what tends to matter, what doesn't, what fraction of the time things happen in, and to what magnitude. Nothing too daunting and there is only as much math as you need to understand the concepts. Larry takes a few hundred serious research papers and turns them from mathematical exercises into understandable stories.

Like I said, the stories still have a little bit of math. The tales Larry tells are not quite the same as a 7th‐century BC Greek reciting Homer by the fire (sorry, Larry). But they are a lot closer to that than the papers he draws from! Larry uses stories, mostly as analogies, to make the difficult easy and the complex simple. Instead of regression analysis and matrix algebra, Larry teaches with examples ranging from Gaylord Perry to Sisyphus. You won't find that in the Financial Analysts Journal!

To play favorites, and get a little personal, out of the entirety of a great book, perhaps the chapter that resonated most with me was Chapter 24: Why Do Smart People Do Dumb Things?3 No, it isn't because I think I'm a smart person who often does (very) dumb things, though that is certainly the case (and I'm definitely right about the second part). It's very personal and it's about the 2018–2020 horrendous period for most forms of quantitative stock selection (led by the famous “value factor”). Larry presents reams and reams of evidence that past performance doesn't predict future performance.4 Wait. Actually, that's not quite right. He presents evidence that it does (mildly) predict future performance but with the wrong sign!5 He discusses this for choosing mutual funds and for professionally managed pension funds choosing managers. He does so under a wide variety of rebalancing rules and a wide variety of ways to evaluate performance (e.g., benchmark relative performance, raw performance, risk‐adjusted performance done a variety of ways). Quoting Larry:6

The bottom line is that so many investors are doing the same thing over and over again and expecting a different outcome. Most seem to never stop and ask the question: If the managers I hired based on their past outperformance have underperformed after being hired, why do I think the new managers I hire to replace them will outperform if I am using the very same criteria that have repeatedly failed? And, if I am not doing anything different, why should I expect a different outcome? I've asked these very questions, and never once received an answer—just blank stares.

Larry is not alone in making this point. To pick an utterly randomly chosen example of someone else making this point, in 2014 I wrote an article in the Financial Analysts Journal called “My Top 10 Peeves” and out of the 10 my number 3 was “had we but world enough, and time, using three‐ to five‐year evaluation periods would still be a crime.” It was a shorter, less evidence‐based, more sarcastic take on what Larry is explaining here. Picking winning money managers7 over three to five years isn't just wrong; it's mildly backwards. Picking the losers is (again, the predictive power is only mild, don't bet a lot on this either!) on average the right thing to do. Of course, I wrote this in 2014 when the prior three‐ to five‐year period was quite good for us. You know why? Because you don't get to write about this when it's been a bad period for you. If you do, people roll their eyes and say you're just making excuses. You only get to scream this from the rooftops when the last three‐ to five‐year period is great for you. I did that. Well, I didn't so much as scream as discuss it. But inside I was screaming.

Then, 2018–2020 rolled around and things got ridiculously tough for the academic factor‐based strategies we favor. We could show precisely why it was so bad. We could put it into historical context. We could even measure how extreme was the pain and what we thought the concomitant opportunity. Yet exactly when, in a Vulcan world of rational investors, investors should've doubled up on value investing (and us!), we lost lots of clients and had (nearly) zero investors take up the opportunity (and our clients are, I dare say, of a high level of sophistication—remember Larry's admonition that this doesn't seem to help!).8 Rather people, yet again, went the other way, adding what had worked recently and running from what had not despite its (sorry, I have to say) rather obvious attractiveness. It seems that despite overwhelming evidence of how crazy the world had gotten, despite my own prior statements in good times about not automatically selling after bad times, despite us surviving and thriving from a similar episode in 1999–2000 so we knew what the path looked like, and despite the gigantic and robust set of research Larry cites that people sell what they should be buying and buy what they should be selling, most still couldn't do it.9 If I sound a bit bitter, well, it's not that much more than my average.10

From my description thus far, you might think this book is pure nihilism, glorying in shooting down harmful myths about investing. There is a healthy dollop of that, and it's very valuable unto itself. But Larry doesn't end with nihilism, not at all. Yes, implicitly springing from nearly every chapter is indeed the depressing all‐caps “YOU CANNOT WIN” by doing what so many self‐interested experts tell you to do. But behind that there is also the ultimately uplifting “YOU DO NOT HAVE TO WIN TO WIN” as Larry convinces you that you mostly win by not playing. He even gives some good life advice along the way (not playing doesn't just leave you wealthier and more secure, it gives you some of your life back!).

