If you follow the financial media day-to-day, you get caught up in a narrative that is as appealing as it is wrongheaded. It goes something like this: You must know what’s going on, because you must take action immediately.
It’s wrongheaded because almost nobody should be trying so hard to outmaneuver the market. Even the very largest institutional investors are loath to make a move until necessary. They realize it’s dangerous to second-guess themselves when billions of dollars are in play — and often extremely costly.
That point was brought home to me the other day when I happened across an interesting bit of Silicon Valley history, tucked away online. According to the story, as the Google engineers were set to become overnight IPO millionaires, back in August 2004, a senior vice president began to worry.
Anyone who has followed the fortunes of lottery winners knows that instant wealth is easily squandered and lost. The VP worried in particular about his young engineers falling victim to investment advisors.
Wall Street hawks were circling company headquarters, as the story goes, hoping to be among the first to buttonhole a suddenly rich young engineer. So Google held them off and instead called in some famous names in investing research.
The Google managers knew their audience well. The men they invited to talk were among the best-known academics in the finance business, people who could communicate on a wavelength engineers would appreciate — data first, empirical evidence and proof, not conjecture.
In they came. Bill Sharpe from Stanford, Burton Malkiel from Princeton, Vanguard Group Founder John Bogle. The men came with distinctly different presentations, but each had the same bottom-line message: You won’t beat the market, and you’ll make more money if you accept that and move on.
Needless to say, once the Wall Streeters poured over the ramparts of the Googleplex, they were met with an entirely different conversation than the one they had expected and hoped for. Fees, commissions and performance questions were top of the list.
That was then, and I am happy to say that the front lines of that war have pushed forward, paying dividends to all investors. For instance, as the use of inexpensive index funds and exchange-traded funds has risen, the cost of active mutual funds has steadily declined.
According to the Investment Company Institute, which tracks these things, equity mutual fund fees fell from 100 basis points as late as 2003 to 77 basis points at the end of 2012. Bond funds dropped from 75 basis points to 61 in the same period.
That’s a nice decline, but it counts only the cost of the underlying funds. You have to add back in whatever the advisor decides to charge, plus the costs inherent in active trading. Most people using active managers and advisors still pay well north of 1.5% all-in, and the advice they get is often dangerously wrong or simply worthless. That is, they would have done the same or better with no advice at all.
Put another way, active management is still very expensive, but it used to be stupidly expensive. Progress is relative that way.
I had nearly the same experience as the folks at Google. Being in Palo Alto and in the same milieu, I certainly understand the reticence to take “trust me” as an assurance of expertise. No amount of pinstripes, haircuts and wingtip shoes can carry the weight of real numbers.
I had those same conversations with many of the same Wall Street types, and I kept coming back, over and over, to the fundamental problem: If the advice is mediocre, why pay so much for it?
Winning the War
After all, a rising tide lifts all boats. The market will go up and it will go down, but the long-term experience of portfolio investing is a steady, predictable incline. Nobody can predict the future, that’s for certain, but the alternative is to crawl under a rock and hoard canned foods. Not my style.
If you accept that you should be in the investment markets and that you should expose your savings to some level of risk, the implication that follows is easy to grasp: All things being equal, what can I control for?
One is taxes, easily solved by saving the maximum into your workplace 401(k) or IRA account. That’s another discussion, but the government has given us powerful tools for tax-deferral and, by extension, tax-free compounding. We don’t use them enough.
The second is investment risk. You might own stocks, bonds or a variety of real estate, commodities and cash. In the end, however, you want the same thing, a steady, long-term return well above the inflation rate with a minimum chance of losing money.
You can settle the first issue by using tax-deferred accounts and the second with a diversified, risk-adjusted portfolio. All that’s left is expenses. In my experience, nothing really does the job quite like index ETFs.
Wall Street is coming around to the way of Silicon Valley. Schwab just announced, for instance, that it will offer a 401(k) platform that uses low-cost ETFs exclusively. BlackRock is expected to double its low-cost ETF offering this year.
The battle is long, but well worth fighting. It’s your own retirement that’s at stake, after all.