Advisor Risks

You have probably know about the risks you face when investing: market risk, inflation risk, timing risk, concentratin risk, investment risk, sector risk, company risk, currency risk, event risk, political risks, etc.


One that you may not be as familiar with is Advisor or Manager risk. In this case we are talking about people who manage other peoples money (mutual fund managers), analysts (like S&P, Moody's, TV commentators, or newsletter writters), hedge funds, money managers, and personal advisors (investment advisors, financial planners, etc.).


Managers and Advisors are also risk-averse, just as they are with their own money and you are with your own. But they're averse to a different kind of risk - the risk of looking bad to the person who's paying you the fee. When they provide their investors their (daily, wekly, monthy or annual) reports, they don't waqnt to be holding investments that have recently done bad or not holding ones that have recently done well. That is not what you are paying them for.

This risk can incline them to buy high and sell low. Avisors then buy what has just gone up and sell after investments have gone down becasue it will make them look better. The problem is that over time, it will not maximize the wealth of their clients.
 

Outsmart your emotions, cut your fees, keep it simple -- and reap higher returns.

The Hulbert Financial Digest estimates that mutual fund investors lost $42 billion more than they should have during the 12-month period that ended last May.


How could this have happened? The simple answer is that emotion, not logic, usually rules our investing habits. In many ways we're predisposed not just to buy high and sell low, but to cling to losing investments we should sell, ignore threats to our wealth and follow the investing herd off a cliff again and again.

But just recognizing our mental kinks won't help us undo them, experts say. "I don't believe it's possible to change behavior that's really hard-wired into our biology," says Andrew Lo, director of the Massachusetts Institute of Technology Laboratory for Financial Engineering. But "Homo sapiens can do what we've always done: adapt. We don't have wings, but we can fly. So we develop tools to protect ourselves from these emotional shortcomings."

The silver lining to the recent bear market is that painful experiences remain in our memories for a long time and provide lessons for the future. So let's review the past few years through the eyes of experts in investor psychology and behavioral finance, studying events not as a financial roller coaster, but rather as an emotional one.

As a result of the recency effect, says Davies, "what's most recent in our minds stands out." For instance, "if investments have been going up for a while, I start seeing them as less risky. I start thinking, Well, my budget for risky investments isn't full -- I can put more in there."

For many people, plunging portfolio values became too much to bear, and they just wanted the pain to end. So they sold. According to the Investment Company Institute, the greatest net monthly outflow from stock funds in the past two years -- $25 billion -- came in February 2009. The timing couldn't have been much worse for those who sold then. As it turned out, stocks bottomed on March 9 and surged about 50% over the ensuing six months.

So, if you recognize yourself in some of the actions (or lack thereof) we've just described, now's the time to take steps to make sure you don't suffer the same mental miscues in the future. You may not be able to change your behavior in trying times, but you can change your investing strategy to neutralize negative impulses.

One bold idea: If you handle your own investments and you find that emotions are tripping you up, hire an adviser. A good adviser should help you avoid those impulses-which typically stem from short-term fluctuations in the value of your investments-and keep you focused on meeting long-term goals. The extra cost could be worth the money.

Read the article at Kiplinger's

analysts frequently head in the wrong direction

From a Bloomberg article


10 years of data...suggests that the stocks analysts love the most usually do poorly.


From 1998 through 2007, the four stocks rated highest by brokerage-house analysts at the beginning of the year dropped 1.7 percent, on average, in the ensuing 12 months. The four stocks they rated lowest gained 2.2 percent. Neither group beat the Standard & Poor’s 500 Index, which had an average annual gain of 7.2 percent.
The pattern doesn’t hold true every year, but it is more than coincidence. The problem... is that analysts are drawn to companies with strong and improving operating results. Generally, they aren’t fussy about how expensive a stock is when they recommend it.

Stocks advance when a company exceeds prevailing expectations. The higher the expectations, the more difficult they are to exceed. No wonder that stocks favored by hoards of analysts do badly.

More than one-third of Vanguard's 401(k) investors didn't lose money in 2008

For workers who are young, newly hired or lower-paid, falling market values are counteracted by the new cash pumped in with each payroll contribution. More than one-third of Vanguard's 401(k) investors didn't lose money in 2008, while 10% or less. These people were barely scathed by the stock-market crash.

