Investment Gems from "The Big Investment Lie"

[Taylor Larimore]

Hi Bogleheads:

Author Michael Edesess is a mathematician who was a founding partner and chief economist of the Lockwood Financial Group until its sale for $200 million to the Bank of New York in 2002. His book, containing insider knowledge of the investment industry "shines a spotlight on the true cost of the industry's useless advice."

(Author just out of college with a PH.D. in mathematics) "I'm smart; surely I can figure out how to beat the market. Little was I to know how many people I would meet over the years with the same idea, all of whom would be wrong"

"The average stock portfolio in our database (the largest database of tax-exempt investment funds in the world) did not outperform a naive strategy of buying the whole market."

"I quickly realized that the whole industry was about what would sell, and not about what was true or factually based."

"I tested the data to see whether professional managers could beat the market consistently and predictably; and once again the answer was that they could not."

"The investment advice and management industry is enormous, with total revenues well over $200 billion per year in the United States alone. A percentage of investors' assets provides the entire financial support for this industry."

"Investment advisors may speak of 'dollar-cost-averaging' and, perhaps, 'regression toward the mean,' efficient frontier,' 'mean-variance analysis,' and Nobel Prize-winning technology---all with the predictable effect of snowing the client and helping to spread the Big Investment Lie."

"The lure of getting rich quick, of finding the Holy Grail, can make the client a willing partner in assisted self-delusion."

"Be supremely suspicious of investment advisors who imply they will beat the market or who do not fully reveal, in every minute and cumulative detail, what their services cost."

"The smartest investment strategy is so simple and so direct that you can easily do it yourself."

"Most things about investments are unpredictable, but fees are highly predictable."

"Financial planners can be almost anyone--even astrologers, or just someone who hangs out a shingle."

"Hedge fund management is not just a license to steal; it is a license to steal literally billions."

"The term hedge funds is now applied to all funds that avoid oversight by regulatory authorities because they are not offered to the general public."

"The statistics on hedge fund performance cited in business and financial publications are highly inaccurate."

"Most of the hedge fund that were launched are now defunct."

"In 2004--the average cash take-home pay for each of the top 25 hedge fund managers was $251 million.--It comes straight out of the investors' accounts."

"People are vain, especially many wealthy people. Appearing to be a high-roller can be more important than actually making money."

"Government and government regulatory bodies cannot wholly protect customers from themselves."

"Many important voices in the aceademic financial field do clearly speak the truth. Notably, among others, is distinguished Princeton professor Burton Malkiel, author of the best-selling book A Random Walk Down Wall Street."

"If the investments are in a taxable account, then tax avoidance should be the first and foremost consideration of an investment manager."

"The vast majority of investment managers do not give taxes a thought."

"If you can pay a tax later instead of now, it's like getting a zero interest loan. That's a very valuable thing to have."

"The best long-run strategy for tax avoidance is the simplest: buy and hold."

"The Big Investment Lie is that you can beat the market by a whole lot if you're smart and well paid."

"What do the former Soviet Union and active investment managers have in common? Both believe prices can be determined independently of the market."

"One of the reasons investors seek out investment advice is because of the bewildering array of investment options."

"If you had invested at the beginning of 2000 in the top ten performing mutual funds for the previous three years, in the next three years you would have lost 70% of your investment."

"Any patterns and trends that may, for a time, appear to have persisted in the past, either do not continue or are not strong enough for an investor to exploit them advantageously after paying normal costs."

"When survivorship bias is corrected for, studies of mutual fund data invariably reach the same finding: the average mutual fund, adjusted for risk, does not outperform the market average."

"Such a large volume of price data is available that it has been possible to test the random walk model over and over again. It has held up in the tests like a champ."

"Everybody who is touting a new investment strategy performs backtests to show that the strategy would have worked in the past.--All you've got to do is try hundreds or even thousands of variations of your strategy until you get one that backtests well. It's all done by fast computer so it's easy. Therefore, a successful backtest is meaningless."

"The statistics are crystal clear: market-beating performance has no holding power."

"In 1974 John Bogle founded the Vanguard Corporation with a not-for-profit structure, dedicating it to the principle that costs should be kept as low as possible, and launched Vanguard's S&P 500 index fund."

