Charley Ellis On NPR
Deciding how to invest in the stock market can be daunting. That’s why I called on someone who’s seen it all. Charley Ellis founded Greenwich Associates, a research and consulting firm, and wrote an influential investing book called Winning the Loser’s Game. He worked in investment management for 50 years. His advice: Don’t fear being boring. Embrace boring if you can. Passive is better than active.
“Most of the people who are trying harder are actually hurting themselves,” he says.
When Americans invest in the stock market, it’s usually through mutual funds. There are two varieties: actively traded funds, where an investment manager and his team try to pick winning stocks, and index funds, which passively mimic a benchmark like the S&P 500. Ellis says those actively traded funds are a bad bet.
“Candidly, the data’s very disturbing. Comfortably more than half [of funds] over any reasonable 12-month period fall short of the target they choose for themselves,” he says. But if you say a year is not long enough, over 10 years it rises to 70 percent. “While the data gets pretty thin, by the time you get it out to 20 years, it gets even worse. … Somewhere around 80 percent fall short,” he says.
For Ellis, this is a crucial point. A significant majority of funds that rely on managers to make trades do worse than passive index funds. And those active funds that happen to shine for a few years, you can’t be sure they’ll do it again in the future. The Warren Buffetts of the world are rare, and I’m not one of them. That’s why Ellis is telling me not to try to beat the market.
“It’s not that you can’t,” he says. “It’s that you won’t.” The odds, he says, are stacked against me. The stacking comes from something called the expense ratio. It’s the annual fee the fund charges you for the manager’s salary and various administrative costs.
The Perils Of High Fees
“People pay way too much attention to past returns and way too little attention to the fees,” says Terrance Odean, a finance professor at the University of California, Berkeley, Haas School of Business. While fees for actively managed funds have been coming down, they still charge almost 1 percent a year on average. Average fees for index funds are much more modest — just over one-tenth of a percent. Over the long haul, in a retirement account those higher fees can cost an investor tens of thousands of dollars.
“One thing about fees is [that] high fees this year almost always means high fees next year,” Odean says. “In fact, you know what your fees are going to be next year. But high performance this year doesn’t really tell you much about next year’s performance.”
So that must mean that most investors seek out lower-cost index funds to avoid those fees, right? Actually, they don’t. There’s more than six times as much invested in actively managed funds, some $9.8 trillion, according to the Investment Company Institute.
I wanted to find out why those numbers are lopsided in favor of higher-cost funds. Brian Smith is a spokesman for the Mutual Fund Education Alliance, an industry trade group. When I asked him to make the case for actively managed funds, he said they give investors a chance to beat the market. “People want to build wealth over time; they want to build their futures. And to do that, you need a diversified plan, which is across the spectrum of different areas of the investing marketplace. That’s where an active manager can make a big difference.”
“People pay way too much attention to past returns and way too little attention to the fees. – Terrance Odean, University of California, Berkeley, Haas School of Business.
Ellis says that may be true — but probably not. He says instead many investors are tempted by company marketing and media coverage that focuses on hot streaks. “And so you have the feeling that, ‘Oh, come on, people are winning,’ ” Ellis says. ” ‘In every other part of my life I’ve always played to win. Let me just get the right fund or the right manager, and I’m going to be a winner.’ ”
Finally — and this is where the psychology comes in — lots of people who study financial behavior say we’re just too confident in our ability to spot good investments.
“Life feels better to the extent you have this belief that things are going to be better than reality suggests,” says Max Bazerman, a professor at the Harvard Business School and the Harvard Kennedy School. Bazerman studies human blind spots and decision-making. He calls this overconfident frame of mind “motivated bias.” And he says it can be helpful in pushing us to reach a goal, say in sports or landing a new job or even fighting an illness — but not when it comes to investing. “Positive illusions may be fine for helping us cope. They may be fine for motivating us, but we don’t want to have those positive illusions when we’re at the moment of decision,” he says.
