Terror on Wall Street, a Financial Metafiction Novel (17 page)

     A 30-year-old investor with family earned income of $50,000 a year saving 12% and investing in index funds can build a portfolio (after 40 years, just on the difference in expenses alone) worth
$2,666,555
versus just
$290,900
for the average actively managed mutual fund with an identical portfolio. 

     My thesis was titled
Personal Liberty and the Managed Economy
, which forecasted the collapse of the Russian managed economy 40 years later.  Socialism just cannot compete with free market economies in today’s world markets.  By comparison, actively managed mutual funds just cannot compete with index fund mutual funds.

     Vanguard has a number of policies and schemes to prevent speculators from damaging the index funds. For example, for their index funds, they close trading two hours before the market closes; thus preventing speculators from placing trades just before the market closes or forcing Vanguard to buy or sell shares in a fund the next trading day that may be at higher or lower prices.

     Vanguard puts a gap between each equity asset class so that if, as often happens, stock in one asset class bounces between small and medium asset classes, the fund does not have to trade until the stock makes up its mind (so to speak).  Sometimes speculators start to trade their index funds or follow a crowd, chasing certain asset classes to the detriment of buy and hold investors, so Vanguard will add a fee to trade or just close the fund to new investors.

Make a plan of action

Write down some things that you know and, from time to time, read them to yourself, like:

-I know that I should buy low and hold my stocks until I retire and then sell high.

-I know that the market is usually right and that stocks are usually priced correctly.

-Is the market nervous, or is it just me?

     Look at the VIX (the CBOE Volatility Index), and if it is around 20, you are okay; but if it is climbing toward 50 or so, your portfolio is in for a rough ride - so get ready to save a little more and gather some funds, because stocks are going on sale.  Say to yourself, “I am not worried, because it is normal for stocks to go on sale from time to time.” Bear markets usually last for two or three years, while bull markets last much longer.

     If you are relatively young, say in your twenties or thirties (or even a little older), you have 40 years to accumulate your nest egg, so look forward to accumulating your invested funds.  Now get a notebook, crank up the computer, and go to a web site like MoneyChimp to develop your plan. The web site is named after a contest in the WSJ between a chimpanzee throwing darts at a page in the WSJ and some of Wall Street’s best stock pickers. The monkey won.  Now, go to the area where you can use the site to run some numbers.  Enter the size of your portfolio, then the rate at which you think that your portfolio will grow (somewhere between 7% and 9%).  Then, enter the amount you plan to add to your portfolio each month. I recommend 12.5 to 15.5% of the family's earned income. Then, add the number of years left for your accumulation phase.

     Now you should have a look at any pension income and estimate your social security. For those of you with a good pension plan and accumulated social security, part of your problem is solved and you can take more risk, so count on a very aggressive portfolio. For those of you who are risk adverse you too can have an aggressive portfolio. An aggressive portfolio has value stocks, an overload of small cap stocks, and an asset allocation of 30% debt and 70% equities. A good ratio is to keep your debt at your age.  It is a good idea to keep an eye on the VIX, which is a measure of the volatility of the market. Your allocation to foreign equities should be about 30% of your domestic. A good way to handle this allocation business is to place in your portfolio two very broad index funds. Vanguard’s total domestic stock index fund and their total foreign stock index fund has a nice allocation of small cap stocks.

The Future

     History and Gordon’s equation tells us that these are good times to invest in equities. But you are cautioned not to get greedy. If your savings are such that you do not have enough to take risks, invest your funds in immediate annuities and fixed income short-term bonds. You will find definitions of the above terms in the books of the authors I recommend.

     Now, here is my take on the Wall Street meltdown. Any time our government passes out guarantees, they are asking for problems. It happened in housing, in guaranteed pension plans, and in the bailout of those companies that take on too much risk.  The minute the government legislates a guarantee, there are many very smart people trying to figure out how to make tons of money from the situation.

