Tag Archives: saving

The Reality Of Frictional Costs And The Clash Of Cultures

I was referred to Jack Bogle’s novel, “The Clash of the Cultures, Investment Vs. Speculation,” through a Berkshire chairman letter a few weeks ago and decided to pick a copy up from the public library. In the book, Bogle talks about the importance of mitigating frictional costs (management fees, brokerage fees and taxes) during the investment process. He also goes into great detail about the toxic culture that has been created through the conflicts of interest between hedge fund managers, corporate executives, analysts, salesmen and mutual fund, pension and endowment managers. Much of the book is based on an indexing approach, focused on the long-term value creation of businesses as well as the ethics and fiduciary duty an agent has to the client(s) to act in his/her best interest. 

This is sadly not the case in today’s speculative frenzy of exotic derivatives, high frequency trading, short-term focused managers incentivized by assets under management (AUM), day traders, market timing strategies, actively managed funds and any other speculative “bets” you may think of. As elegantly stated in 1776 by Adam Smith, “Managers of other people’s money rarely watch over it with the same anxious vigilance with which… they watch over their own.” 

The present day industry is built on the cornerstone of marketing, not stewardship, collecting assets, not adequately deploying other people’s capital. How can one tell which fund or manager will outperform in the future? If we could accurately tell, wouldn’t we all be identifying the next Berkshire or Fairfax? Morningstar implemented a new rating system in 2011 using “The 5 Ps” as criteria when selecting a manager. 

People: Thinking about the advantages the manager or team brings to the table in terms of differentiation, experience, demonstrated skill, expertise and how much the manager(s) has invested in the fund. 

Process: Is the manager doing something unique or doing what anyone could replicate? (Mirror funds I believe they are called.) 

Parent: Manager turnover at the firm, the culture, the quality of research, directors, SEC litigation or sanctions, and ethics. 

Performance: The past performance of the current manager: the longer the record the better. What is the strategy and holdings of the fund and how did they perform during different periods, how consistent are the returns and what is the risk profile? 

Price: The fund’s expense relative to the asset size, peer group expense comparison and overall trading costs. 

I do not hold mutual funds, ETFs or index funds as I find the entire investment process very enjoyable and exhilarating. When I am looking at businesses that involve investing in marketable securities I do examine the concentration, strategy and turnover of the portfolio with the most scrutiny. The difference between 1% to 2% annually, compounded over a lifetime, can be truly eye opening and astounding. Using the term of 30 years and a present value of $100,000 we will see the beneficial effects of no-load funds, low portfolio turnover and low management fees. 

At 8% (with higher expenses): $100,000(1.08)^30 = $1,006,265

At 10% (index approach): $100,000(1.10)^30 = $1,744,940

A staggering difference of $738,675 or 73.4% more by mitigating controllable costs. Now imagine 8% reduced by 35% to 5.2% if you decide to trigger taxes annually instead of once every 30 years. You would have $1,134,211 in the latter scenario and only $457,585 in the first scenario of annual tax triggers. These differences used for illustration purposes essentially sum up the difference between annually changing your mutual fund investments versus a long-term indexing approach. Simply stated, taxes and fees shouldn’t be given the cold shoulder. 

Here Are Jack Bogle’s 9 Simple Rules for Investment Success:

1) Remember Reversion to the Mean

This rule is based on the philosophy of “what can’t go up forever, wont” and “what goes up, must come down.” Analyzing long-term winners in the mutual fund business like the Legg Mason Value Trust Fund or the Fidelity Magellan Fund show that under closer scrutiny both actually underperformed the market over a 30-year stretch (1982 to 2012) and the hype of these well-known funds come from short-term sporadic performance that has since fizzled out. 

If you hold mutual funds, read the prospectus. RTM can be simply visualized by a pendulum that is moving from optimistic valuations to pessimistic valuations and back again. What is earned in market returns in excess of what the underlying businesses actually earns will simply be borrowed from the future, based on optimistic speculation from the present. Eating your dessert before your dinner is fine and dandy, until those cooked carrots need to me muscled down. 