Shopping For Exchange-Traded Funds
When I’m at that moment of decision — ready to pull the trigger on my investment in the stock market — I’m still tempted to try to beat the market despite everything I’ve heard. So I ask Bazerman to talk me out of it.
He’s pretty blunt: What makes me think I’ll be on the right side of a trade and not the wrong one? What makes me think I can pick the right fund manager? Is there any reason whatsoever for thinking I would have a competitive advantage?
“So I would ask you to think about why do you think you can outperform the market realizing that if you pay an extra percent a year on your investment for the next 20 years, you’re giving up 20 percent?”
That’s a ballpark estimate. The percentage would be a bit more or a bit less depending on your rate of return. But over the years it still adds up to a huge amount going to fees. It’s so big that when I finally decide to buy, I look for someone who knows how to find a bargain.
Miranda Marquit is a personal finance blogger. She developed a grudge against high fees after winding up in some expensive funds when she was younger.
We go shopping together online for exchange-traded funds, or ETFs. They’re similar to mutual funds. We’re hunting for diversification and minimal expenses. She’s checking out low-cost funds.
“The very top fund on the list, the U.S. Large Cap, has an expense ratio of .04 percent,” Marquit says. “That’s really low.” We also look at a bunch of other funds, including an international fund for some geographical balance.
In the end, I spend $749 on a broad U.S. stock fund, $652.34 on a global fund and $577.44 on a stock fund that pays out regular dividends. I’ve got diversification in stocks, and the fees are low. It’s a boring portfolio — really boring. But that’s the point. I’ll have to find my thrills elsewhere.
NPR FULL TRANSCRIPT:
RENEE MONTAGNE, HOST:
NPR’s Uri Berliner has been trying to figure out what to do with some of his savings. The money in his bank account is losing value to inflation – something many of us are familiar with. So for our series Dollar for Dollar, Uri had taken $5,000 of his own and is putting it to work exploring different types of investments. Today the stock market offers an unexpected lesson in psychology.
URI BERLINER, BYLINE: Deciding how to invest in the stock market can be kind of daunting. That’s why I called on someone who’s seen it all.
CHARLEY ELLIS: My name is Charley Ellis and I’ve had 50 years of experience in investment management from virtually every perspective.
BERLINER: Ellis founded Greenwich Associates, a research and consulting firm, and wrote an influential investing book called “Winning the Loser’s Game.”His advice: Don’t fear being boring. Embrace boring if you can. Passive is better than active.
ELLIS: Most of the people who are trying harder are actually hurting themselves.
BERLINER: When Americans invest in the stock market, it’s usually through mutual funds. There are two varieties: actively traded funds, where an investment manager and his team try to pick winning stocks, and index funds that passively mimic a benchmark like the S&P 500. Charley Ellis says those actively traded funds, they’re a bad bet.
ELLIS: Candidly, the data’s very disturbing. More than half, comfortably more than half, over any reasonable 12-month period fall short of the target they choose for themselves. And if you say, well, a year is too little, you really ought to extend it, make it 10 years – it rises. About 60 percent fall short over one year to about 70 percent fall short over 10 years. And while the data gets pretty thin, by the time you get it out to 20 years, it gets even worse. It goes up somewhere around 80 percent fall short.
BERLINER: For Ellis, this is a crucial point. A significant majority of funds that rely on managers to make trades do worse than passive index funds. And those active funds that happen to shine for a few years, you can’t be sure they’ll do it again in the future. The Warren Buffetts of the world are rare, and I’m not one of them. That’s why Charley Ellis is telling me, don’t try to beat the market.
ELLIS: Well, it’s not that you can’t. It’s that you won’t.
BERLINER: The odds, he says, are stacked against me. The stacking comes from something called the expense ratio. It’s the annual fee the fund charges you for the manager’s salary and various administrative costs.
TERRANCE ODEAN: People pay way too much attention to past returns and way too little attention to the fees.