     FHA home loan guarantees are a prime example. The cost of insuring a loan was far less than the profit originating loans (think big return, no risk). The requirement for a large down payment – a simple solution – is to jack up the price by $20,000 and give the buyer the money for the down payment. You know, it wasn’t until mid-July 2009 that the FHA figured out how these buyers got their down payments.

     Take Social Security. The system was in big trouble since 1970, and Congress knew it, and they did nothing to repair the damage. By knowing the birth rate and the death rate, anyone with any brains can predict the impending problem. But that is not how our government works. Politicians spent all the Social Security taxes that had been withheld. There is only one way to solve this problem – and that is with a Constitutional amendment to limit terms of
Congressional members to two terms and prosecute those who use their power to make illegal money. That bunch in Washington is a smart bunch, but they lack common sense. Their need to be re-elected overshadows what they should do. They know this and ignore the consequences.

     Your stock portfolio grows just like a fetus. A baby puts on about one ounce by the end of the first trimester. Your stock portfolio gains about 13% of its final sum at the end of your accumulation phase at about the first five years.  By the end of the second trimester, the baby weighs 9% of its final birth weight and adds 27% of its final value. During the third trimester, the baby puts on 67% of its final birth weight, while your portfolio will gain 60% of its total amount at retirement.

     This is how buy and hold works and why it is so important to avoid excessive portfolio expenses and taxes caused by portfolio turnover and trading costs.

     A study by William Bernstein showed that over a recent 29-year period (ending in 2009), a total stock market portfolio returned 10.4% and just 25% of the stocks made all the money while the other 75% lost about 2% for the period.  Show me someone who can pick the 25% of the 8,600 common stock shares traded today over the next 40 years which will be in the group of winners. It can’t be done.  A portfolio of index funds can produce these and even greater returns.  In fact, four a young couple saving 12% of their earned income can expect somewhere in the neighborhood of $2,500,000 after forty years with a slice and dice index fund portfolio with a probability of somewhere around 85%. By placing your funds with a full service broker, you will be lucky to amass $150,000, while the broker will have about five times that amount.

Remember

     The premium for large cap value stocks in a slice and dice portfolio has, in the past, outperformed the market by 10% over a 20-year period and by 20% over a 35-year period. This does not mean that it will happen during your accumulation period, but the odds are in your favor.  High returns require taking high risks.  Your ability to take high risks depends on your age and the time available prior to retirement and, most importantly, what you have learned about the market.

     It is highly unlikely that Medicare and social security benefits will be as generous as in the past, so you should be careful with your money.  Anyone who guarantees even reasonable returns is a scam artist.

     Searching for bargains in the stock market is a loser’s game.  There are people who, with skill and luck, have been able to outperform the market; but no one has ever been able to identify them before the fact and only one  person has even suggested how to identify them.  Our most recent guru was Bill Miller who, after 15 years beating the market, took a beating for the next three years.

     Over a recent 29-year period, the domestic market returned 10.4% - and all this was done by 25% of the stocks. The other 75% lost 2%.  The financial services industry charges outrageous fees for mediocre results.  50% of American workers have not even figured out how much they will need to retire.  Those who have and who are saving have an average of only about $25,000 saved.  From 1984 to 2000, 90% of investors’ portfolios earned 5.23% while the market returned 16.2%.

     Here is a bit of data to remember: A study of market timing recently came up with the following: for 2,000 trading days (that’s almost ten years)  the market was up 357%.  Miss the 10 best days and your return would have been 7.4%. Miss the 50 best days and your return would have been zero; zip.  It is not possible to make reliable predictions on when the market will rise or fall. If it were possible, the market could not rise and fall the way it does.  A retirement savings program requires at least 30 years to mature. In the first trimester you will have gained 13% of your goal, over the next trimester, another 27%; and the final trimester, 60%.

