Elements Of Investing

This summary is based on the ideas and learnings from "The Elements Of Investing, Easy Lessons For Every Investor", 10th Anniversary Edition, by Burton Malkiel and Charles Ellis in 2020. The description of the book mentions: "Investors today are bombarded with conflicting advice about how to handle the increasingly volatile stock market - from pronouncements of the death of diversification to the supposed virtues of cryptocurrencies, investors can be forgiven for being thoroughly confused". The authors go on to deliver short and straightforward lessons in the rules and principles needed to mitigate risk and realize long-term success for investments. Overall, the premise of the book is structured around six elements of investing: save, index, diversify, avoid blunders, keep it simple, and troubled times. The authors present understandable information.

Summary Disclaimer

It should be emphasized that the summary only includes the content which was found to be relevant. There may have been additional information for many chapters, but it was seen to be unnecessary or incorrect in several cases. In this sense and as a consequence, the information included in the summary may appear different from the information included in the book. Finally, there is every possibility some information was mistakenly missed while reading the book.

Save

The fastest way to becoming affluent is by reducing expenses well below income. The first step for people to start towards saving is to stop spending more than they earn - it is not possible to accumulate a small reserve without saving regularly and starting as early as possible. In "David Copperfield" by Charles Dickens, a law is proposed: "Annual income twenty pounds, annual expenditure nineteen pounds nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery". However, the real purpose of saving is to empower people to keep their priorities (buying a new home, sending children to university, or having a secure retirement - stuff to need, want, and enjoy) and not to make sacrifices or lead to regrets.

For most people, the secret to getting rich is the slow miracle of compound interest - earning a return not only on original savings but also on the accumulated interest which has already been earned. Albert Einstein is said to have described compound interest as the most powerful force in the universe. For example, the stock market in the United States has rewarded investors with an average annual return close to 10% over the past 100 years and, if $100 was invested, it would be worth about $1.378 million after 100 years.

The rule of 72 can be used to estimate the number of years it will take for an amount to double when compounded at a certain rate. Simply find the quotient of 72 and the rate specified. For each consecutive doubling, the amount will then increase exponentially and, because of this power of compounding, it is vital to start saving and investing as early as possible.

As a theoretical example, consider starting at 20 and investing $4 thousand for 20 years for total contributions of $80 thousand. Alternatively, consider starting at 40 and investing $4 thousand for 25 years for total contributions of $100 thousand. If an annual return of 10% is assumed, the first case will have almost $2.5 million, while the second case will only have $400 thousand. This is a difference of 525% (relative to the second case), despite having a lower amount of total contribution.

Benjamin Franklin provides an actual example of the power of compounding. When he died in 1790, he left a gift of $5 thousand to each of the cities of Boston and Philadelphia. He stipulated that the money was to be invested and could only be paid out at 100 years and 200 years after the date of the gift. After 100 years in 1891, each city was allowed to withdraw $500 thousand for public works projects and, after 200 years in 1991, they received the balance which had compounded to approximately $20 million for each city. Benjamin Franklin said: "Money makes money. And the money that money makes, makes money".

It should be mentioned that, just like compounding can have remarkably successful results for investing, it can also have drastically detrimental results when taking on debt. Unfortunately, most forms of unsecured debt have interest rates which are much higher than the expected return from investments. There are few absolute rules in finance, but one of the most inviolable is to never take on credit card debt (interest rates are typically higher than 18%). An exception for debt can be in the case of a mortgage, which makes sense if it enables a young family to have a nice place to live when children are young, the amount borrowed is sensible relative to income, the interest costs may be tax deductible depending on the country, and the interest rate is acceptably low.

Index

If a plan is clear, it will be easier to follow. One of the simplest strategies in investing is indexing to buy a total representation of the market based on holding weights from the market capitalization of each company in the market. This clear strategy has outperformed all by a handful of the thousands of funds available to the public. In addition, index funds eliminate the anxiety and expense of trying to predict or having a manager try to predict which individual stocks, bonds, or funds will beat the market.

It is difficult for most investors to believe that the stock market is actually smarter or better informed than they are. Even most financial professionals still do not accept this premise, although perhaps this is because they earn lucrative fees to irrationally believe they can pick the best stocks and bonds to beat the market - as observed by Upton Sinclair, "it is difficult to get a man to understand something when his salary depends upon his not understanding it". The truth is that financial markets, while prone to occasional excesses of either optimism or pessimism, are actually smarter than almost all individuals. Almost no investor consistently outperforms the market either by predicting its movements or selecting particular stocks or bonds.

