Commercial Real Estate
Selwyn Gerber writes: We now know that historically, markets have always recovered from their lows, only to reach new highs. While this is definitely true of markets, it is sadly untrue of individual stocks. In a free market economy, some companies will stand the test of time, while others will fade from the face of the earth, never to return.
Selecting the winners, and avoiding the losers is the chief focus of building an actively managed portfolio. Unfortunately, doing so is far easier said than done. For example, of the original companies included in the Dow Jones Industrial Average when it was created in 1896, only 3 companies have survived. In these rapidly changing times, selecting which companies – if any – will make it into the future is more difficult than ever.
The more stocks we own, the less vulnerable our portfolios are to the catastrophic decline of any individual company. Through “diversification” we are able to spread the risk throughout our portfolio. While, this technique will also mute the dramatic upward move of any individual stock, the portfolio as a whole will capture the slow upward grind of its components. Without question, diversification is a cornerstone of sound investment. The most powerful method of diversification is not to own individual stocks at all, but to own the whole market, or segments of it, through indexing.
Although the most well known indexes are the Dow Jones Industrial Average of 30 stocks and the S&P 500, they cover only the largest companies. There are many distinct groupings within the market. For example there are indexes for mid-sized and small companies. And the smaller companies frequently perform far better than the larger ones. Over 50% of global equities are now located outside the USA – and trade on the bourses of Europe, Japan, and Australia. Each of those has an index fund associated with it. There are also indexes to reflect commodities and resources such as gold, oil and metals. In addition to providing the safety of additional diversification, these sub-markets frequently move independently of each other, thus providing insulation from excessive volatility. As an example, in 2000 the S&P 500 Index declined by 9.1% while the Russell 2000 Value Index which includes smaller asset-heavy companies grew by 22.8%.
“Tis the part of a wise man to keep himself today for tomorrow, and not to venture all his eggs in one basket.”
- Miguel de Cervantes, author of Don Quixote
Index-based investing ensures that the investor is exposed to those strong but brief spurts that deliver most of the gains. The cost of being out of the market during these surges is almost always far greater than the cost of being in during a cyclical bear market. Although many believe that they can time the markets and avoid the declines while participating in the gains, research shows that this is a near-impossible task. A recent study reviewed performance of the 32 leading market timing newsletters and found that not one had beaten the S&P 500 over a 10 year period.
In recent years, index investing has become easier than ever before with the advent and proliferation of Exchange Traded Funds (ETFs). ETFs are index funds which trade just like stocks, in real time, on exchanges around the world and carry lower imbedded fees than most mutual funds. ETFs are the cheapest, easiest and most efficient way to invest in indexes. It is a wonder that they have not yet become the cornerstone of the typical investor’s portfolio.
Nevertheless, many investors still chose active management over strategic index-based investing. Index-based investing is backed by Nobel laureates who have provided unbiased, rigorous, empirical analysis. Studies have demonstrated that over a 10 year period, more than 90% of active managers and mutual funds under perform their benchmark indexes. You may be astounded to learn that portfolios selected by throwing darts routinely outperform the professionals’ selections (Figure 1-2). While individual stock-picking is like looking for a needle in a haystack, with index investing you buy the haystack. Why put your money on the roulette table when you can buy a share of the casino?
Active investors pay substantial transaction costs and management fees – and profits are taxed when earned, at ordinary income tax rates. Index funds on the other hand tend to be very efficient since they aren’t bearing these heavy costs of management and there are no high-paid Wall Street types involved. In addition, there are far fewer transactions so gains accumulate tax-free over long periods of time, and when they are ultimately taxed it’s generally at far lower long term capital gains rates.
Some investors think they can avoid the risks of the stock market by investing in bonds. This decision can be very expensive. In Figure 1-3, we see that while an investment in equities grew to over $13 million, the bond portfolio only amounted to $23,120 over the same period. Bonds certainly have their place in a portfolio because they work in exactly the opposite time horizon to equities.
Bonds are best for shorter term needs – they’re contractually guaranteed to pay interest regularly and repay principal on a given date so you have certainty of income and principal. The real enemy of bondholders is inflation. So the further out the time horizon, the worse bonds look. This explains why bonds and equities work so well together – equities really shine over the longer term, while bonds provide steadiness over the shorter term.