2) Time Is Your Friend, Impulse Is Your Enemy 

As briefly outlined above there is large differences between annual capital gains tax triggers and once-in-a- generation tax triggers. Do the math yourself and research the correlation between net fund returns and the turnover of fund holdings; my bet would be the relationship is an inverse one, meaning the lower the portfolio turnover the higher net returns. I also remember reading an article or comment on GuruFocus relating to how often Buffett or other concentrated value investors turn their portfolios. Again, I have no empirical evidence but my guess would be that most successful ones have a turnover rate under 25% and some may have turnover as low as 5% to 15%. 

3) Buy Right and Hold Tight

Relating to portfolio allocation, John Bogle and I seem to have similar views. When it comes to risk profiles and fixed income concentration, age should be a large factor. The easiest heuristic to remember would be 100 – (Your Age) = Equity Exposure. Personally, I like to take the sum and multiply it by 1.1 as I have a strong stomach for volatility, increasing my exposure to equities. Relating to the equity exposure portion it is up to each individual investor’s preference to dictate what the holdings should consist of based on personal risk profiles. 

4) Have Realistic Expectations

In the book an elaborate metaphor is used comparing an “Investment Bagel” to a “Speculative Donut.” The Bagel is nutritious and represents the dividend yield plus the earnings growth. The donut is sugary and it tastes great but is terrible for you repetitively in the long run. Having realistic expectations will help thwart the inclination to speculate for larger returns and keep you satisfied with returns in excess of a few hundred basis points of the S&P 500 (or another preferred benchmark). Remember the power of compound interest: A few percent can and will make all the difference. “In the short-term the market is a voting machine, in the long-run it is a weighing machine.” 

5) Forget the Needle, Buy the Haystack

I do not entirely agree with this statement but for the people who do not have the time nor the inclination to research and “turn rocks,” indexing is the best alternative. Because (as most people that understand math would agree) everyone that is involved in the market is the market,proactively and reactively placing bets on new information received that represents each individual’s perception of the probability of outcomes that may occur. Because we are the market,at least 50% of the participants must underperform the market. If you do not believe you have the correct psyche, skill or amount of time it takes to outperform the market (over a lifetime average), it may be best to index your returns using low-cost approaches. As Munger once said, the market in a (very) simplified state, is a parlay horse track, actively adjusting spreads based on participants’ expectations of the outcomes. 

6) Minimize the Croupier’s Take

This cannot be stressed enough! If you understand the effects of compound interest, even 0.50% over a lifetime can make a noticeable difference. You need to be proactive in reducing management’s take, the government’s take and the broker’s take of your hard-earned dollars. No-load funds with low annual turnover and a low MER are a great place to start. It is absolutely ridiculous that expenses attributed to marketing can be eliminated from an investor’s net return. The sole purpose of marketing funds and institutions is to increase AUM or the fees that the portfolio managers can collect and is in no way beneficial to an individual shareholder who is subsidizing this service. (One could argue it is actually harmful due to the law of large numbers.) 

Whatever happened to fiduciary duty and stewardship or am I just a naïve young kid? Agents must act in the best interest of the client and should only be given one chance. We are dealing with people’s life-long earnings here: Show some respect. Keep an eye on those fees and do all you can to minimize taxes. “The best holding period is forever.” 

7) There’s No Escaping Risk

A capital markets line sums up this statement and with greater reward comes greater risk. This is not always the case (as measured by risk adjusted returns) but it is a general rule of thumb. Embrace risk but only to the point where you are still comfortable sleeping at night. If this is not the case “sell down” or change your portfolio exposure to a more comfortable level. 

8) Beware of Fighting the Last War

Fighting the last war is related to the bias the immediate past casts on our perception. A brief example of this is how skittish investors are to the thought of a large-scale decline in the market similar to 2008 through 2009 or over-valuation of the late ’90s. We fear events after they have happened, essentially driving with the rear view mirror. Yikes! 

9) The Hedgehog Bests the Fox

The Greek poet Archilochus once said, “The fox knows many things but the hedgehog knows one thing.” The fox, that is sly and astute, represents the institutional investors of today, that know (or believe they know) about the complex market and strategies that will outperform. While the hedgehog, which curls into a ball with an almost impenetrable spine, knows only one thing: Long-term investment success is built on the cornerstone of simplicity. The simplicity is known to be the magic of compounding returns and low frictional costs, keeping costs to a minimum, while efficiently allocating capital. 