BERLINER: That’s Terrance Odean, a finance professor at UC Berkeley’s Haas School of Business. While fees for actively managed funds have been coming down, they still charge almost 1 percent a year on average. Average fees for index funds are much more modest – just over one-tenth of a percent. Over the long haul in a retirement account those higher fees can cost an investor tens of thousands of dollars.
ODEAN: One thing about fees is high fees this year almost always means high fees next year. In fact, you know what your fees are going to be next year. But high performance this year doesn’t really tell you too much about next year’s performance.
BERLINER: So that must mean most investors seek out lower-cost index funds to avoid those fees. Actually, they don’t. There’s more than six times as much money invested in actively managed funds, some $9.8 trillion, according to the Investment Company Institute. I wanted to find out why those numbers are lopsided in favor of higher-cost funds. Brian Smith speaks on behalf of the mutual fund industry for the trade group MFEA. When I asked him to make the case for actively managed funds, he said they give investors the chance to beat the market.
BRIAN SMITH: People want to build wealth over time; they want to build their futures. And to do that you need a diversified plan, which is across the spectrum of different areas of the investing marketplace. And there’s where an active manager can make a big difference.
BERLINER: Charley Ellis says that may be true but probably not. He says instead many investors are tempted by company marketing and media coverage that focuses on hot streaks.
ELLIS: And so you have the feeling that, oh, come on, people are winning. It looks sensible to win. In every other part of my life I’ve always played to win. That must be one of the things that can be done here. Let me get – just get the right fund or the right manager and I’m going to be a winner.
BERLINER: Finally – and this is where the psychology comes in – lots of people who study financial behavior say we’re just too confident in our ability to spot good investments.
MAX BAZERMAN: Life feels better to the extent that you have this belief that things are going to be better than reality suggests.
BERLINER: Max Bazerman is a Harvard professor who studies business psychology. He calls this overconfident frame of mind motivated bias. And he says it can be helpful in pushing us to reach a goal, say in sports or landing a new job or even fighting an illness.
BAZERMAN: Positive illusions may be fine for helping us cope. They may be fine for motivating us, but we don’t want to have those positive illusions when we’re at the moment of decision.
BERLINER: Now, I’m at that moment of decision, ready to pull the trigger on my investment in the stock market. And despite everything I’ve heard, I still have a real temptation to want to beat the market. So can you talk me out of it?
BAZERMAN: I don’t know if I can talk you out of it. I’d be happy to try.
BERLINER: Bazerman is pretty blunt. What makes me think I’ll be on the right side of a trade and not the wrong one? What makes me think I can pick the right fund manager? Is there any reason whatsoever for thinking I would have a competitive advantage?
BAZERMAN: So I would ask you to think about why do you think you can outperform the market, realizing that if you pay an extra percent a year on your investments, over the next 20 years you’re giving up 20 percent.
BERLINER: That’s a ballpark estimate, but over the years it still adds up to a huge amount going to fees. It’s so big that when I finally decide to buy, I look for someone who knows how to find a bargain. Miranda Marquit is a personal finance blogger. She developed a grudge against high fees after winding up in some expensive funds when she was younger.
MIRANDA MARQUIT: The very top fund on the list is the U.S. Large Cap ETF. And this has an expense ratio of .04 percent. So that’s really – that’s low.
BERLINER: We shopping online together for exchange-traded funds, or ETFs. They’re similar to mutual funds.
MARQUIT: Next they’ve got the U.S. broad market ETF. So that’s also a very low expense ratio and it includes everything in the U.S. market.
BERLINER: For some geographical balance, we’re also checking out an international fund.
MARQUIT: Yeah, that one would be – that one would be a good one. So you can get most of the total world stocks. It’s pretty low expense ratio, and it’ll expose you to everything in the world.
BERLINER: In the end I spend $749 on a broad U.S. stock fund, $652 on a global fund, and $577 on a stock fund that pays out regular dividends. I’ve got diversification in stocks and the fees are low. It’s a boring portfolio – really boring – but that’s the point. I’ll have to find my thrills elsewhere. Uri Berliner, NPR News.