In a UCLA study, a large sample of investors who filled out a risk-tolerance questionnaire for a major 401(k) provider. Only 7% described themselves as aggressive; yet 33% invest as if they are, putting 80% to 100% of their 401(k) into stocks.

• Among the more than three million 401(k) participants served by Vanguard Group, 17% were 100% in stocks in 2007; at year-end 2008, 16% still were
• Of the 11.2 million participants served by Fidelity Investments, 15% still have every penny in their 401(k) invested in stocks, including 14% of those between the ages of 60 and 64.
• The share of U.S. households that own stocks in any account has fallen from 53% in 2001 to around 45% in 2008
• Since 2007, 401(k) investors at both Fidelity and Vanguard have lowered the rate of new contributions they are putting into stocks.

"We had the most drastic market decline since the Depression, we nearly had a total collapse of the global financial system, and all that caused most people not to do much at all."

If you were one of the unfortunate few that sold low, if you relieved that the market has come back but question how to move forward from here, or if you just want a second opinion, the 401(k) Optimzer is for you.

Read the WSJ article

The growth illusion

When investors pick the countries they want to back, they tend to be guided by economic growth prospects. The faster an economy grows, they reason, the faster corporate profits will grow in the country concerned, and thus the higher the returns investors will achieve.

Alas, this is not the case.

• going back to 1900, there was actually a negative correlation between investment returns and growth in GDP per capita
• no statistical link between one year's GDP growth rate and the next year's investment returns

Why might this be?

• growth countries are like growth stocks; their potential is recognized and the price of their equities is bid up to stratospheric levels.
• a stock market does not precisely represent a country's economy - it excludes unquoted companies and includes the foreign subsidiaries of domestic businesses.
• growth is siphoned off by insiders - executives and the like - at the expense of shareholders.

What does work?

• Over the long run (but not the short), it is valuation.

As we always point out, the past is not an indicator of the future, but these facts do support the Visible Investing principle that you must get a good value for anything you buy - stock, bond, home, TV, or anything else.

Visible Investment Advisors feel it is important for most investors to have international assets in their portfolio, but taking the route most discussed by the gurus on TV and newspapers will (like it always does), be hazardous to your wealth.

Read the entire Economist article

Are investors too optimistic?

Ever since the financial meltdown, and throughout this recession, people keep asking us if we're optimistic about the future.

Conversations reveal that people are less optimistic then they had been, but want to be more optimistic and are looking for some outside reinforcement.

A lot of research has been done about optimism and the impact it can have on people's lives (read Dan Ariely & The Curious Paradox Of `Optimism Bias’).

Researchers have found that when people judge their chances of experiencing a good outcome–getting a great job, having a successful marriage, or financial security–they estimate their odds to be higher than average. And when they contemplate the probability that something bad will befall them (a heart attack, a divorce, a parking ticket), they estimate their odds to be lower than those of other people.

We usually ask when doing a 401(k) seminar the following questions:

1. How many people feel they will accumulate the nest egg they need to support their desired retirement lifestyle? – usually more 50% feel they can.
2. How many people know how much money they will need at retirement or know where they stand today in relation to their goal? – of course, most do not know, and when pressed to guess how they stand today, they acknowledge they're probably behind and will have to work longer then they anticipated.

This can be a huge problem:

• chances of hitting your target nest egg when you don't know what that amount is, is extremely low
• not knowing where you stand in relation to wealth accumulation, can cause errors in the investment decisions you make

Both have the consequence of hurting your chances for the retirement at a time and in a manner of your choosing.

Oh, and are we optimistic about the future–extemely. Lot's of money has been lost (and lots of money has not been gained) by betting against (or not investing in) America.

For this reason, we've created an extremely low cost investment advisory service – the 401(k) Optimizer program to help you know how much you will need and how you should monitor and invest your 401(k) to reach the retirement security you've earned. Contact us if you need some information.

Can "butter in Bangladesh" predict the market?

How about the superbowl indicator, seasonality, back-testing strategies (this is hot now with the online trading brokers). You may have a fovorite of your own, but does knowing what happened in the past help you predict the future?