This is primarily due to the rapid distribution of information, where there are armies of professional analysts and computers ready to react to any news which will affect stock and prices. These professional analysts and computers overwhelmingly dominate pricing one stock or bond versus another and do such a good job that pricing errors are too few, too short-lived, and too small for even the best experts to cover the costs of operations and fees. In addition, most important pieces of news, such as earnings or takeovers, are usually announced when the market is closed, such that prices already reflect this new information once the market opens. As a result, over periods of 15 years, over nearly 90% of active managers underperform an appropriate index as the benchmark.

This does not necessarily mean that the overall market is always correctly priced. Stock and bond markets often make major mistakes and market prices tend to be far more volatile than the underlying conditions warrant. Nonetheless, active managers still fail to outperform the market and are unable to avoid bubbles and drawdowns. This is because the market price is still the most efficient guess of the actual price and nobody knows more than the market. Rex Sinquefield from Dimensional Fund Advisors said that "there are three classes of people who do not believe that markets work: Cubans, North Koreans, and active managers".

Investors will be much better off investing in low-cost and broad-based index fund which buy and hold all the stocks in the market as a whole. The amount by which index funds trounce the typical active manager is staggeringly large with the percentage outperformed by the S&P 500: 1 Year, 70%; 3 Years, 72%; 5 Years, 83%; 10 Years, 89%; 20 Years, 89% (SPIVA US Scorecard 2019), where the average annual return of the S&P 500 was 8.75% compared to the average annual return of active managers at 7.76% over the 15 years ending June 2019 (Lipper and the Vanguard Group) - this is a difference of 1.29% which is fairly close to the typical difference in fees between index funds and active managers. Unsurprisingly, the story does not change when considering global stocks and the percentage outperformed by the S&P Global 1200: 1 Year, 57%; 3 Years, 65%; 5 Years, 75%; 10 Years, 82%; 15 Years, 83% (SPIVA US Scorecard 2019).

Considering bonds, a similar trend is observed, where investors will be much better off investing in low-cost and broad-based index fund which buy and hold all the bonds in the market as a whole. The amount by which index funds trounce the typical active manager is also staggeringly large with the percentage outperformed by government bond indices: 15 Year: short-term bonds, 83%; intermediate-term bonds, 89%; long-term bonds, 98% (SPIVA US Scorecard 2020). A similar trend is also evident for the percentage outperformed by government bond indices: 15 Years: short-term Bonds, 71%; intermediate-term bonds, 89%; long-term bonds, 97% (SPIVA US Scorecard 2020).

However, this is not surprising, since it is mathematically true for the average active manager to underperform the market return. This is because all the stocks and bonds which are outstanding need to be held by someone. The ultimate holders, as a group, cannot beat the market because they are the market. Professional analysts and computers are responsible for about 98% to 99% of all market trading, but these people are simply competing against each other in a zero-sum game before fees (negative-sum game after fees). The participants in the market must, on average, earn the market return before fees. If some investors are fortunate enough to own only the stocks and bonds which have done better than the overall market, then it must follow that some other investors must be holding the stocks and bonds which have done worse - winnings of winners will equal to losings of losers (minus fees). Thus, before fees, it is mathematically true for the average active manager to match the market return and, after fees, it is mathematically true for the average active manager to underperform the market return and underperform the average passive fund which captures this market return (assuming fees for the average passive manager are negligible).

There are often headlines of rare active managers who have managed to beat the market. However, in the same breath, there are also headlines of lottery winners. Based on evidence, most of these active managers are lucky rather than skilful - if there are enough mindless stock and bond picks from all the active managers in aggregate, eventually some of them are going to be correct based on pure chance. Even if the active managers who beat the market were skilful, it is impossible to predict who these active managers are going to be before they deliver their outperformance and, since most active managers are average by definition, the odds are not in favour of the investor making the correct choice - since 1970, it is possible to count on one hand the number of managers who have managed to beat the market by any meaningful amount out of the many thousands of other managers. At the end of the day, the probability of continuing a winning streak is no greater than the probability of flipping heads in the next fair toss of a coin, even if there have been several heads in a row in previous tosses.

