I recently spoke to Charley Ellis about his latest book The Index Revolution: Why Investors Should Join It Now, his ideas about investing in stocks and bonds now, and what he tells his own children about the investing life, here is part 2 of our talk featured in this blog post.
Investors of a certain age laugh at indexing and point to one manager or another who has beaten the market for 20 years. What do you say to these folks?
There aren’t very many people who have a 20-year record that’s really impressive. The real challenge is not will somebody have a terrific record. I think that’s something we all have to accept right away in any game of chance with no skill at all.
I do a coin-tossing contest in the class that I teach at Yale. Take out a coin, toss the coin, how many of the class got heads? Hands go up. Okay, let’s do it again. How many got heads? Hands go up. Okay, let’s do it again.
Pretty soon you get to 10 or 15 or 20 coin tosses and there’s somebody who is still doing it — all heads. You ask him, “How do you do that?” And there is an enormous temptation for that individual to say “Well, I hold it in my thumb a particular way and throw it.”
That isn’t what happened, what happened was just normal statistics. In a class of a particular size you will have one or two people that last through 10 tosses, all heads. That’s random numbers. If you look at investment management returns and you think okay, I’m going to really steel myself and I’m going to just look for random behavior, it will explain an enormous fraction of the bad results and the good results. Just random statistics.
Is it possible at some point that so many active investors will index that the stock market becomes just a means of distributing dividends, that there’s just no growth anymore because there’s nobody out there to trade against?
It’s intellectually possible to think that way, but you really have to have a pretty vivid imagination to go down that pathway. First of all, think how difficult it was for people to give up smoking when it was clear that smoking leads to death, your death, and that the typical smoker loses 10 or 15 years. They’re still smoking and actually teenage smoking has increased in the last half-dozen years.
If people were being in any way rational, Las Vegas would close up without a doubt and so would Monte Carlo. There’s no way that gambling casinos aren’t anything other than a waste of money from a rational point of view. If you look at investment management, just imagine if people started indexing more and more and my guess is somewhere around 90% to 95% indexing there would be a turnaround going back the other way. It would make sense to then be an active investor because there would be so little competition.
By the time you get there, wow, what a lot of changes will have to have taken place. Investment management is the highest-paid line of work in the world. It’s the most interesting line of work for most people that’s even been. You hang out with and work with absolutely a wonderful group of people. They are smart as the dickens. They know a lot. It’s great fun. It’s a continuous, competitive game, which gets the adrenalin flowing, and you know and learn more about other things that are really interesting than anybody in any other field. You know about politics, you know about economics, you know about technology, you know about companies, you know about people, you know about national differences.
So, before you get an inefficient market, before active investing can be attractive again, you’ve got to get rid of a huge fraction of the people who are now involved in active investing, and I don’t think that getting rid of half of them would do it. I think you would have to get rid of more than half. Wow, is that a major change.
And an unlikely course of events.
It doesn’t have anything to do with what percentage of the market is indexed as opposed to being actively managed. What matters is, of those who are actively managing, what are their customers or clients prepared to pay to have talented people working very hard at trying to figure out the mistakes that other talented people have made so they can capture an increment of profit.
If the argument of indexing is there’s no “edge” to be had, is portfolio construction really what matters now? How can an ordinary investor get better at that?
Two different things: Understanding yourself and your objectives, really being truthful about what your objectives are. One of those objectives is what rate of return are you looking to achieve? Second, how much market risk are you willing to live through and stay on target with your portfolio structure?
That’s really important stuff, and every individual is different. My fingerprint is different from yours. The retina of my eye is different from yours. We can both be recognized anywhere in the world by a fingerprint, an eye retina. DNA is so different that they can dig up our bodies 500 years from now and identify who we were.
So, individuals, look at how many ways we differ from an investment point of view. We’re all different in age, different in terms of how long we’re going to live, we differ in terms of wealth, we differ in terms of income, we differ in terms of possible inheritances, we differ in terms of possible responsibilities to others, schooling for our children, leaving something for the kids to make a better life.
We all differ in our tolerance for risk. We all differ in our history and experiences. When you take all of those things together that’s more differences than your fingerprint needs to be able to make yourself unique, and that’s more differences than the iris of your eye needs to make itself unique. So, actually, every individual investor is trying to find the right way for them to invest, each person is unique, each institution is unique, and that’s the hard work of investing that we all should be spending our time on. Because it really pays off.
You’ve known John Bogle, the founder of Vanguard, for quite a while.
Jack and I are friends and we go back and forth on a whole bunch of stuff.
When people think of Vanguard and his legacy the first thing they think, which is an unfortunate sort of marketing problem, is “cheap.” But it’s more than just lower cost. What do you think is the secret to the way they approach things?
Well, lower cost is a very important central value. Another central value is sensible investing and another great value is superb service. The service they give is low cost, but it’s awfully good and they’re always working to make it better and better through automation. High value in terms of plain vanilla stuff and low cost. Their active investing is low cost and their index investing is low cost.
When you go to a party you must get questions about money. What is the question people most often ask you?
It does happen fairly often that people ask me questions. I have to admit that some people ask the questions looking for a hot stock tip, and they don’t get that from me because I don’t think there are any hot stock tips that are worth a damn, and I do think that indexing is a great idea.
Thinking about who you really are and what you are trying to do with your investing and being sure that you are saving enough so that you can provide for your retirement are really important ideas, so that’s what I make people talk about.
What do you tell your children about investing?
One of the questions they’ve got is, “Dad, do I really want to think about that as a career?” And the answer is no, no reason for you to do anything just because I’m doing it and, candidly, if I were coming out of graduate school today I would not go into the investment world knowing what I know. I would go and do something else that I think would be much more interesting because it would be much more difficult, much more complex.