So, what's Larry's prescription? Simple. Stay very diversified. Pay low costs. Do not chase performance or run from tough performance if you understand what drove it. Do not try to time the market. If you do try to beat the market, focus on the “factors” that have been discovered in academia and refined by applied researchers in industry.11 Of this last piece of advice, I will say little save that I have no quarrel with him here.12

Do less. Pay less. Think about it all less. Don't put all your eggs in one basket. Think about the worst outcomes and make sure you aren't doomed if they occur.13 If you're going to attempt to beat markets, do so using sound evidence‐based academic findings consistent with behavioral finance or harvesting a risk premium. Stay the course.

I know. He could've just told you all that upfront, without the reams of academic evidence and the great stories/analogies, but would you have believed him? Nah. Well, you should now!

—Cliff Asness, managing and founding principal, AQR Capital Management

Notes

1.

Though if you have been an investor for a while and have not read some of Larry's other books, shame on you!

2.

You can also just read the dictionary straight through following the comedian Stephen Wright who says on his 1981 comedy album “I Have a Pony,” “I was reading the dictionary. I thought it was a poem about everything.” But I do not recommend it!

3.

If I had to pick a second favorite, it would be

Chapter 35

on Jim Cramer of CNBC. Spoiler alert: watching his show can be very expensive.

4.

I have to be a bit careful here. Larry focuses on past active stock picking or market timing success not predicting the future—particularly when looking back over common time horizons. Larry shares my view that “evidence‐based” investing, looking for what factors systematically outperform over very long periods with good economic explanations, is a very different (and potentially more attractive) beast.

5.

At the time horizons studied—mainly three‐ to five‐year periods. Also, the word

mildly

is important. If you had to choose one, picking the three‐ to five‐year losers would be better than the winners, but it would still not be a very reliable strategy and you should not bet the ranch on it.

6.

Though perhaps my favorite quote from the whole book is the staggeringly understated, “It is rare for a new fund to be brought to market when an asset class has performed poorly.” Preach Larry! Hens' teeth should be so rare.

7.

Or individual stocks, or asset classes, or “investment styles.”

8.

Narrator: “It turned out it was an incredible opportunity and the next three years were excellent. Though, admittedly not as excellent as I would've thought in late 2020. The incredible record‐setting bubble in what the market would imprecisely call ‘growth vs. value stocks' that reached its heights in late 2020 has come down steadily in the nearly three years since it peaked, rewarding those who stuck with or even added to rational strategies, but it's come down slowly. The most comparable period to the last five‐plus years is the 1999–2000 dot‐com bubble and aftermath. That fully reversed in the next two to three years from the peak in March 2000. This one has only reversed by about 1/3 (meaning right now I would

not

fade three‐year prior performance—remember doing so is only a mildly good strategy!). When you are historically unprecedented levels of cheapness even a 1/3 reversal can lead to multiple strong years. But it's still only 1/3. I want my other 2/3.

9.

I guess that's why the research exists but man it's different to live through!

10.

I pride myself on an exceptionally high bitterness‐to‐success ratio. As perhaps an odd coda to my ranting fervent wish that investors would listen to people like Larry and stop making mistakes like this, the very strategies I believe in, and that Larry advocates as structured systematic positions, would likely cease, in all or in part, to be long‐term attractive if investors didn't do irrational things. What every investor wants is to profit from other investors' irrationality, but quickly and painlessly. Sadly, it just doesn't work that way. Perhaps there is some odd kind of fairness to the whole thing. The harder something good is to stick with, the better it is long term, if (if!) you can stay the course.

11.

Though Larry rather rudely, though perhaps not inaccurately, says they're becoming “betas.” Them's fightin' words!

12.

Astute readers will notice how staggeringly world‐class‐level self‐serving I am being here.

13.

Chapter 27

: Pascal's Wager.

