فصل 2 بخش 1

CHAPTER 2.1

MYTH 1: THE $13T LIE: “INVEST WITH US. WE’LL BEAT THE MARKET!”

The goal of the nonprofessional should not be to pick winners—neither he nor his “helpers” can do that—but should rather be to own a cross section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.

—WARREN BUFFETT, 2013 letter to shareholders

When you look at the results on an after-fee, after-tax basis, over reasonably long periods of time, there’s almost no chance that you end up beating the index fund.

—DAVID SWENSEN, author of Unconventional Success and manager of Yale University’s more than $23.9 billion endowment

FINANCIAL ENTERTAINMENT

When you turn on the financial news today, you can see that it is less “news” and more sensationalism. Talking heads debate with zeal. Stock pickers scream their hot picks of the day while sound effects smash, crash, and “kaching!” through our living room speakers. Reporters film “live on the scene” directly from the trenches of the exchange floor. The system, paid for by advertisers, breeds the feeling that maybe we are missing out! If only we had a hot tip. If only we knew the next “must-own” mutual fund that would surely be the “5 star” comet. (Mutual funds are rated between 1 and 5 stars by rating authority Morningstar.) Chasing returns is big business. Personal finance writer Jane Bryant Quinn once referred to this sensational hype as “financial porn.” Luring us into glossy pages where the centerfolds are swapped with five-star ratings and promises of carefree walks on the beach and fishing off the dock with our grandkids. The bottom line is that advertisers are fighting to get a grasp on our money. The war for your assets rages on!

So where do you put your money? Who can you trust? Who will protect you and get you the best return on your investment?

These are the immediate questions that are sure to come to mind now that you’ve committed to becoming an investor—now that you’ve committed to socking away a percentage of your income. So where do most people put their money for the long haul? Usually the stock market.

And the stock market has indeed been the best long-term investment over the past 100 years. As Steve Forbes pointed out at one of my financial events in Sun Valley, Idaho, in 2014, “$1 million invested in stocks in 1935 is worth $2.4 billion today (if you held on).” But the moment you open an IRA or participate in your 401(k) plan at work, there will be a jolly salesman (or sales process) telling you to park your money in a mutual fund. And by buying an actively managed mutual fund, what exactly are you buying? You are buying into the fund manager in hopes that his or her stock-picking abilities will be better than yours. A completely natural assumption, since we have insanely busy lives, and our method of picking stocks would be the equivalent of throwing darts!

So we hand over our money to a “five-star” actively managed mutual fund manager who by definition is “actively” trying to beat the market by being a better stock picker than the next guy. But few firms will discuss what is sometimes called the $13 trillion lie. (That’s how much money is in mutual funds.) Are you ready for this?

An incredible 96% of actively managed mutual funds fail to beat the market over any sustained period of time!

So let’s be clear. When we say “beat the market” as a whole, we are generally referring to a stock index. What’s an index, you ask? Some of you might know, but I don’t want to risk leaving anyone in the dark, so let’s shed a little light. An index is simply a basket or list of stocks. The S&P 500 is an index. It’s a list of the top companies (by market capitalization) in the United States, as selected by Standard & Poor’s. Companies like Apple, Exxon, and Amazon make up the list. Each day, they measure how all 500 stocks performed, as an aggregate, and when you turn on the news at night, you hear if the market (all the stocks on the list collectively) was either up or down.

So instead of buying all the stocks individually, or trying to pick the next highflyer, you can diversify and own a piece of all 500 top stocks simply by investing in a low-cost index fund that tracks or mimics the index. One single investment buys you a piece of the strength of “American capitalism.” In a way, you are buying into the fact that over the past 100 years, the top-tier companies have always shown incredible resiliency. Even through depressions, recessions, and world wars, they have continued to find ways to add value, grow, and drive increasing revenues. And if a company fails to keep making the grade, it falls off the list and is replaced with another top performer.

The point here is that by investing in the index, you don’t have to pay a professional to try picking which stocks in the index you should own. It’s effectively been done for you because Standard & Poor’s has selected the top 500 already. By the way, there are number of different indexes out there. Many of us have heard of the Dow Jones index, for example, and we will explore others soon.

