peter l. bernstein

On Common Sense on Mutual Funds

I recently finished reading Common Sense on Mutual Funds – New Imperatives for the Intelligent Investor – by John C. Bogle.

Below are key excerpts from this book that I found to be insightful:

Investing is an act of faith. We entrust our capital to corporate stewards in the faith—at least with the hope—that their efforts will generate high rates of return on our investments. When we purchase corporate America’s stocks and bonds, we are professing our faith that the long-term success of the U.S. economy and the nation’s financial markets will continue in the future.

To state the obvious, the long-term investor who pays least has the greatest opportunity to earn most of the real return provided by the stock market.

In my view, market timing and rapid turnover—both by and for mutual fund investors—betray both a lack of understanding of the economics of investing and an infatuation with the process of investing.

My guidelines also respect what I call the four dimensions of investing: (1) return, (2) risk, (3) cost, and (4) time. When you select your portfolio’s long-term allocation to stocks and bonds, you must make a decision about the real returns you can expect to earn and the risks to which your portfolio will be exposed. You must also consider the costs of investing that you will incur. Costs will tend to reduce your return and/or increase the risks you must take. Think of return, risk, and cost as the three spatial dimensions—the length, breadth, and width—of a cube. Then think of time as the temporal fourth dimension that interplays with each of the other three. For instance, if your time horizon is long, you can afford to take more risk than if your horizon is short, and vice versa.

Rule 1: Select Low-Cost Funds…Rule 2: Consider Carefully the Added Costs of Advice…Rule 3: Do Not Overrate Past Fund Performance…Rule 4: Use Past Performance to Determine Consistency and Risk…Rule 5: Beware of Stars…Rule 6: Beware of Asset Size…Rule 7: Don’t Own Too Many Funds…Rule 8: Buy Your Fund Portfolio—And Hold It.

No matter what fund style you seek, you should emphasize low-cost funds and eschew high-cost funds. And, for the best bet of all, you should consider indexing in whichever style category you want to include.

There are three major reasons why large size inhibits the achievement of superior returns: the universe of stocks available for a fund’s portfolio declines; transaction costs increase; and portfolio management becomes increasingly structured, group-oriented, and less reliant on savvy individuals.

Four principal problems are created by this overemphasis on marketing. First, it costs mutual fund shareholders a great deal of money— billions of dollars of extra fund expenses—which reduces the returns received by shareholders. Second, these large expenditures not only offer no countervailing benefit in terms of shareholder returns, but, to the extent they succeed in bringing additional assets into the funds, have a powerful tendency to further reduce fund returns. Third, mutual funds are too often hyped and hawked, and trusting investors may be imperiled by the risks assumed by, and deluded about the potential returns of, the funds. Lastly, and perhaps most significant of all, the distribution drive alters the relationship between investors and funds. Rather than being perceived as an owner oi the fund, the shareholder is perceived as a mere customer of the adviser.

On a closing note, on leadership:

To wrap up this litany, I put before you—both tentatively and humbly—a final attribute of leadership: courage. Sometimes, an enterprise has to dig down deep and have the courage of its convictions—to “press on,” regardless of adversity or scorn. Vanguard has been a truly contrarian firm in its mutual structure, in its drive for low costs and a fair shake for investors, in its conservative investment philosophy, in market index funds, and in shunning hot products, marketing gimmicks, and the carpet-bombing approach to advertising so abundantly evident elsewhere in this industry today. Sometimes, it takes a lot of courage to stay the course when fickle taste is in the saddle, but we have stood by our conviction: In the long run, when there is a gap between perception and reality, it is only a matter of time until reality carries the day.

A recommended read in the areas of investing and leadership.

On Reinventing the Bazaar

I recently finished reading Reinventing the Bazaar – A Natural History of Markets – by John McMillan. Below are key excerpts from the book that I found particularly insightful:

1- “A definition of a market transaction, then, is an exchange that is voluntary: each party can veto it, and (subject to the rules of the marketplace) each freely agrees to the terms. A market is a forum for carrying out such exchange.”

2- “Markets are too important to be left to the ideologues. In fact, markets are the most effective means we have of improving people’s well-being. For poor countries they offer the most reliable path away from poverty. For affluent countries they are part of what is needed to sustain their living standards.”

3- “The key feature of markets of all kinds is brought home when we look at the growth of new market mechanisms. Benefiting both buyer and seller, any transaction creates value. Buying and selling is therefore a form of creation. Elementary at this point is, its importance cannot be overstated. There are gains from trade, and people are relentless in finding ways to realize them.”

4- “Two kinds of market frictions arise from the uneven supply of information. There are search costs: the time, effort, and money spent learning what is available where for how much. And there are evaluation costs, arising from the difficulties buyers have in assessing quality. A successful market has mechanisms that hold down the costs of transacting that come from the dispersion of information.”

5- “Well-designed markets have a variety of mechanisms, formal and informal, to ensure there is indeed money in being honest. marketplace confidence rests on rules and customs that give even unscrupulous people reason to keep their word…Contracting rests not only on the courts but also on informal devices based on reputation. Information must flow in reputational incentives are to work.”

6- “Some externalities can be corrected by defining and enforcing property rights. In other cases the harmful activity can be taxed. In extreme cases the only solution is to ban it.”