"An index fund has three all-important advantages: it offers the investor the theoretical maximum expected return for its level of risk; it charges the lowest fees; and because of its low turnover, it keeps commissions to a minimum as well as taxes when investments are in a taxable account."

"For each percent of expected return you get above the risk-free rate, you'll have to pay a proportionate amount in increased risk. There's no 'free lunch.'"

"How much risk to take in order to increase your chance of reward is one of those existential decisions in life that we wish someone could tell us how to make--but it's up to us, ourselves, alone, to decide."

"If you're investing for five years or less, or think you'll panic and sell whenever your portfolio goes down, you should probably just forget equities."

"The investment field engage in astounding monologues of what I call 'technical word salad,' spiraling and self-elaborating fantasies piling technical words and statistics on top of more technical words an statistics, frequently making no sense at all--but the layman doesn't know that."

"The Big Investment Lie: 'We know how to make money in investment and you don't.'"

"Investors are alarmingly prone to self-delusion, and most investment advisors and managers are only too happy to take advantage of that fact."

"The financial writer Jane Bryant Quinn has labeled trash investment advice books 'investment porn.'"

"People want to get rich quickly. They want to beat the stock market. So just to give their neuron hope, they blow it by paying huge amounts to investment advisors and managers who will give them hope."

"Random luck is interpreted as innate skill."

"The investment advice and management business tucks away costs so they become almost invisible."

"The only things that can be predicted are fees and taxes. Fees and taxes can be very, very large; they can be predicted; and they can be reduced enormously by anyone who merely tries."

"There are good and cogent reasons why it should not be worth paying much, if anything, to try to beat the stock market."

"Stop searching for the Holy Grail. Give up the quest to beat the market."

"Stop believing that past investment performance predicts future performance."

"You can pay only the bare minimum by investing in the lowest cost, most widely diversified investment vehicle, such as index funds which are, in fact, the most 'sophisticated' investments you can get."

"Don't pay anyone to pick stocks for you. There's no reward for the cost and risk."

"You must choose the risk (stock/bond ratio) you are comfortable with--no one can do it for you."

"Keep fees and taxes as low as possible. They can swamp your investment returns."

"Equal weighted 'index' funds have to be frequently re-weighted incurring significant taxes and commissions in the process."

"There's no reason to buy several index funds to represent different segments of the market when you can simply buy the broadest market index fund that already includes all of these segments.

"It is my hope that this book will make a substantial contribution to a massive information campaign that will finally debunk--once and for all--the grand lie that is being told to customers of investment advice and management services, often with the customers' willing, even exuberant cooperation."

Thank you Michael Edesess.

More Investment Gems

[bobcat2]

As Taylor notes in 2007 Michael Edesess wrote the Boglehead like investment book, The Big Investment Lie. Edesess also has an investment blog and here is part of what he has written about mechanical portfolio rebalancing.

Like so much prescriptive advice in the investment advisory field, the admonition "You should rebalance your portfolio" has been repeated so often, without full and clear explanation why, that it has acquired the character of a shibboleth.

"Rebalancing" means restoring the asset allocation of a portfolio -- mainly the allocation between stocks and bonds -- to what you set it to in the first place. Why should you do this? What are the arguments for rebalancing?

There are basically two arguments for rebalancing, a risk argument and an expected return argument:

1. You decided on the risk level you were comfortable with when you first established your portfolio's asset allocation; you need to reset it to that allocation periodically to make sure you don't exceed your risk level.

2. A rebalancing discipline buys an asset class when its price is lower than it was, and sells some when it is higher than it was -- buying low and selling high, and taking advantage of "reversion to the mean".

Unfortunately, both of these arguments are questionable.

Argument 1.

In the first case, the assumption is that you measure risk using something like the short-term volatility of your returns. If that is indeed your measure of risk, then if you don't rebalance, your risk will drift out of its bounds.

But what if your risk measure is the chance of unacceptably low cash flows in 30 years? And what if you control that risk by holding part of your portfolio in 30-year Treasury bonds to provide a secure safety net?