TEN THOUSAND OPTIONS

There are 7,707 different mutual funds in the United States (but only 4,900 individual stocks), all vying for a chance to help you beat the market. But the statistic is worth repeating: 96% will fail to match or beat the market over any extended period. Is this groundbreaking news? No, not to insiders. Not to the smart money. As Ray Dalio told me emphatically, “You’re not going to beat the market. No one does! Only a few gold medalists.” He just happens to be one of those medalists honest enough to issue the warning “Don’t try this at home.” Even Warren Buffett, known for his incredibly unique ability to find undervalued stocks, says that the average investor should never attempt to pick stocks or time the market. In his famous 2014 letter to his shareholders, he explained that when he passes away, the money in a trust for his wife should be invested only in indexes so that she minimizes her cost and maximizes her upside.

Buffett is so sure that professional stock pickers can’t win over time that he was more than happy to put his money where his mouth is. In January 2008 Buffett made a $1 million wager against New York–based Protégé Partners, with the winnings going to charity. The bet? Can Protégé pick five top hedge fund managers who will collectively beat the S&P 500 index over a ten-year period? As of February 2014, the S&P 500 is up 43.8%, while the five hedge funds are up 12.5%. There are still a few years left, but the lead looks like the world’s fastest man, Usain Bolt, running against a pack of Boy Scouts. (Note: for those unfamiliar with what a hedge fund is, it is essentially a private “closed-door” fund for only high-net-worth investors. The managers can have total flexibility to bet “for” the market and make money when it goes up, or “against” the market, and make money when it goes down.) THE FACTS ARE THE FACTS ARE THE FACTS

Industry expert Robert Arnott, founder of Research Affiliates, spent two decades studying the top 200 actively managed mutual funds that had at least $100 million under management. The results are startling: From 1984 to 1998, a full 15 years, only eight out of 200 fund managers beat the Vanguard 500 Index. (The Vanguard 500, put together by founder Jack Bogle, is a mirror image of the S&P 500 index.) That’s less than 4% odds that you pick a winner. If you’ve ever played blackjack, you know the goal is to get as close to 21 without going over, or “busting.” According to Dan and Chip Heath in their Fast Company article “Made to Stick: The Myth of Mutual Funds,” “by way of comparison, if you get dealt two face cards in blackjack (each face card is worth 10, so now your total is 20), and your inner idiot shouts, ‘Hit me!’ you have about an 8% chance of winning!” Just how badly does chasing performance hurt us? Over a 20-year period, December 31, 1993, through December 31, 2013, the S&P 500 returned an average annual return of 9.28%. But the average mutual fund investor made just over 2.54%, according to Dalbar, one of the leading industry research firms. Ouch! A nearly 80% difference.

In real life, this can mean the difference between financial freedom and financial despair. Said another way, if you were the person who simply owned the S&P 500, you would have turned your $10,000 into $55,916! Whereas the mutual fund investor, who was sold on the illusion that he or she could outperform the market, ended up with only $16,386.

Why the huge performance gap?

Because we buy high and sell low. We follow our emotions (or our broker’s recommendations) and jump from fund to fund. Always looking for an edge. But when the market falls, when we can’t take the emotional pain any longer, we sell. And when the market is up, we buy more. As a famous money manager named Barton Biggs observed, “A bull market is like sex. It feels best just before it ends.” WISDOM OF AGES

At 82 years young, Burt Malkiel has lived through every conceivable market cycle and new marketing fad. When he wrote A Random Walk Down Wall Street in 1973, he had no idea it would become one of the classic investment books in history. The core thesis of his book is that market timing is a loser’s game. In section 4, we will sit down and you’ll hear from Burt but for now what you need to know is that he was the first guy to come up with the rationale of an index fund, which, again, does not to try to beat the market but simply “mimics,” or matches, the market.

Among investors, this strategy is called indexing or passive investing. This style is contrary to active investing, in which you pay a mutual fund manger to actively make choices about which stocks to buy or sell. The manager is trading stocks—“actively” working with hopes of beating the market.

Jack Bogle, founder of the behemoth Vanguard, subsequently bet the future direction of his company on this idea by creating the first index fund. When I sat down with Jack for this book, he echoed why Vanguard has become the largest index mutual fund manager in the world. His best single rant: “maximum diversification, minimal cost, and maximum tax efficiency, low turnover [trading], and low turnover cost, and no sales loads.” How’s that for an elevator pitch!

SHORTCUT

Now, you might be thinking that there must be some people who can beat the market. Why else would there be $13 trillion in actively managed mutual funds? Mutual fund managers certainly have streaks where they do, in fact, beat the market. The question is whether or not they can sustain that advantage over time. But as Jack Bogle said, it all comes down to “marketing!” It’s our human nature to strive to be faster, better, smarter than the next guy. And thus, selling a hot fund is not difficult to do. It sells itself. And when it inevitably turns cold, there will be another hot one ready to serve up.

