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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.

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On The Most Important Thing

I recently finished reading The Most Important Thing – Uncommon Sense for the Thoughtful Investor – by Howard Marks.

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

Few people have what it takes to be a great investors. Some can be taught, but not everyone… and those who can be taught can’t be taught everything. Valid approaches work some of the time but not all. And investing can’t be reduced to an algorithm and turned over to a computer. Even the best investors don’t get it right every time.

Because investing is at least as much art as it is science, it’s never my goal—in this book or elsewhere—to suggest it can be routinized. In fact. one of the things I most want to emphasize is how essential it is that one’s investment approach be intuitive and adaptive rather than be fixed and mechanistic.

Second-level thinking is deep, complex and convoluted. The second level thinker takes a great many things into account: What is the range of likely future outcomes? Which outcome do I think will occur? What’s the probability I’m right? What does the consensus think? How does my expectation differ from the consensus? How does the current price for the asset comport with the consensus view of the future, and with mine? Is the consensus psychology that’s incorporated in the price too bullish or bearish? What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

Return alone—and especially return over short periods of time—says very little about the quality of investment decisions. Return has to be evaluated relative to the amount of risk taken to achieve it. And yet, risk cannot be measured. Certainly it cannot be gauged on the basis of what “everybody” says at a moment in time. Risk can be judged only by sophisticated, experienced second-level thinkers.

The road to long-term investment success runs through risk control more than through aggressiveness. Over a full career, most investors’ results will be determined more by how many losers they have, and how bad they are, than by the greatness of their winners. Skillful risk control is the mark of the superior investor.

The pendulum swing regarding attitudes toward risk is one of the most powerful of all. In fact, I’ve recently boiled down the main risks in investing to two: the risk of losing money and the risk of missing opportunity. It’s possible to largely eliminate either one, but not both. In an ideal world, investors would balance these two concerns. But from time to time, at the extremes of the pendulum’s swing, one or the other predominates.

What weapons might you marshal on your side to increase your odds? Here are the ones that work for Oaktree: a strongly held sense of intrinsic value. insistence on acting as you should when price diverges from value. • enough conversance with past cycles—gained at first from reading and talking to veteran investors, and later through experience—to know that market excesses are ultimately punished, not rewarded. a thorough understanding of the insidious effect of psychology on the investing process at market extremes. a promise to remember that when things seem “too good to be true,” they usually are. willingness to look wrong while the market goes from misvalued to more misvalued (as it invariably will), and • like-minded friends and colleagues from whom to gain support (and for you to support).

To boil it all down to just one sentence, I’d say the necessary condition for the existence of bargains is that perception has to be considerably worse than reality. That means the best opportunities are usually found among things most others won’t do. After all, if everyone feels good about something and is glad to join in, it won’t be bargain-priced.

What We Learn from a Crisis—or Ought To: Too much capital availability makes money flow to the wrong places…When capital goes where it shouldn’t, bad things happen…hen capital is in oversupply, investors compete for deals by accepting low returns and a slender margin for error…Widespread disregard for risk creates great risk…Inadequate due diligence leads to investment losses…In heady times, capital is devoted to innovative investments, many of which fail the test of time…Hidden fault lines running through portfolios can make the prices of seemingly unrelated assets move in tandem…Psychological and technical factors can swamp fundamentals…Markets change, invalidating models…Leverage magnifies outcomes but doesn’t add value…Excesses correct.

On a closing note:

Thus, it’s our goal to do as well as the market when it does well and better than the market when it does poorly. At first blush that may sound like a modest goal, but it’s really quite ambitious.

A must read in the area of investing.

On The Wealth of Nations

I recently finished reading the landmark classic The Wealth of Nations by Adam Smith. This book has been on my reading list for a long time, but I was discouraged by its length (1200+ pages). Having now read it, I am very glad I did. The breadth and depth of this book is – even after 239 years of publication – a monumental achievement.

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

As it is by treaty, by barter, and by purchase, that we obtain from one another the greater part of those mutual good offices which we stand in need of, so it is this same trucking disposition which originally gives occasion to the division of labour.

The value of any commodity, therefore, to the person who possesses it, and who means not to use or consume it himself, but to exchange it for other commodities, is equal to the quantity of labour which it enables him to purchase or command. Labour, therefore, is the real measure of the exchangeable value of all commodities.

The five following are the principal circumstances which, so far as I have been able to observe, make up for a small ~ pecuniary gain in some employments, and counter-balance a great one in others: first. the agreeableness or disagreeableness of the — employments themselves; secondly, the easiness and cheapness, or the difficulty and expence of learning them; thirdly, the constancy or inconstancy of employment in them; fourthly, the small or great trust which must be reposed in those who exercise them; and fifthly, the probability or improbability of success in them.

I shall conclude this very long chapter with observing that every improvement in the circumstances of the society tends either directly or indirectly to raise the real rent of land, to increase the real wealth of the landlord, his power of purchasing the labour, or the produce of the labour of other people.