In 2007, Warren Buffett offered any taker a $1 million bet that an index fund would outperform a basket of hedge funds over the decade. Protégé Partners took up the challenge. The selected basket of hedge funds had an annualized return of 2.2% while the index fund had an annualized return of 7.1%. Warren Buffett, arguably the greatest active manager of all time, has instructed his estate after he dies to be invested with 90% in the S&P 500 and 10% in short-term bonds.

An index fund is also very tax efficient, because the weightings are self-adjusting without the need for trading. For example, if the market capitalization of a company increases, then the holding weight will increase automatically since the price needed to have increased for the market capitalization to increase - it can be seen as a mirror of the market. Thus, an index is able to maintain its methodology without trading. Conversely, active managers usually trade often and sporadically which leads to capital gains tax and other tax liabilities which need to be inappropriately distributed to investors (unfortunately, this is not necessarily declared in the return, so the performance of an active fund after taxes can be even worse than that which is reported). In addition, this high turnover of the portfolio incurs other costs, such as brokerage commissions and spreads between bid and asked prices, which are not always clearly defined in the fees of a fund. Lastly, active funds have a mutual fund structure, but an exchange-traded fund structure used by most index funds is much more efficient, optimized, and inexpensive.

(Just to emphasize, this weighting is not arbitrary and more information into weighting based on market capitalization is detailed through the capital asset pricing model and efficient market hypothesis in academic finance. It is easy to get a simplistic overview for most people to grasp, but it is much more complex to actually understand - William Sharpe, who proposed the capital asset pricing model, and Eugene Fama, who formalized the efficient market hypothesis, are both Nobel-prize laureates in economics for their research (and the research gets even more complicated with other asset pricing models which develop from the capital asset pricing model)).

Diversify

Surprisingly, many large and seemingly stable companies have collapsed, gone bankrupt, or been forced into mergers. These include Enron, Chrysler, General Motors, Wachovia, Lehman Brothers, AIG, and many others. Unfortunately, the employees of these companies often end up holding a significant portion of their net worth in the stock of their employer and, when the company fails, these people are left with no job and no retirement savings.

Diversification avoids a concentrated bet on a specific company, sector, or country and objectively focusses on a broad range of companies, sectors, and countries. This requires a fund which holds hundreds or thousands of different companies over all sectors across all countries without bias. Due to this wide variety, an investor is able to reduce uncompensated risk, because most economic events do not affect all companies the same way.

In most cases, it is necessary to also diversify across asset classes with a wide selection of stocks and bonds. For bonds, these should be spread over governments as well as corporations with differing terms and credit ratings. High-quality bonds can moderate the risk of a common stock portfolio by providing offsetting variations to the inevitable volatility of the stock market. Typically, when interest rates fall, bond prices rise and, when interest rates rise, bond prices fall. Alternate forms of diversification could also include real assets, such as real estate, commodities, and gold.

Another lesson in diversification is to diversify across time. In other words, it is important to make contributions throughout a given time period. Consider a first scenario, where the stock market is very volatile, declining sharply after the period is commenced and ending exactly where it started, and a second scenario, where the stock market rises each year after the period begins. Although it may intuitively seem as if the second scenario is always better, this is not necessarily the case and it is possible for the first scenario to outperform given the right conditions. This behaviour is similar to Shannon's Demon for rebalancing.

A similar sentiment was portrayed by Warren Buffett when he wrote: "A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves. But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the hamburgers or car they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices".

Rebalancing is the technique to ensure that a portfolio remains efficiently diversified. Since market prices change over time, the share of a portfolio allocated between stocks and bonds will also change. Rebalancing simply involves periodically checking the current allocation in the portfolio and bringing them back to the desired allocation if they have drifted. This reduces the volatility and maintains the risk of the portfolio and can often enhance returns by inadvertently buying low and selling high. The correct response to a decrease in the price of one asset class is never to panic and sell out, but, rather, to have the long-term discipline and personal fortitude to buy more.