Introduction

Most Americans, having taken a biology course in high school, know more about amoebas than they do about investing. Despite its obvious importance to every individual, our education system almost totally ignores the field of finance and investments. This is true unless you go to an undergraduate business school or pursue an MBA in finance. For example, my oldest daughter attended an excellent high school and graduated in the top 10 of her class. Having taken a biology course, she could tell you all you would ever need to know about amoebas. She could not, however, tell you the first thing about how financial markets work. She certainly could not tell you how markets set prices. Without that basic understanding, there is simply no way for her to know how to make informed investment decisions.

Most investors, many without realizing it, are in the same boat. They think they know how markets work. However, the reality is quite different. The following quote has been attributed to humorist Josh Billings: “It ain't what a man don't know as makes him a fool, but what he does know as ain't so.” The result is that individuals are making investments without the basic knowledge required to understand the implications of their decisions. It is as if they took a trip to a place they have never been without a road map, directions, or a GPS. Lacking a formal education in finance, most investors make decisions based on the accepted conventional wisdom—ideas that have become so ingrained that few individuals question them.

Most of what you will read in this book directly contradicts the conventional wisdom that smart people, working diligently, can discover which stocks are mispriced by the market. Thus, they can buy stocks that are undervalued and avoid (or sell short) the stocks that are overvalued. This conventional wisdom also says these smart investors can also time the market—that is, they can get into the market before the bull enters the arena and sell before the bear emerges from its hibernation. This is what the practice of active management is all about—stock picking and market timing. Anything else is even considered by some to be un‐American. To quote my ex‐boss, “Diligence, hard work, research, and intelligence just have to pay off in superior results. How can no management be better than professional management?”

The problem with this thought process is that while these statements are correct generalizations (and as a result become conventional wisdom), success in beating the market is the exception to the rule. If hard work and diligence always produce superior results, how do you explain the failure of the majority of professional money managers (intelligent, capable, hard‐working individuals) to beat the market year in and year out? Why is there no persistence of outperformance beyond the randomly expected? And why have not the leading consulting firms been able to identify the future outperformers?

If you keep an open mind, you will find that when exposed to the light of logic and evidence you will be convinced that not only is the conventional wisdom wrong—Moshe Levy, author of the article, “The Deadweight Loss of Active Management,” evaluated the performance of US active equity funds and estimated that the aggregate annual loss to investors in US active equity funds was $235 billion—but it never made any sense in the first place.1 In fact, it is illogical. I am confident that you will find the simple, yet compelling logic of the stories presented here, and the evidence supporting that logic, so overwhelming that you will be convinced of its accuracy. Remember “the Earth is flat” was once conventional wisdom, as was “the Earth is the center of the universe.” As these examples make clear, however, just because something is conventional wisdom doesn't make it correct. In other words, even if millions of people believe a foolish thing, it is still a foolish thing.

Legends do die hard—especially when there is an establishment (Wall Street and the financial media) that is interested in perpetuating the legend. Thus, this book has three objectives. The first is to explain how markets really work, doing so in a way that makes it easy to understand even difficult concepts. I hope to accomplish this objective through the use of stories and analogies that present the logic in a paradigm with which you are already familiar, and relating that logic to the world of investing. If you understand the logic in the story, it should be just as clear when the logic is related to investing—especially when the evidence supports the logic.

If I am successful in meeting the first objective, I will have also achieved the second objective—to forever change the way you think about investing and how markets work.

The third objective is to provide you with sufficient knowledge to begin to make more informed and more prudent investment decisions.

The book was written with two audiences in mind. The first is individual investors. The second is financial advisors. Hopefully, my stories will provide advisors with the ammunition they need to convince their clients to stop throwing their hard‐earned money away, to stop making brokers and fund families wealthy, and to start playing the winner's game.

The book is divided into four sections. The first is designed to help you understand how markets really work, how prices of securities are established, and why it's so difficult to outperform on a risk‐adjusted basis. The second is designed to help you with the key decisions you have to make when designing your portfolio. The third is designed to help you understand how human nature leads us to make investment mistakes—being informed will help you avoid them. And the fourth is designed to help you play the winner's game by providing key insights.

You will learn that the winning strategy is actually simple and takes less energy. Thus, the strategy is not only likely to dramatically increase the odds of achieving your financial goals but also it will allow you to improve the quality of your life, as the tale of “The Big Rocks” illustrates. The way smart money invests today is by building a globally diversified portfolio of “passively managed” funds. Since there is some debate about exactly what is meant by passively managed, with some considering only index funds to be passively managed, my definition includes not only index funds but also other funds whose construction rules are evidence‐based (as opposed to being based on opinions), transparent, and implemented in a systematic, replicable way. The key word is systematic. But owning only systematically managed funds is only the necessary condition for investing success. The sufficient condition is to be able to stay the course, ignoring the noise of the market and the investment propaganda put out by Wall Street and the financial media.