If you rebalance periodically you won't maintain your risk hedge, you'll destroy it. Suppose, for example, you start out with 50% stocks and 50% Treasuries, which you will hold to maturity. Suppose the market drops 20%. Rebalancing means you'll have to sell some of the Treasuries that provide your safety net.

Edesess then goes on to question the reasonableness of the expected return argument in favor of mechanical rebalancing.
Link to complete article:
http://www.thebiginvestmentlie.com/2009/09/what-does-rebalancing-do-for-you.html

Of course these arguments pointing out that mechanical portfolio rebalancing, at best, accomplishes little are not new, whether done on a calendar or bounds basis. Highly respected financial economists like Nobel laureate Bill Sharpe and Zvi Bodie have been making these arguments for many years, but it is refreshing to see that respected financial practitioners are finally beginning to be making these same sound arguments.


Edesess also makes the sound argument that stocks are not less risky the longer you hold them, but instead more risky the longer you hold them.

In 1995, Boston University finance professor Zvi Bodie published a paper in the Financial Analysts Journal, "On the Risk of Stocks in the Long Run." The article should have been immediately regarded as a seminal work. Instead, it was largely ignored -- confirming that academia, too, tends to throw its weight toward bandwagon-bubble phenomena.

Bodie peformed a calculation showing that the cost to insure a stock portfolio against poor performance grows over time. If the portfolio underperforms the risk-free rate, the insurance makes up the difference in wealth accumulation.

A poor -- and poorly-specified -- measure of risk has become entrenched in the finance community: the annualized standard deviation of returns. It is poorly specified because there is no universally-accepted standard as to how it should be calculated. It is a poor measure because it measures poorly how much money an investor risks.

Bodie used a superior measure. How better to compare two risks than by the cost of insurance to avert them?

By that measure, stocks are riskier in the long run than in the short run.

Misled by the wrong measure, most academicians and advisors thought stocks were more risky in the short run -- that is, more "volatile", having a larger annualized standard deviation -- than in the long run.

But Bodie's calculation shows that while the chance of falling short of the risk-free rate may be smaller in the long run, the cost of that shortfall is likely to be larger. When you consider the cost to make an investor whole after poor long-run returns, it turns out that the risk of poor long-term stock market performance is greater than the short-term risk.

That is why we often recommend taking the edge off the potential long-run downside by investing a bedrock portion of the portfolio -- enough to ensure at least the bare essential minimum income stream in the future -- in safe long-term assets like TIPS (Treasury Inflation-Protected Securities), held to maturity.

Link:
http://www.thebiginvestmentlie.com/2009/09/stocks-are-riskier-in-the-long-run.html


So thank you Michael Edesess for making the sound argument that mechanical portfolio rebalancing accomplishes little and also for debunking the argument that stocks are less risky in the long-run.

BobK

[ThePrune]

Thanks for highlighting Edesess' book The Big Investment Lie. I discovered this book by accident at a library book sale, bought it (for $1 ) and thoroughly enjoyed the read. I like to lend this book as well as Ken Fisher's How To Smell a Rat - The 5 Signs of Financial Fraud to friends who want to learn some "financial self-defense".

As to Zvi Bodie's work about how equities become more risky with time, I personally have a "yes and no" attitude. First, fundamentally he is right: the range of possible equity portfolio values will become progressively wider the farther into the future that you project the anticipated values. As I remember the article cited, Prof. Bodie uses option pricing theory to quantify the increasing riskiness as time increases into the future. And no doubt about it, this approach to "insurance pricing" always increases the cost as time increases.

On the other hand, there is one sense in which equity riskiness diminishes into the future: the risk of a substantial loss of original principal decreases. Using historical market data one can pretty strongly assert that the chance of a loss of orginal principal dimishes as the holding time of an equity portfolio increases from 10 to 20 to 30 to 40 years. It has always been my personal view that insurance companies take advantage of this observation when they offer variable annuity insurance riders against principal loss for longer term contracts. (But I don't have enough direct insight into the insurance industry to actually know if this is actually how they view things. I could easily be wrong )

But in spite of what I wrote in the previous paragraph, I never forget that I could always lose 20-40% of my equity portfolio within the next year due to a bear market. In my mind that risk never disappears. So I agree with Prof. Bodie to never risk next year's (or even next decade's !) living expenses to an equity investment. Ultimately, my goal is not to finish as rich as possible, but simply to fund my anticipated retirement expenses with the least risk possible.