7- “A workable platform for markets has five elements: information flows smoothly; people can be trusted to live up to their promises; competition is fostered; property rights are protected but not overprotected; and side effects on third parties are curtailed.”

8- “Governments sometimes conspire to undermine markets. Corruption cuts into productivity because firms that fear they will be at the mercy of bribe-takers are reluctant to invest. Price-fixing also cuts into productivity by preventing the price system from doing its job of allocating resources. Constructive government actions are needed…to help the market system work as it is supposed to. But there is a risk that government intervention will be perverted in counterproductive directions.”

9- “Well-functioning markets rely on a judicious mix of formal and informal controls. While the government helps to set the rules for the market, so do that market participants. an economy cannot be designed from above. If it were possible to plan the reforms, if would have been possible to plan the economy.”

10- “Those on the far left of the political spectrum, who abhor poverty, espouse policies that would entrench it. The fervent proponents of laissez-faire, who esteem market, advocate a system that would trigger their collapse.”

11- “The market system is like democracy. It is the worst form of economy, except for all the others that have been tried from time to time. It succeeds because, precisely as in Forster’s view of democracy, it admits variety and permits criticism. We should cheer it because it solves some all-but-intractable problems, which have been tackled by none of the alternative forms of economic organization. It generates wealth. It alleviates poverty. But it has its limits. There are things it cannot do. It does not necessarily do even what it is supposed to; it works well only if it is well designed. Two cheers are enough.”


Omar Halabieh

Reinventing the Bazaar

On Against The Gods

I recently finished reading Against The Gods – The Remarkable Story of Risk by Peter L. Bernstein. As the title indicates this book narrates the history of Risk and its role in human advancement.

Peter best summarizes the content of the book in his introduction: “this book tells the story of a group of thinkers whose remarkable vision revealed ow to put the future at the service of the present. By showing the world how to understand risk, measure it, and weight its consequences, they converted risk-taking into one of the prime catalysts that drives modern Western society.”

The book presents the history of Risk in a chronological sequence, and outlines its understanding in the respective timeframe and through the lenses of the people advancing the field. It also reflects on how that understanding affected the advancement in the various aspects of their lives.

A great educational and informative book. Peter manages to present the content in a very fluid manner, without getting caught up in the technicalities and the jargon – making this book accessible to all readers. A recommended read!

Below are excerpts from the book that I found particularly insightful:

1- “The revolutionary idea that defines the boundary between modern times and the past is the mastery of risk: the notion that the future is more than a whim of the gods and that men and women are not passive before nature. Until human beings discovered a way across that boundary, the future was a mirror of the past or the murky domain of oracles and soothsayers who held a monopoly over knowledge of anticipated events.”

2- “The word “risk” derives from the early Italian risicare, which means “to dare.” In this sense, risk is a choice rather than a date. The action we dare to take, which depend on how free we are to make choices, are what the story of risk is all about. And that story helps define what it means to be a human being.”

3- “Risk and time are opposite sides of the same coin, for if there were no tomorrow there would be no risk. Time transforms risk, and the nature of risk is shaped by the time horizon: the future is the playing field.”

4- “The trick is to be flexible enough to recognize that the regression to the mean is only a tool; it is not a religion with immutable dogma and ceremonies. ”

5- “The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome and the linkage between effect and cause is hidden from us.”

6- “Knight builds his analysis on the distinction between risk and uncertaintly: Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated…It will appear that a measurable uncertainty, or “risk” proper…is so far different from an unmeasurable one that it is not in effect an uncertainty at all.”

7- “Once we understand that we are not obliged to accept the spin of the roulette wheel or the cards we are dealt, we are free souls. Our decisions matter. We can change the world. Keynes’s economic prescriptions reveal that as we make decisions we do change the world. Whether that change turns out to be for better or for worse is up to us. The spin of the roulette wheel has nothing to do with it.”

8- “Game theory brings a new meaning to uncertainty. Earlier theories accepted uncertainty as a fact of life and did little to identify its source. Game theory says that the true source of uncertainty lies in the intentions of others.”

9- “Tversky offers an interesting speculation on this curious behavior: Probably the most significant and pervasive characteristic of the human pleasure machine is that people are much more sensitive to negative than to positive stimuli….[T]hink about how you feel today, and then try to imagine how much better you could feel….[T]here are a few things that would make you feel better, but the number of things that would make you feel worse in unbounded.”

10- “Occasional large gains seem to sustain the interest of investors and gamblers for longer periods of time than consistent small winnings. That response is typical of investors who look on investing as a game and who fail to diversify; diversification is boring. Well-informed investors diversify because they do not believe that investing is a form of entertainment.”

11- “Derivatives are not transactions in shares of stock or interest rates, in human lives, in houses vulnerable to fire, or in home mortgages. The product in derivative transactions is uncertainty itself.”

12- “But there is only a fine line between guaranteeing absolute safety and stifling the development of financial innovations that, properly handled, could reduce the volatility of corporate cash flows. Corporations that shelter their cash flows from volatility  can afford to take greater internal risks in the form of higher levels of investment or expenditures on research and development. Financial institutions themselves are vulnerable to volatility in interest rates and exchange rates; to the extent that they can hedge that volatility, they can extend more credit to a wider universe of deserving borrowers.”


Omar Halabieh

Against The Gods

Against The Gods