Political economy considered as a branch of the science of a statesman or legislator, proposes two distinct objects: first, to provide a plentiful revenue or subsistence for the people, or more properly to enable them to provide such a revenue or subsistence for themselves; and secondly, to supply the state or commonwealth with a revenue sufficient for the public services. It proposes to enrich both the people and the sovereign.

The importation of gold and silver is not the principal. much less the sole benefit which a nation derives from its foreign trade. Between whatever places foreign trade is carried on, they all of them derive two distinct benefits from it. It carries out that surplus part of the produce of their land and labour for which there is no demand among them, and brings back in return for it something else for which there is a demand. It gives a value to their superfluities, by exchanging them for something else, which may satisfy a part of their wants, and increase their enjoyments. By means of it, the narrowness of the home market does not hinder the division of labour in any particular branch of art or manufacture from being carried to the highest perfection.

We must carefully distinguish between the effects of the colony trade and those of the monopoly of that trade. The former are always and necessarily beneficial; the latter always and necessarily hurtful. But the former are so beneficial, that the colony trade, though subject to a monopoly, and notwithstanding the hurtful effects of that monopoly, is still upon the whole beneficial, and greatly beneficial; though a good deal less so than it otherwise would be.

The discovery of America, and that of a passage to the East Indies by the Cape of Good Hope, are the two greatest and most important events recorded in the history of mankind. Their consequences have already been very great: but, in the short period of between two and three centuries which has elapsed since these discoveries were made, it is impossible that the whole extent of their consequences can have been seen.

When a landed nation, on the contrary, oppresses either by high duties or by prohibitions the trade of foreign nations, it necessarily hurts its own interest in two different ways. First, by raising the price of all foreign goods and of all sorts of manufactures, it necessarily sinks the real value of the surplus produce of its own land, with which, or, what comes to the same thing. with the price of which, it purchases those foreign goods and manufactures. Secondly, by giving a sort of monopoly of the home market to its own merchants, artificers and manufacturers, it raises the rate of mercantile !e and manufacturing profit in proportion to that of agricultural profit, and consequently either draws from agriculture a part of the capital which had before been employed in it, or hinders from going to it a part of what would otherwise have gone to it. This policy, therefore, discourages agriculture in two different ways; first, by sinking the real value of its produce, and thereby lowering the rate of its profit; and, secondly, by raising the rate of profit in all other employments. Agriculture is rendered less advantageous, and trade and manufactures more advantageous than they otherwise would be; and every man is tempted by his own interest to turn, as much as he can, both his capital and his industry from the former to the latter employments.

According to the system of natural liberty, the sovereign has only three duties to attend to; three duties of great importance, indeed, but plain and intelligible to common understandings: first, the duty of protecting the society from the violence and invasion of other independent societies; secondly, the duty of protecting, as far as possible, every member of the society from the injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice; and, thirdly, the duty of erecting and maintaining certain public works and certain public institutions, which it can never be for the interest of any individual, or small number of individuals, to erect and maintain; because the profit could never repay the expence to any individual or small number of individuals, though it may frequently do much more than repay it to a great society.

Commerce and manufactures, in short, can seldom flourish in any state in which there is not a certain degree of confidence in the justice of government. The same confidence which disposes great merchants and manufacturers, upon ordinary occasions, to trust their property to the protection of a particular government; disposes them, upon extraordinary occasions, to trust that government with the use of their property. By lending money to government, they do not even for a moment diminish their ability to carry on their trade and manufactures. On the contrary, they commonly augment it. The necessities of the state render government upon most occasions willing to borrow upon terms extremely advantageous to the lender. The security which it grants to the original creditor, is made transferable to any other creditor, and, from the universal confidence in the justice of the state, generally sells in the market for more than was originally paid for it.

But if the empire can no longer support the expence of keeping up this equipage, it ought certainly to lay it down; and if it cannot raise its revenue in proportion to its expence, it ought, at least, to accommodate its expence to its revenue. If the colonies, notwithstanding their refusal to submit to British taxes, are still to be considered as provinces of the British empire, their defence in some future war may cost Great Britain as great an expence as it ever has done in any former war. The rulers of Great Britain have, for more than a century past, amused the people with the imagination that they possessed a great empire on the west side of the Atlantic. This empire, however, has hitherto existed in imagination only. It has hitherto been, not an empire, but the project of an empire; not a gold mine, but the project of a gold mine; a project which has cost, which continues to cost, and which, if pursued in the “”same way as it has been hitherto, is likely to cost, immense expence, without being likely to bring any profit; for the effects of the monopoly of the colony trade, it has been shewn, are, to the great body of the people, mere loss instead of profit. It is surely now time that our rulers should either realize this golden dream, in which they have been indulging themselves, perhaps, as well as the people; or, that they should awake from it themselves, and endeavour to awaken the people. If the project cannot be completed, it ought to be given up. If any of the provinces of the British empire cannot be made to contribute towards the support of the whole empire, it is surely time that Great Britain should free herself from the expence of defending those provinces in time of war. and of supporting any part of their civil or military establishments in time of peace, and endeavour to accommodate her future views and designs to the real mediocrity of her circumstances.

A must read for anyone seeking a deeper understanding of economics.