One of VIA's favorite writters, Jason Zweig, wrote a great article in the WSJ (the outcome of which you undoubtably know if it is a post by VIA) and video on this subject that I highlight below:

"The stock market generates such vast quantities of information that, if you plow through enough of it for long enough, you can always find some relationship that appears to generate spectacular returns -- by coincidence alone. This sham is known as "data mining."

Every year, billions of dollars pour into data-mined investing strategies. No one knows if these techniques will work in the real world. Their results are hypothetical -- based on "back-testing," or a simulation of what would have happened if the manager had actually used these techniques in the past, typically without incurring any fees, trading costs or taxes.

Those assumptions are completely unrealistic, of course. But data-mined numbers can be so irresistible that, "they are one of the leading causes of the evaporation of money, especially in quantitative strategies."

Over history, humans have become the ultimate "pattern recognition machines" which served us well when we had to hunt for our food in the wild, but doesn't work in the financial markets.

We have added Nerds on Wall Street: Math, Machines and Wired Markets to our reading list. Light reading. Enjoy.

Do fast growing economies provide better investor returns?

The Emerging Markets index has gained 45% so far this year, versus 9% for the U.S., and investors have noticed, pouring $10.6 billion into emerging-markets mutual funds so far this year, more than 34 times the total they added to U.S. stock funds.

Based on decades of data from 53 countries, studies have found that the economies with the highest growth produce the lowest stock returns, by an immense margin.

Stocks in countries with the highest economic growth have earned an annual average return of 6%; those in the slowest-growing nations have gained an average of 12% annually.

If you think about this, it's not surpiring after all. In stock markets, value depends on both quality and price. Economic growth is high, but stock valuations are even higher, eve though they should be much cheaper than U.S. stocks, because they are far riskier.

High growth draws out new companies that absorb capital, bid up the cost of labor and drive down the prices of goods and services. That is good news for local workers and global consumers, but it is ultimately bad news for investors.

The role of emerging markets is to provide diversification, not to add to returns. Like all performance chasing, this latest investing binge is doomed to disappoint the people who don't understand what they are doing.

Note: history should not be used to predict future returns.

Don't Count on TIPS

Treasury inflation-protected securities may rank as today's most over-hyped investment product. To hear their proponents talk, TIPS will shelter you from the ravages of inflation, which does seem likely to worsen. But they forget to mention that TIPS are Treasury bonds, which are almost certain to fall in value as inflation heats up.

TIPS protect you from inflation with one hand, but they punish you with interest-rate hikes with the other.

If you buy TIPS directly from the Treasury and hold them to maturity, you'll receive the full CPI increase. If you invest through a regular mutual fund or an exchange-traded fund, you're at the mercy of the market's expectations for the CPI.

TIPS probably won't lose money when inflation heats up, but they're unlikely to make much, either. It's pure fantasy to think that putting 10% or 20% of your assets in TIPS will insulate your portfolio against inflation.

Read more on Kiplinger

Investors Are Getting Killed In ETFs

A new analysis by Vanguard Group founder John Bogle indicates that investors are generally making poor decisions when buying and selling exchange-traded funds.

Bogle compared the returns of 79 ETFs in a variety of major asset categories over the past five years to the returns of the average dollar invested in those ETFs over the same time period. It’s a common statistical practice in mutual fund analysis, allowing investors to see whether they’re buying at the bottom and selling at the top, or vice versa.

While investor returns typically trail fund returns by some margin, Bogle expressed surprise at the degree to which investor returns suffered in ETFs.

“These numbers … are unbelievably consistent,” said Bogle. “Out of 79 ETFs we covered, 68 had investor returns that were … short of the returns earned by the funds themselves. “

And by no small margin. The degree of investor-lag ranged from 0.4% per year for large-cap value funds to -17.9% per year for financials ETFs. Investors seemed to do the worst in high-profile and volatile sectors like emerging markets, financials and REITS.

“So we have evidence—strong evidence—that exchange-traded funds, because of the timing that goes on in them, are not acting in the best interest of investors. Or, that investors are not acting in their own best interests, which may be a better way to put it.”

Click here to view a full replay of the Bogle webinar.

Read more Journal of Indexes and IndexUniverse.com

How does this bear market compare?