One of my favorite expressions is “If you think education is expensive, try ignorance.” Hopefully this book will whet your appetite for a deeper understanding of the issues raised and create a desire to broaden your knowledge. If you find this book entertaining and educational, I have authored 18 other books on investing, each of which goes into greater depth than the scope of this book allowed, and they also cover many important topics not covered here.

Note that some of these tales appeared in Wise Investing Made Simple, published in 2007, or in Wise Investing Made Simpler, published in 2010. Those tales and all the data have been updated.

Note

1.

Moshe Levy, “The Deadweight Loss of Active Management,”

The Journal of Investing

(July 2023).

Part OneHOW MARKETS WORK: HOW SECURITY PRICES ARE DETERMINED AND WHY IT'S SO DIFFICULT TO OUTPERFORM

Chapter 1The Determinants of the Risk and Return of Stocks and Bonds

What the wise do in the beginning, fools do in the end.

—Warren Buffett

In 1977, Bill James self‐published the book 1977 Baseball Abstract: Featuring 18 Categories of Statistical Information That You Just Can't Find Anywhere Else. Seventy‐five people found the book of sufficient interest to buy it.1 Today James's annual edition (now called The Bill James Handbook) is considered a must‐read for all serious fans of our national pastime.

James demonstrated, through rigorous research, that certain statistics are more meaningful than others in determining the effectiveness of a player. Among his many findings are that a player's batting average and the number of homers he hits are not as important as people had assumed. James found other statistics are more vital, namely, the total of a player's on‐base percentage and his slugging average.

James revolutionized the way people think about baseball statistics and how to build a winning team. Today, every team in every major sport employs statistical experts (sabermetricians) on their staff. In his book Moneyball, Michael Lewis explained how Billy Beane, the general manager of the Oakland Athletics, used sabermetricians to build a winning team despite the constraint of a limited payroll.

By assessing which factors are the most significant in determining the impact a player has on the outcome of a game James changed the way we think about baseball. The 1992 publication of the paper “The Cross‐Section of Expected Stock Returns,” by Eugene Fama and Kenneth French in The Journal of Finance, had a similar impact on the field of financial economics.2 The Fama‐French research produced what has become known as the three‐factor model. A factor is a common trait or characteristic of a stock or bond. The three factors are market beta (the return of the market minus the return on one‐month Treasury bills), size (the return on small stocks minus the return on large stocks), and value (the return on value stocks minus the return on growth stocks). The model is able to explain more than 90% of the variation of returns of diversified US equity portfolios.

Lesser known is that professors Fama and French also provided us with a similar two‐factor model that explains the variation of returns of fixed‐income portfolios. The two risk factors are term and default (credit risk). The longer the term to maturity, the greater the risk; and the lower the credit rating, the greater the risk. Markets compensate investors for taking risk with higher expected returns. As is the case with equities, individual security selection and market timing do not play a significant role in explaining returns of fixed‐income portfolios and thus should not be expected to add value.

Advances in our understanding of asset prices did not end there. Over the ensuing years, other common factors were found to add explanatory power. Among the leading ones are momentum (the tendency for securities that have outperformed in the recent past to continue to do so for a relatively short period), profitability (the tendency for more profitable companies to provide higher returns than less profitable ones despite higher valuations), and quality. Quality is a broader trait than profitability. Quality companies are those that are not only more profitable but also tend to have less financial and operating leverage (less debt and lower fixed costs), lower volatility of earnings, high asset turnover (they use their capital efficiently), and less idiosyncratic risk (risks not related to the broad economy).

An example of how the academic research has advanced our understanding of investment performance is the study “Buffett's Alpha.”3 The authors—Andrea Frazzini, David Kabiller, and Lasse Pedersen—examined the performance of the stocks owned by legendary investor Warren Buffett's Berkshire Hathaway and found that, in addition to benefiting from the use of cheap leverage provided by Berkshire's insurance operations, Buffett buys stocks that are safe, cheap, high‐quality, and large. Their most interesting finding was that stocks with these characteristics tend to perform well in general, not just the stocks with these characteristics that Buffett buys. In other words, it is Buffett's strategy, or exposure to factors, that explains his success, not his stock‐picking skills. That, and because he never engages in panicked selling.