“Compound interest is the eighth wonder of the world. Those who understand it, earn it. Those who do not, pay it.”

http://www.gurufocus.com/news/231552/the-reality-of-frictional-costs-and-the-clash-of-cultures

Why Investing is the Greatest Business in One Quote

WarrenI recently read an article from 1974 by Warren Buffet in which he was quoted saying “I call investing the greatest business in the world,” he says, “because you never have to swing.” You stand at the plate, the pitcher throws you General Motors at 47! U.S. Steel at 39! And nobody calls a strike on you. There’s no penalty except opportunity lost. All day you wait for the pitch you like; then when the fielders are asleep, you step up and hit it.” and I couldn’t agree more.

Patience and discipline are key qualities of investors and when combined with thorough research & analysis, grade five math, a basic accounting class, hard work, persistence and perseverance you are destined to win.

Risk is obsessed over in the finance industry but using a value investing approach (intrinsic value) as assets get cheaper (provided allocation concentration is controlled as well as leverage minimal or non existent) the risk is mitigated in an arguably perfect correlation with negative price moves. An example of this would be if you are buying a $1 for 50 cents and it went to 30 cents, it has not become more risky but less risky as would any rational person believe. How could someone possibly believe if $1 increased to $2 it is less risky? The latter is certainly not the case. Intrinsic value can provide an anchoring point and increase confidence provided apples are apples and $1 is $1.

Buffet was also quoted from the article saying “You’re dealing with a lot of silly people in the marketplace; it’s like a great big casino and everyone else is boozing. If you can stick with Pepsi, you should be OK.” “First the crowd is boozy on optimism and buying every new issue in sight. The next moment it is boozy on pessimism, buying gold bars and predicting another Great Depression.”

From personal experience I have found I made the best decisions and made the biggest returns looking in unconventional spots doing the opposite of the majority (Buying when others are selling, Selling when others are buying) as reflected in one of my favourite Mark Twain quotes, “Whenever you find yourself on the side of the majority it is time to pause and reflect.” 

It is not incredibly hard and the professionals would not like you to know the actual simplicity of the business or they would be out of jobs. Now use your head and look for incredibly cheap companies/business as if you were buying a piece of ownership using net worth or book value calculations and KISS (keep it simple stupid) only analyzing business you understand.

Dividends & earnings growth can provide extra income or can be re-invested and compounded throughout your life time at an extraordinary pace.  Proof Here.

Investing is truly a business you are paid for your time and the sky is the limit as countless billionaires and multi millionaires have proven over the last century. If the word was going to end I don’t think fiat currency and gold bars are a concern (food,water,safety) so just sit back relax and let the dividends roll.

Investing can quickly provide financial security and help finance businesses around the world, creating jobs, as it truly is the lifeblood of our capitalist economy.

The Five Laws of Gold

The principles below are from the book “The Richest Man in Babylon” by George Samuel Clason. The novel is made up of clever analogies that promote financial wisdom and managing household finances more efficiently.

  • 1) Gold cometh gladly and in increasing quantity to any man who will put by not less than one-tenth of his earnings to create an estate for his future and that of his family. (Save 10%)
  • 2) Gold laboreth diligently and contentedly for the wise owner who finds for it profitable employment, multiplying even as the flocks of the field. (Keep the money working diligently in profitable scenarios)
  • 3) Gold clingeth to the protection of the cautious owner who invests it under the advice of men wise in its handling. (Keep a Wise Council)
  • 4) Gold slippeth away from the man who invests it in businesses or purposes with which he is not familiar or which are not approved by those skilled in its keep. (Invest in what you know and understand)
  • 5) Gold flees the man who would force it to impossible earnings or who followeth the alluring advice of tricksters and schemers or who trusts it to his own inexperience and romantic desires in investment. (If it is too good to believe, it probably is.)Using these laws of gold, Nomasir became rich. “Yet, who can measure in bags of gold, the value of wisdom? Without wisdom, gold is quickly lost by those who have it, but with wisdom, gold can be secured by those who have it not, as these three bags of gold do prove.”A small passage from the novel that I believe to be valuable to anyone, even the people that may be foolish enough not to read the entire book or at least put aside the time to listen to the audio link attached below. (Youtube)

    Finally I leave you with a quote from the Richest Man in Babylon,

    “Advice is one thing freely given away, but watch that you take only what is worth having.”