     At about the age of 72, immediate annuities are a bargain. Those who die before the median age are helping you by getting those high returns and paying for your golden years. One of my annuities, purchased several years, ago returns 12.7% for life.  A  good rule to follow is that if you view that every stock broker, insurance salesman, or investment advisor you are likely to meet as a common criminal, you will survive the perils of the market.  Hedge funds are gambling with your money and taking 2% on average for losing your money, and 20% of the profits (if any).

     Stock prices go up or down because of random events one cannot predict.  In ancient Babylon, contracts had to be notarized to be valid in court. The notary had to guarantee that the loan was for a capital project and not for consumption.  Don’t expect the same guarantees from the stock market.

Best regards,

Gordon L. Eade

APPENDIXES

INVESTING TIPS BY GORDON

Investing Tips by Gordon #1

The sum total of all those advisory fees, market expenditures, sales loads, brokerage commissions, custody and legal fees, and securities processing expenses add up to approximately $350,000,000,000 per year, or about 25% of the market return. Clearly, this massive drag on the profits (which industry siphons off) needs careful analysis to see where we can cut costs. First, let’s see where the money goes:

· Investment banks and brokers— $220 billion

· Direct mutual fund costs— $70 billion

· Pension fund management costs—$15 billion

· Personal financial advisors—$5 billion

· Hedge funds—$25 billion

· Annuities—$15 billion

Comparing the average active mutual fund with an index fund, we find that we can save costs in the following areas:

Transaction costs: 30%: index funds seldom trade—active funds trade often.

Expenses: 30%: money spent on fund expenses is   lost forever and has a             negative compounding effect   on funds available for retirement or other purposes.

Taxes: 67%: Uncle Sam’s take is the largest of all.

     Now let’s examine the cumulative effect of this difference on one’s investment. We are going to look at a couple who saves 12% of their pretax income and invests in the average actively managed fund versus a broad market index fund over a 20-year period. After taxes, the average active fund accumulates the sum of $495,909 while the index fund accumulates $778,107: a difference of $282,198.

     There is more bad news coming for the active investor. First, there is no known method for discovering a fund that will outperform a broad market index fund. Second, the odds are 3 to 4 that the fund that is selected will underperform the index next year. Third, funds beating the index fund performance this year rarely beat the index the following year. If we look at longer periods of time, we see the magnitude of the problem. For the 14 years ending 2004, one single fund out of 10,000 mutual funds beat the performance of the S&P 500 index - and then only by 1%. The fund was a “value fund” by Legg Mason, managed by Bill Miller.

Investing Tips by Gordon #2

The only portions of the population who can count on their retirement benefits are those working for city, county, state, and federal governments. Even these entities currently face severe underfunding to the tune of $2,000,000,000, but they will get their pensions—and you will pay for their good fortune. Those in the 40 to 45 age group can count on the full benefit retirement age being about 73 for social security benefits with reduced benefits pegged to the recipient's means to finance their own retirement. I don’t want to debate the subject but to state simply that this is a reasonably accurate forecast for planning for the future. Any other scenario does not meet the test of a feasible solution.

     This is going to be a very tough decision for those in politics, but it is a problem that has been known since 1960, when we started escalating social security contributions. Medical costs are a bigger problem, and the solution here will be a combination of tort reform—that is, limiting malpractice awards - and placing the burden for sensible medical spending on the patient. By way of example, in my little town, an ambulance ride to the hospital (a maximum of 7 miles) costs $300, and emergency room treatment another $300 for a nosebleed.

     If you and your spouse want to live a comfortable retirement life, you must do two things. First, you must save a minimum of 12% of your gross income, have your home paid for by your retirement date, and be debt-free. Second, you must learn how to manage your own portfolio of stocks and bonds using index funds. The hardest task awaiting you is to overcome the fear and greed present in owning marketable securities: greed that will cause you to make foolish and disastrous decisions and the fear you will experience when the market declines 20% or 30% for several years, as it has (and will do so again at some time in the future, I guarantee). When the market takes a dive, think of this: stocks are on sale – better buy some now before they go up.