The good news for investors is that the “discovery” of these common factors enables individuals to invest in the same type of stocks as legendary investors such as Warren Buffett—who had been successfully exploiting these factors for decades—without having to do all the research. Instead, they can simply invest in funds that provide exposure to these common factors. One example, the iShares MSCI USA Quality Factor ETF (QUAL), which buys quality stocks, has an expense ratio of just 0.15% and, as an ETF, is highly tax efficient.

Implications for Investors

The implication for investors is that the academic research has demonstrated that efforts to outperform the market by either security selection or timing are highly unlikely to prove productive after taking into account the costs, including taxes, of the efforts. For example, studies such as the “Luck Versus Skill in the Cross‐Section of Mutual Fund Returns” have found fewer active managers (about 2%) are able to outperform their three‐factor‐model benchmark than would be expected by chance.4 And that is even before considering the impact of taxes, which for taxable investors is typically the greatest expense of active management (greater than the fund's expense ratio and/or trading costs).

The prudent strategy, therefore, is to do the following:

Develop a portfolio that reflects your unique ability, willingness, and need to take risk. The equity portion should be globally diversified across multiple asset classes. The fixed‐income portion should be diversified in terms of credit and term risk, as appropriate.

Avoid the use of actively managed funds. Instead, invest in funds (such as index funds) that provide systematic exposure to the factors you seek exposure to, and which are low cost and tax efficient. In the case of fixed‐income assets (for those individuals who have sufficient assets to do so), build a portfolio of individual Treasury securities and/or FDIC‐insured CDs, and for taxable accounts, AAA‐ and AA‐rated municipal bonds that are also either general obligation or essential service revenue bonds. Doing so greatly reduces the credit risk and therefore the need for diversification (which is the benefit of a mutual fund). Those strategies will save you the expense of a mutual fund as well as allow you to tailor the portfolio to your unique state and tax situation.

Have the discipline to stay the course, ignoring the noise of the markets as well as the emotions caused by the noise—emotions that cause investors to abandon even the most well‐developed plans.

The Moral of the Tale

Intelligent people maintain open minds when it comes to new ideas. And they change strategies when there is compelling evidence demonstrating the “conventional wisdom” is wrong.

Why are some individuals unable to make a change in the face of what some would consider convincing evidence? One explanation is that when you are familiar with a certain way of thinking about a subject, whether it's investing or baseball, it is hard to make the leap to another model. Making the leap, however, is well worth the effort, as the Boston Red Sox demonstrated. In late 2002 they hired Bill James as a senior baseball operations advisor. In 2004, the Boston Red Sox won the World Series, breaking what some consider one of baseball's most famous curses, as well as my heart—I am a diehard Yankees fan and the Yankees are the only team in history to blow a 3–0 lead in the League Championship Series.

The next story is the most important one in the book. It explains how the market prices of securities are established. Understanding this is critical to determining a winning investment strategy.

Notes

1.

Michael Lewis,

Moneyball

(Norton, 2003), p. 67.

2.

Eugene Fama and Kenneth French, “The Cross‐Section of Expected Stock Returns,”

The Journal of Finance

(June 1992).

3.

Andrea Frazzini, David Kabiller, and Lasse Pedersen, “Buffett's Alpha,”

Financial Analysts Journal

(September 2018).

4.

Eugene Fama and Kenneth French, “Luck Versus Skill in the Cross‐Section of Mutual Fund Returns,

The Journal of Finance

(September 2010).

Chapter 2How Markets Set Prices

It is not easy to get rich in Las Vegas, at Churchill Downs, or at the local Merrill Lynch office.

—Paul Samuelson

On any given Saturday during the college basketball season, there may be 100 games being played. In some of those games, it is easy to identify the better team. For example, Duke is a perennial contender for the national college basketball championship. Mike Krzyzewski (Coach K), who coached Duke from 1980 through 2022, was a graduate of West Point. Each year he scheduled a game with Army as a favor to his alma mater. Though the likelihood of Army winning was about as likely as the sun rising in the west, the game did generate a large amount of revenue for West Point. These types of mismatches are known as “cupcake” games.