Avoid Blunders

One of the major reasons for the success of Warren Buffett is that he has managed to avoid the major mistakes which have crushed so many portfolios. For example, in early 2000, many observers declared that Warren Buffett had lost his touch, since Berkshire Hathaway had underperformed the popular funds which enjoyed spectacular returns by loading up on stocks of technology companies and internet startups. Warren Buffett avoided all tech stocks and told his investors that he refused to invest in any company whose business he did not fully understand or where he could not figure out how the business model would sustain a growing stream of earnings. He had the last laugh when the irrational euphoria collapsed. As another example, in 2005 and 2006, Warren Buffett largely avoided the popular complex mortgage-backed securities and the derivatives which found their way into many investment portfolios. Again, his view was that they were too complex and opaque - called them "financial weapons of mass destruction". In 2007 when they brought down many financial institutions and ravaged the entire financial system, Berkshire Hathaway avoided the worst of the meltdown.

Avoiding serious troubles, particularly troubles which come from incurring unnecessary risks, is one of the great secrets to investment success - investors all too often beat themselves by making serious and completely unnecessary mistakes. As in so many endeavours, the secrets to success are patience, persistence, and minimizing mistakes. The research from behavioural finance shows that most investors are not always rational and they are often their own worst enemies. In general, people tend to be overconfident, harbour illusions of control, and get stampeded by the crowd. And, as it is so often in investing, if someone does make a successful investment, they usually confuse luck with skill.

Investors should also avoid any urge to forecast the market, as almost all forecasts, even by recognized experts, are unlikely to be better than random guesses. Economic forecasts have a poor record, because the market is already the aggregate result of many well-informed investors making their best estimates and expressing their views with real money. Predicting the stock market is really predicting that other investors will change the estimates they are already making with all their best efforts. Thus, this means that, for someone forecasting the market to be right, the consensus of all other participants must be wrong and the forecaster must then also determine in which direction the market will be moved by changes in the consensus of those same active participants - given the wisdom of crowds, this is very unlikely.

The largest and longest study of economic forecasts from experts was performed by Philip Tetlock, who is a professor at the Haas Business School of the University of California-Berkeley. He studied 82 thousand predictions over 25 years by 300 selected experts. Tetlock concludes that expert predictions barely beat random guesses and, ironically, the more famous the expert, the less accurate their predictions tended to be.

When the flows of money going into equity mutual funds is superimposed against the general level of market prices, it is clear that money flows into the funds when prices are high - investors pour money into equity mutual funds at exactly the wrong time. For example, more money went into equity mutual funds during the fourth quarter of 1999 and the first quarter of 2000 than ever before (not to mention that this money primarily went into technology companies and internet startups). In addition, during the punishing bear market of 2007 and 2008, new record withdrawals were made by investors who threw in the towel and sold their mutual fund shares. The market has delivered an average rate of return of about 9.5% over long periods, but the returns actually earned by the average investor are at least two percentage points lower (almost 25% of the actual return).

Cash flow into and out of equity funds follows the stock market as reported by the Vanguard Group:

The best predictor of the future performance of a mutual fund is the fee charged, where a higher fee corresponds with lower investment returns. Considering quartiles of fees between 2001 and 2018, the low-cost quartile had a total expense ratio of 0.41%, annual turnover of 39.46%, and annual total return of 10.29%; second quartile had a total expense ratio of 0.97%, annual turnover of 50.88%, and annual total return of 9.63%; third quartile had a total expense ratio of 1.18%, annual turnover of 58.82%, and annual total return of 9.25%; and high-cost quartile had a total expense ratio of 1.59%, annual turnover of 89.17%, and annual total return of 8.85% (excluding tax consequences from turnover). As Jack Bogle said, "you get what you do not pay for".

Keep It Simple

Albert Einstein remarked that "everything should be made as simple as possible, but no simpler". The financial media is full of stories about the complexity of modern finance, but, despite all the convoluted gimmicks charlatans would like to sell, most investors are better off by embracing simplicity. This can be summarized as saving early and regularly, taking advantage of contribution matches from employers, using tax-advantaged accounts, setting aside a cash reserve, having the necessary insurance, reducing risk through diversification, avoiding debt (specifically credit card debt), ignoring short-term trends and speculation, using low-cost index funds, and focussing on equities and bonds (and possibly real estate, as a lifestyle decision, but skip alternative investments, like exotics, venture capital, private equity, and hedge funds). The secret to getting wealthy is that there is no secret - it is a simple, long, and mundane process.

