Highlights
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In the casino, the house always wins. In horse racing, the track always wins. In the Powerball lottery, the state always wins. Investing is no different. In the game of investing, the financial croupiers always win, and investors as a group lose. After the deduction of the costs of investing, beating the stock market is a loser’s game.
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Indeed, 240 years ago, the same challenge was faced by Thomas Paine, whose 1776 tract Common Sense helped spark the American Revolution. Here is what Tom Paine wrote: Perhaps the sentiments contained in the following pages are not yet sufficiently fashionable to procure them general favor; a long habit of not thinking a thing wrong, gives it a superficial appearance of being right, and raises at first a formidable outcry in defense of custom. But the tumult soon subsides. Time makes more converts than reason. . . . I offer nothing more than simple facts, plain arguments, and common sense.
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The higher the level of their investment activity, the greater the cost of financial intermediation and taxes, the less the net return that shareholders—as a group, the owners of our businesses—receive.
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Active management as a whole cannot achieve gross returns exceeding the market as a whole, and therefore they must, on average, underperform the indexes by the amount of these expense and transaction costs.
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To this crucial distinction, I would add that the expectations market is largely a product of the expectations of speculators, trying to guess what other investors will expect and how they will act as each new bit of information finds its way into the marketplace.
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Whichever measure we use, it should now be obvious that the returns earned by the publicly held corporations that compose the stock market must of necessity equal the aggregate gross returns earned by all investors in that market as a group. Equally obvious, as will be discussed in Chapter 4, the net returns earned by these investors must of necessity fall short of those aggregate gross returns by the amount of intermediation costs they incur.
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Owning the stock market over the long term is a winner’s game, but attempting to beat the stock market is a loser’s game.
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Some years ago, the S&P Indices versus Active (SPIVA) report began to do exactly that. The report provides comprehensive data comparing active mutual funds grouped by various strategies with relevant market indexes.
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Equally important, it is consistent with the age-old principle of simplicity expressed by Sir William of Occam: Instead of joining the crowd of investors who dabble in complex algorithms or other machinations to pick stocks, or who look to past performance to select mutual funds, or who try to outguess the stock market (for investors in the aggregate, three inevitably fruitless tasks), choose the simplest of all solutions—buy and hold a diversified, low-cost portfolio that tracks the stock market.
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The curious fact is that most investors seem to have difficulty recognizing what lies in plain sight, right before their eyes. Or, perhaps even more pervasively, they refuse to recognize the reality because it flies in the face of their deep-seated beliefs, biases, overconfidence, and uncritical acceptance of the way that financial markets have worked, seemingly forever.
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You can be more successful in selecting winning funds by focusing, not on the inevitable evanescence of past performance, but on something that seems to go on forever or, more fairly, a factor that has persisted in shaping fund returns throughout the fund industry’s long history. That factor is the cost of owning mutual funds. Costs go on forever.
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Fund investors have been chasing past performance since time immemorial, allowing their emotions—perhaps even their greed—to overwhelm their reason.
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I hesitate to assign to any single one of these negative factors the responsibility for being “the straw that broke the camel’s back” of equity fund returns. But surely the final straws include (1) high costs (Chapters 4, 5, and 6), (2) adverse investor selections and counterproductive market timing (Chapter 7), and (3) taxes (Chapter 8). Whichever way one looks at it, the camel’s back is surely broken. But the very last straw, it turns out, is inflation.
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In that chapter, I described three sources of return on stocks: the initial dividend yield and the earnings growth (together, “investment return”), and changes in the P/E multiple (“speculative return”).
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My point is that you don’t need to accept my cautious scenario. Feel free to disagree. Project the coming decade for yourself by applying the current dividend yield (there’s no escaping that!), your own rational expectations for earnings growth, and your own view of the P/E ratio in 2027. That total will represent your own reasonable expectation for stock returns over the coming decade.
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When the reported investment returns generated by Magellan and Contrafund were noticed by investors, cash poured in, and they reached giant asset totals. But, as Warren Buffett reminds us, “a fat wallet is the enemy of superior returns.” And so it was. As these two popular funds grew, their records turned lackluster.
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The simple fact is that trying to select a mutual fund that will outpace the stock market over the long term is, using Cervantes’s formulation, like “looking for a needle in the haystack.” So I offer you a cautionary corollary: “Don’t look for the needle in the haystack. Just buy the haystack!”
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Paul Samuelson summed up the difficulty of selecting superior managers in this parable. “Suppose it was demonstrated that one out of twenty alcoholics could learn to become a moderate social drinker. The experienced clinician would answer, ‘Even if true, act as if it were false, for you will never identify that one in twenty, and in the attempt five in twenty will be ruined.’ Investors should forsake the search for such tiny needles in huge haystacks.”
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The old saying that “past performance is no guide to the future” is not a piece of compliance jargon. It is the math.
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In all, this evidence suggests that, yet again, the simplicity of a broad-market, low-cost index fund, bought and then held forever, is likely to be the optimal strategy for the vast majority of investors.
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Note: Good summary of the main idea
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The arc of investment is long, but it bends toward fiduciary duty.
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Note: Is this a riff on a MLK Jr quote?
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WHAT LESSONS HAVE WE learned in the previous chapters? Costs matter (Chapters 5, 6, and 7). Selecting equity funds based on their long-term past performance doesn’t work (Chapter 10). Fund returns revert to the mean (RTM) (Chapter 11). Relying even on the best-intentioned advice works only sporadically (Chapter 12).
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There are two fundamental factors that determine how you should allocate your portfolio between stocks and bonds: (1) your ability to take risk and (2) your willingness to take risk.
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Taken together, your ability to accept risk and your willingness to accept risk constitute your risk tolerance.
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Finally, we’re all just human beings, operating in a fog of ignorance and relying on our circumstances and our common sense to establish an appropriate asset allocation.
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Our task remains: earning our fair share of whatever returns our business enterprises are generous enough to provide in the years to come. That, to me, is the definition of investment success.
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Don’t think that you know more than the market; no one does. And don’t act on insights that you think are your own but are usually shared by millions of others.
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While the interests of Wall Street’s businesses are well served by the aphorism “Don’t just stand there—do something!,” the interests of Main Street’s investors are well served by an approach that is its diametrical opposite: “Don’t do something—just stand there!”
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