They and I have had hour, hour-and-a-half conversations about investing and why indexing makes a lot of sense to me, why I do it, and I urge them to do index investing and at present that’s exactly what they do.
So hearing all this, some people would say “Okay, I’ll go buy an S&P 500 Index Fund and that’s it.” But you and your colleagues on the Investment Committee of Rebalance spend a lot of time analyzing a variety of different index funds for inclusion in the firm’s portfolios. Why is that?
Well, the main decision is to index, and if you are going to index the simplest indexing decision is either the S&P 500, which represents what 98% of the stock market, or you can do a total market index fund. That would be fine.
Or you can make a decision. Instead of being U.S.-centric, you might want to increase your diversification by investing internationally, and if you did that you might want to do it market-weighted, which would be 50/50 roughly, or you might buy an index portfolio that is a global index. That would be fine.
You could, if you are going to be investing for a long, long time, like my grandchildren for example, you might say “You know, for these little kids, they are 10 on average, why don’t we put most of the money in a small company index because over the long period of time small companies do better. Not a hell of a lot but some, and that might be a better thing. Or you might put more emphasis on the emerging markets because you believe in the future.
Fine. Those are adjustments that, if you have a serious reason for wanting to do it — that you feel comfortable and you thought it through carefully and that you are willing to hold those investments for at least a decade — I have no problem with people doing something a little differently. But the big decision will come back over and over again to indexing instead of active investing.
That’s stocks. Should investors be concerned about current high bond prices?
Well, there are several different parts to that. One is, we are being exceedingly well-served by our central bank. The Federal Reserve is doing a fabulous job. Federal Reserve Chairman Janet Yellen, I’ve happened to have had the privilege of getting to know her when we both Yale Endowment trustees. She is an unbelievably talented person and particularly good at drawing out the best thinking of every single person who is qualified to be at the table to make decisions, and I can promise you one thing for sure, old people with their experience base, young people with their recent discoveries, all know that they are being truly listened to for understanding by Janet Yellen and, therefore, by the other members of the Federal Reserve Board.
I think they are doing a terrific job, but their job as they have correctly identified it and continue to say it, is not to worry about bond investors or bond sellers. Their job is to help get the economy going again and to get unemployment and under-employment down as soon as possible. They are doing a terrific job at what they are supposed to be doing, but from an investor’s point of view you’ve got to stand back and say, “Well yeah, they are doing a great job but they are not doing a job for me. They are doing a job for the economy.” I think anybody looking at bond prices today has got to say to themselves, “Boy, the returns from here going forward in bonds are going to be pretty damn small, particularly after inflation.”
What do you think of the recent federal fiduciary ruling, requiring retirement advisors to act in the best interest of investors?
For me that’s a “thank goodness” because it’s outrageous the charges that are buried and out of view. A little bit on page 2, a little bit on page 7, a little bit in the footnote on page 8 all add up. Nobody says front and center, “Charley, let me tell you how much this is going to cost you.”
The people who are selling don’t want it to be known because they would be ashamed and embarrassed if it was known and they know damn well they would get a lot of resistance if it was understood how much is being charged. What I find really terribly upsetting is that the president of the United States had to raise the question.
You certainly have succeeded in just about every measureable way as an investor, author, teacher, thinker and, I’m sure, father and husband and all of the other things that go along with it. So what drives you to keep talking about investing and to keep studying it?
Well, first of all you are way too generous and I deny most of what you said (laughing). You know, there is an alternative. I’m not yet 79 and I could go play golf all day every day. Jeepers creepers, what a bore!
My own personal belief, and I have not checked this out with physicians who know something about it, is that if you are active you’ve got a much better chance of living longer and living better and having some fun. So, that’s part of it and I just confessed to it.
The second part of it is I am competitive, and it is very hard to stop when you think there might be a chance that you could do something worthwhile. The third thing is I’m married to a somewhat younger woman and she’s a bundle of energy and full of go and so it fits to our style.
Mostly, I think the answer is I’m doing something that I really believe could make a difference to other people, and I confess to being a screwball. When we’re walking down the street, if I see a piece of paper on the street I usually pick it up and carry it until we get a trash bin. It’s an affliction that I’ve learned to live with. Members of my family find it more of an affliction and harder to live with than I do. I really like trying to be helpful to people. This is a place where there is quite a large number of people that could use some help and they seem to appreciate it and like it.
If you were to say to me that nobody gives a damn and nobody is going to read any of your writing and nobody is going to come to your classes and stuff like that you know I guess I would gradually give up on it, but it’s too much fun.
You joined Princeton professor Burt Malkiel and former IBM Retirement Funds Director Jay Vivian on the Rebalance Investment Committee. I’m sure a lot of people are trying to get a little bit of your time and a little bit of your talent, so what tipped you toward working with Rebalance?
Well, first, the basic idea of Rebalance is we can reduce the cost of distributing good information and good investment management to fairly large numbers of people. That’s a major positive because the cost of investment management is a big factor and it hasn’t been reduced as much as it should be. That’s the biggest single thing.
Then, as you know, the people who work at Rebalance are really engaging people. Mitch and you, Scott, are smart, savvy and engaging as individuals and it just happens that we’ve got a commonality in Harvard Business School. The chance to work with Burt and Jay is something that draws on long, long wavelengths. I’ve known Jay when he was at IBM, gee, 35, 40 years, and Burt and I have had shared activities that go back at least 35 or 40 years.
So the chance to work with them on a specific task that didn’t take a hell of a lot of time but might make some real difference, and then working with the good guys who are the entrepreneurs in the effort, what a combination! It has turned out to be even more fun and more interesting and more rewarding than I had hoped it would be.