As for the 4% that do beat the market, they aren’t the same 4% the next time around. Jack shared me with what he says is the funniest way to get this point across. “Tony, if you pack 1,024 gorillas into a gymnasium, and teach them each to flip a coin, one of them will flip heads ten times in a row. Most would call that luck, but when that happens in the fund business we call him a genius!” And what are the odds it’s the same gorilla after the next ten flips?

To quote a study from Dimensional Fund Advisors, run by 2013 Nobel Prize–winning economist Eugene Fama, “So who still believes markets don’t work? Apparently it is only the North Koreans, the Cubans, and the active managers.”4 This part of the book is where anyone reading who works in the financial services industry will either nod in agreement or figure out which door they will prop open with these 600 pages! Some will even be gathering the troops to mount an attack. It’s a polarizing issue, without a doubt. We all want to believe that by hiring the smartest and most talented mutual fund manager, we will achieve financial freedom more quickly. After all, who doesn’t want a shortcut up the mountain? And here is the crazy thing: As much as everyone is entitled to his own opinion, nobody is entitled to his own facts!

Sure, some mutual fund managers will say, “We may not outperform on the upside but when the market goes down, we can take active measures to protect you so you won’t lose as much.” That might be comforting if it were true.

The goal in investing is to get the maximum net return for a given amount of risk (and, ideally, the lowest cost). So let’s see how the fund managers did when the market was down. And 2008 is as good a place to start as any.

Between 2008 and early 2009, the market had its worst one-year slide since the Great Depression (51% from top to bottom, to be exact). The managers had plenty of time to make “defensive” moves. Maybe when the market was down 15%, or 25%, or 35%, they would have taken “appropriate measures.” Once again, the facts speak for themselves.

Whether the fund manager was trying to beat the S&P Growth Index, made up of companies such as Microsoft, Qualcomm, and Google, or trying to beat the S&P Small Cap Index, made up of smaller companies such as Yelp, once again, the stock pickers fell short. According to a 2012 report titled S&P Indices Versus Active Funds Scorecard—SPIVA, for short—the S&P 500 Growth Index outperformed 89.9% of large-cap growth mutual funds, while the S&P 500 Small Cap 600 Growth Index outperformed 95.5% of small-cap growth managers.

THE UNICORNS

Now, having made it clear that almost nobody beats the market over time, I will give one caveat. There is a tiny group of hedge fund managers who do the seemingly impossible by beating the market consistently. But they are the “unicorns,” the rarest of the rare. The “magicians.” The “market wizards.” Like David Einhorn of Greenlight Capital, who is up 2,287% (no, that’s not a typo!) since launching his fund in 1996 and has only one negative year on his track record. But unfortunately, it doesn’t do the average investor any good to know they are out there, because their doors are closed to new investors. Ray Dalio’s fund, Bridgewater, hasn’t accepted new investors in over ten years, but when it did, it required a minimum investment of $100 million and $5 billion in investable assets. Gulp.

Paul Tudor Jones, who hasn’t lost money in over 28 years, called his investors recently and sent back $2 billion. When a hedge fund gets too big, it’s harder to get in and get out of the market—harder to buy and sell its investments quickly and easily. And being slow means lower returns.

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Before you begin to think this is a glowing report on hedge funds, let me be clear. For the fifth year in a row, ending in 2012, the vast majority of hedge fund managers have underperformed the S&P 500. According to the financial news site Zero Hedge, in 2012 the average fund returned 8% as opposed to 16% for the S&P 500. In 2013 hedge funds returned an average of 7.4%, while the S&P 500 soared 29.6%, its best year since 1997. I am sure their wealthy clients weren’t too pleased. And to add insult to injury, they usually charge 2% per year for management, take 20% of the overall profits, and the gains you do receive are often taxed at the highest ordinary income tax rates. Painful.

THE BIGGEST BANK IN THE WORLD

No matter what aspect of life, I am always looking for the exception to the rule, as that’s where outstanding tends to live. Mary Callahan Erdoes fits that bill. In an industry dominated by men, she has risen to the top of the financial world. Wall Street is a place where performance speaks louder than words, and Erdoes’s performance has been extraordinary. Her consistent breakthrough results have led her to become the CEO of J.P. Morgan Asset Management, and she now oversees portfolios that total more than $2.5 trillion—yes, trillion with a t!