[VennData]

Nice quotes Taylor.

However the Edlesess's re-balancing discussion quoted by bobcat miss a fundamental a point:

If you sell the Treasuries, then you are at your chosen asset allocation.

If you need to take more risk than your asset allocation, then you should have a different asset allocation.

If you cannot afford to take more risk, than taking more risk is not an option, so going back to your asset allocation - with the sale of those Treasuries) is appropriate. ...that is what they were there for.

[bobcat2]

The meaningful target for a retirement portfolio is not to have some AA you decided on years ago. The target instead is to have enough assets to support your required income in retirement to meet your retirement living standard goal. You may also have a secondary retirement living standard goal of meeting a minimum living standard goal in retirement with near certainty. So you want to have enough safe assets that provide retirement income to meet that goal with near certainty. That means the retirement assets designated to meet the minimum acceptable retirement income have to be very safe. You give up that lower bound on safe retirement income when you rebalance out of those safe assets when stocks have very bad years. Here's Edesess on this point.

...the assumption is that you measure risk using something like the short-term volatility of your returns. If that is indeed your measure of risk, then if you don't rebalance, your risk will drift out of its bounds.

But what if your risk measure is the chance of unacceptably low cash flows in 30 years? And what if you control that risk by holding part of your portfolio in 30-year Treasury bonds to provide a secure safety net?

If you rebalance periodically you won't maintain your risk hedge, you'll destroy it. Suppose, for example, you start out with 50% stocks and 50% Treasuries, which you will hold to maturity. Suppose the market drops 20%. Rebalancing means you'll have to sell some of the Treasuries that provide your safety net.

BobK

[bob90245]

Deja vu all over again regarding the rebalancing debate. Heck, if you don't want to rebalance, simply start at a high stock allocation. Not rebalancing gets you there eventually anyway.

[VennData]

Bobcat,

It's a straw man to say that if you have an AA you must stick with it.

Change it if it is appropriate, for example as you age (other reasons for change have been sited throughout the forum.) ...but because stocks have dropped isn't necessarily - usually - an appropriate reason.

Edesess misses the rational between the interplay of the asset allocation, re-balancing (aka goals and risk.)

[pkcrafter]

Taylor, thanks for posting gems from Michael Edesses' book. He brings a slightly different perspective and a little different way of explaining what we know to be true. His writing is very clear and leaves no doubt. I highly recommend the book to new investors.

Paul

[bobcat2]

Edesess misses the rational between the interplay of the asset allocation, re-balancing (aka goals and risk.)

No he doesn't. There are basically four things you can do if you can find yourself at some point off track of meeting your retirement living standard goal. Let's take the more important case of finding yourself short of your goal with several years to go. You can increase your savings rate, you can postpone your retirement year, you can accept a lower retirement living standard, or you can take more risk.

Rebalancing your portfolio to a pre-assigned AA does not do any of these things. If the volatility of risky assets was constant over time, which it is not, then mechanically rebalancing the portfolio would keep the portfolio's volatility constant over time. That, however, has little to do with meeting your retirement living standard goal.

This is not necessarily an argument for taking on more or less risk in any particular portfolio, and it is definitely not an argument for keeping the AA constant over time. But it is an argument against the notion that simply mechanically rebalancing a portfolio to a preset AA will be very helpful in meeting your retirement goal. That would only work well when your forecast of expected returns was very close to the portfolio returns that actually occur over time and the returns are fairly smooth.

It's true that you want to stay the course. But the course you want to stay is to keep on track for meeting your retirement living standard goal. Staying the course of keeping your AA in line with a pre-assigned AA strategy from years ago has little in common with being on course to meet your retirement goal. And this criticism of mechanical rebalancing holds whether one is rebalancing to the same AA every year, or instead using some mechanical predetermined rule such as adding 1% to the fixed income portion of the portfolio every year, i.e. using some age in bonds rule to adjust portfolio proportions through time.

BobK