The appropriate asset allocation for individual investors depends upon a few key factors, of which the primary factor is age and investment horizon. For a longer investment horizon, there is a greater certainty in realizing the expected return of equities. For a shorter investment horizon, it is necessary to incorporate bonds to smooth the ride when equities are volatile. Another important factor to consider is employment and current financial situation which will dictate the capacity to increase risk or need to decrease risk.

Burt's allocation ranges for different age groups: age group, percentage in stocks, percentage in bonds; 20-30s, 90-100, 0-10; 40-50s, 80-90, 10-20; 60s, 70-80, 20-30; 70s, 60-70, 30-40; 80+, 50-60, 40-50. Charley's allocation ranges for different age groups: age group, percentage in stocks, percentage in bonds; 20-30s, 100, 0; 40s, 90-100, 10-0; 50s, 80-90, 10-20; 60s, 75-85, 15-25; 70s, 60-75, 20-30; 80+, 65-70, 30-35. Taking on more market risk by increasing the proportion of stocks in a portfolio will probably result in earning a greater long-run rate of return, but it could also result in lots more sleepless nights and, if the investor is not sure if they can live with and live all the way through the worst market turbulence, they should not take on extra market risk.

Remember an important exception that, if an investor is fortunate enough to have enough capital to be able to meet their living expenses without tapping into your assets, they can choose a different asset allocation more heavily weighted to stocks. In addition, money which someone expects to leave to children and grandchildren should be invested according to their age (not the age of the investor).

Timeless Lessons For Troubled Times

At the end of 2010, the stock market index, as measured by the S&P 500, was actually lower than it was at the beginning of the decade in January 2000. However, this would not have been a concern for a disciplined investor with periodic contributions. Assume an investor starts in January 2000 with perfectly terrible timing, their self-discipline, clarity of purpose, and perseverance to continue to invest in each and every period would have paid off, despite losing about half of their initial investment in the Dot Com Bubble and then again in the Great Financial Crisis. With $1 thousand invested per year on the first trading day of January, the remarkable conclusion is that an investor would have enjoyed a moderate positive return, even during this decade which was disastrous for many equity investors. Equity markets will continue to exhibit substantial short-term volatility in the future and, for the long-term investors, this short-term volatility may be an annoyance, but it should be seen as an opportunity rather than a problem.

Comparison between returns in January 2000 and dollar-cost averaging throughout the "lost decade":

Moreover, even when equity markets around the world tend to move up and down almost in unison, there have been vast differences in the performance of different stock markets. While the short-term fluctuations in developed and emerging equity markets were almost perfectly correlated during the first decade of the 2000s, the long-term performance of those markets was vastly different. Developed markets were basically flat during the decade, producing a minuscule rate of return, but emerging markets produced an overall return of 10% per year.

Comparison between returns of developed markets and emerging markets throughout the "lost decade":

Today, bond interest rates are extraordinarily low and the current era may lead to many investors in bonds to likely experience very unsatisfactory investment results with many types of bonds. Unfortunately, this era may last for some time, as many developed economies are burdened with excessive debt and governments are having difficulty reducing spending. The seemingly less painful policy response is a deliberate attempt to force savers to accept returns below the rate of inflation for a considerable period as the real burdens of debt are eroded - this is essentially a subtle form of debt restructuring and represents a type of invisible taxation.

The current situation is similar to that after World War II in the United States. After the war, the United States had a debt-to-GDP ratio over 100% and the response from the government was to keep interest rates at the low levels which they had been at during the war throughout the 1940s - only in the 1950s did the government begin to gradually increase interest rates. Not only were interest rates artificially low at the start of the period, but investors suffered capital losses when interest rates were allowed to rise - even investors who held to maturity received nominal rates of return which were barely positive over the period, while real returns after inflation were significantly negative. However, at the expense of investors, inflation successfully reduced the debt-to-GDP ratio to about 33% in 1980.

Super Simple Summary

The steps to a comfortable and care-free retirement are simple, but they require discipline and emotional fortitude: save regularly and start early; use company-sponsored and government-sponsored retirement plans to supercharge savings and minimize taxes; diversify broadly over different securities with low-cost total market index funds; rebalance annually to the asset allocation corresponding with the desired level of risk; and stay the course, ignore market fluctuations, and focus on the long-term. Always remember, patience and persistence are the key factors for success in investing. The long-term investor who uses these tools with a sensible long-run investment program will have the best success.