We had a fantastic interview for this book, and she shared some profound wisdom, which we will cover in section 6. But when I brought up the studies that no manager beats the market over time, she was quick to point out that many of J.P. Morgan’s fund managers have beaten the market (in their respective classes) over the past ten years. Why? The examples she provided didn’t lose as much as the market when the market went down. This difference, she says, is what provided the edge they needed to stay ahead. Erdoes and many industry experts agree that certain less-developed, or emerging, markets provide opportunities for active managers to get “an edge.” They have the opportunity to gain an even greater advantage in frontier markets—places such as Kenya and Vietnam—where information isn’t as transparent and doesn’t travel as fast. Erdoes says this is where a firm such as J.P. Morgan has massive reach and resources, and can use its on-the-ground contacts in the community to give it valuable insights in real time.

According to Jack Bogle, there is no empirical basis to show that active management is more effective for all the major asset classes: large-cap growth, value, core, mid-cap growth, and so on. But it does appear that these frontier markets present opportunities for active management to sometimes outperform. Will they continue to outperform going forward? Only time will tell. We do know that every active manager, from Ray Dalio to J.P. Morgan, will be wrong at some point in their attempt to outperform. Therefore, developing a system and a proper asset allocation is crucial. We will address this in Section 4. It will be up to you to evaluate them for yourself, and don’t forget to take into account the fees and the taxes (which we will discuss in the next chapter).

ALL WEATHER

You might be reading this book in a bull market, a bear market, or a sideways market. Who knows? The point is that you need to have your investments set up to stand the test of time. An “All Weather” portfolio. The people I have interviewed have done well in both good times and bad. And we can all count on ups and downs in the future. Life isn’t about waiting for the storm to pass; it’s about learning to dance in the rain. It’s about removing the fear in this area of your life so you can focus on what matters most.

WHEN, WHERE, AND HOW?

So what does the All Weather portfolio look like? “Where do I put my money, Tony?!”

First, you don’t have to waste your time trying to pick stocks yourself or pick the best mutual fund. A portfolio of low-cost index funds is the best approach for a percentage of your investments because we don’t know what stocks will be “best” going forward. And how cool to know that by “passively” owning the market, you are beating 96% of the world’s “expert” mutual fund managers and nearly as many hedge fund managers. It’s time to free yourself from the burden of trying to pick the winner of the race. As Jack Bogle told me, in investing it feels counterintuitive. The secret: “Don’t do something, just stand there!” And by becoming the market and not trying to beat it, you are on the side of progress, growth, and expansion.

So far we have referred many times to “the market” or the S&P 500. But remember that the S&P 500 is only one of many indexes or markets. Most have heard of the Dow Jones Industrial Average. There are others, such as a commodities index, a real estate index, a short-term bond index, a long-term bond index, a gold index, and so on. How much of each to buy is critical and something we will get to in section 4. In fact, how would you like to have Ray Dalio tell you what his ideal allocation would be? The strategy he shares in the pages ahead has produced just under 10% annually and made money more than 85% of the time in the last 30 years (between 1984 and 2013)! In fact, when the market was down 37% in 2008, his portfolio model was down only 3.93%! I sure wish I had known this back then!

Or how about David Swensen, the man who took Yale’s endowment from $1 billion to more than $23.9 billion while averaging 14% annually? He too shared his ideal allocation for you in the pages ahead. Priceless information all captured in section 6, “Invest Like the .001%: The Billionaire’s Playbook.” So if you look at these experts’ models without fully understanding asset allocation, it’s like building a house on a weak foundation. Or if you focus on asset allocation before knowing your goals, it will be a complete waste of time. And maybe most importantly, if we don’t protect you from the people looking to take a good chunk of your wealth, all is lost. That’s why we are uncovering the 9 Myths—Step 2 in our 7 Simple Steps to Financial Freedom—so that you become an “insider.” So that you will know the truth. And the truth will set you free.

IT PAYS TO BE A STAR

Even after everything we have showed you about actively managed mutual funds, there are undoubtedly those who will say, “Tony, I have done my research, and not to worry. I only invest in five-star funds, nothing less.” Oh, really?

According to Morningstar, over the decade ending December 2009, roughly 72% of all fund deposits (about $2 trillion) flowed to four- and five-star funds. For those who aren’t familiar, Morningstar is the most popular and thorough service for evaluating mutual funds, and they apply a five-star ranking system to their past performance. Brokers are starry-eyed as they share with you the next hot fund.

David Swensen told me that “the stars are so important that mutual fund companies are quick to eliminate funds which fall below the four-star threshold. For the five-year period ending in 2012, 27% of domestic equity funds and 23% of international equity funds were either merged or liquidated; a common practice to eliminate a poor track record from a family of funds.” It’s routine for mutual fund companies to set up multiple new funds to see which one is hot and euthanize the others. As Jack Bogle explains, “A firm will go out and start five incubation funds, and they will try and shoot the lights out with all five of them. And of course they don’t with four of them, but they do with one. So they drop the other four and take the one that did very well public with a great track record and sell that track record.” Imagine we could adopt this practice in our own investing life? What if you could pick 5 stocks and if four went down and only one went up, you could pretend all your losers didn’t happen? And then tell your friends that you are the hottest stock picker since Warren Buffett.

In addition, the lackluster performance of these four- and five-star supernovas (dying stars) is well researched in a Wall Street Journal article entitled “Investors Caught with Stars in Their Eyes.” A study was done in which the researchers went back to 1999 and studied the ten-year subsequent performance of those who bought five-star funds. Their findings? “Of the 248 mutual stock funds with five-star ratings at the start of the period, just four still kept that rank after 10 years.” How many times have you picked a shooting star only to watch it burn out? We all have at some point. And here we see that it’s because we had less than 2% odds that the shooting star wouldn’t fizzle into darkness. We all want the guy with the hot hand, but history tells us that it’s the hot hand that will inevitably turn cold. Isn’t that why Vegas always wins!?

An “insider” knows that chasing the highflyer is chasing the wind. But it’s human nature to chase performance. It’s almost irresistible. Yet the “herd” mentality quite literally results in financial destruction for millions of families, and I know that if you are reading this book, you are not willing to fall victim any longer. You’re becoming an insider now! And what other cool strategies do “insiders” use? Let’s find out.

UPSIDE WITH PROTECTION

In the past 100 years, the market was up approximately 70% of the time. But that leaves 30% of the time that the market was down. So while investing in the indexes is a great solution for a portion of your money, it shouldn’t be for all of your money. Markets are volatile at times so it only makes sense that you will want to protect a portion of your portfolio if or when the markets take another big dive. Heck, there have been two 50% hits since 2000.

One exciting strategy we will introduce allows us to make money when the market (index) goes up, yet it simultaneously guarantees that we will not lose our original investment if the market goes down. The catch? You don’t get to capture or participate in all of the gains.

Most are in disbelief when I explain that there are tools out there that can guarantee that you don’t lose while still giving you the ability to participate in market “wins.” Why haven’t you heard of them? Because they are typically reserved for high-net-worth clients. I will show you one of the only places where the average investor can access these. Imagine your friends with their baffled and even suspicious looks when you tell them you make money when the market goes up but don’t lose money when it goes down. This strategy alone can completely change the way you feel about investing. It’s your safety rope while climbing the mountain when everyone else is “white knuckling” it with hope. Imagine the feeling of certainty, of peace of mind, knowing that you aren’t at risk. How would this change your life? How would you feel when you open up your monthly statements? Would you be gritting your teeth or feel calm and collected?

We’ve only scratched the surface of the incredible insights and tools that lay ahead, so you must stay tuned. But for now, we can remember the following: • Stocks have by far been the best place to be for long-term growth over time.

• Stocks are volatile. In the pages ahead, you will learn from the “market masters” how to “smooth out the ride” by investing in and diversifying across multiple different indexes.

• Don’t be sold that someone is going to beat the market. Instead, align yourself with the market! Once you put your indexing plan in place (which we will do step by step), you won’t have to spend your time trying to pick which stock to buy because the index will have done it for you. This will save you a tremendous amount of time and angst in trying to pick a winner.

• Begin to think like an insider! Never again will you tolerate the “herd” mentality in your own life.

FEES ON FEES

By tapping into the power of indexing, by passively owning the market, you are also combatting our second myth. Nearly every person I ask doesn’t know exactly how much he or she pays in fees. I’ll admit, I also didn’t know at one stage in my life. The fee factories have become masterful at either hiding the fees or making them appear negligible. “No big deal.” Nothing could be further from the truth. When climbing the mountain of financial freedom you will need every bit of forward progress to succeed. You can’t afford to take two steps forward and one step back by letting excessive fees drain your account. So the real question is: Are you funding your retirement or someone else’s? Find out now!