The 4 major bear markets in the 100 years

• The "crash" of 1929, which lasted 34.2 months (from 9/3/1929 to 7/8/1932)
• The "oil shock" of 1973, which lasted 20.7 months (from 1/11/1973 to 10/3/1974)
• The "tech bubble" of 2000, which lasted 30.5 months (from 3/24/2000 to 10/9/200
• The "housing meltdown" of 2008, which lasted 19.3 months so far (from 10/9/2007 to ?)

Bull and bear markets since 1871 | 4 major bear markets | Bear market rallies | Inflation | Stocks versus bonds

As Warren Buffett says "In the business world, the rearview mirror is always clearer than the windshield."

If you need some help dealing with the current market, contact Visible Investment Advisors.

Personalized advice to 401(k) participants

The 401(k) has become the primary savings vehicle for 60% of workers.

Changes Coming for the 401(k) Plan - the proposed legislation gaining momentum in the House and Senate would require:

• the industry will have to break out 401(k) fees on investors' statements.
• repeal regulations allowing mutual-fund companies to offer personalized advice to 401(k) participants in the plans the companies manage.
• establishment of a program in which all workers would be automatically enrolled in employers' retirement plans. Now, in most cases, they must opt in to participate.
• employers that don't offer a retirement plan would be required to enroll their employees in a direct-deposit individual retirement account.

Many people are using "Target Date" mutual funds, and have found that they too have experienced large losses in the recent downturn. This is because many of these funds did not use appropriate asset allocation.

Visible Investors prefer to select an appropriate mix of asset classes using low cost index funds to accommodate the amount of risk they need to take and are able to take to meet their retirement goals.

Contact us if you would like a free review of your portfolio.

Recoup losses sooner than you think...

From the NY Times article by Mark Hulbert is editor of The Hulbert Financial Digest



"Historical stock charts seem to show that it took more than 25 years for the market to recover from the 1929 crash — a dismal statistic that has been brought to investors’ attention many times in the current downturn."

"But a careful analysis of the record shows that the picture is more complex and, ultimately, far less daunting: An investor who invested a lump sum in the average stock at the market’s 1929 high would have been back to a break-even by late 1936 — less than four and a half years after the mid-1932 market low."

"Three factors have obscured this truth from investors: deflation, dividends and the distinction between the Dow Jones industrial average and the overall stock market."

Deflation
"The Great Depression was a deflationary period. And because the Consumer Price Index in late 1936 was more than 18 percent lower than it was in the fall of 1929, stating market returns without accounting for deflation exaggerates the decline."

Dividends
"When the Dow hit a low of 41.22 on July 8, 1932, for example, the dividend yield of the overall stock market was close to 14 percent, according to data compiled by Robert J. Shiller, the Yale economics professor."

The Dow vs. the Market
"Many researchers consider the overall market — defined as the combined value of all publicly traded stocks — as the best gauge of a typical investor’s experience. The Dow is made up of just 30 stocks, which are weighted in the index according to their price rather than their relative market capitalization."

"So when did the overall stock market really make it back to its pre-crash peak? Just four years and five months after its mid-1932 low, according to data provided to Sunday Business by Ibbotson Associates, a division of Morningstar."

"That seems remarkably fast, given that the stock market lost more than 80 percent of its value from its 1929 high to its mid-1932 low. But the quick recovery of the 1930s is consistent with the typical experience after other bear markets in the United States."

"...according to a Hulbert Financial Digest study of down markets since 1900, the average recovery time is just over two years, when factors like inflation and dividends are taken into account. The longest was the recovery from the December 1974 low; it took more than eight years for the market to return to its previous peak, which was reached in late 1972.

None of this, of course, guarantees that stocks will have a quick recovery from the market decline that began in October 2007. But it suggests that the historical record isn’t as bleak as it looks."

Visible investing principals show that by reinvesting dividends and continuing to dollar cost average during market downturns further decreases the time it takes to recoup your losses.
Contact us if you would like to see how you can shorten the time it takes to recoup your losses.

This Is Your Brain on Money

Read entire Jason Zweig article here.

Here are five ways your brain can trick you into making financial blunders, and how to avoid them:

1. Familiarity breeds admiration, not contempt.
Psychological research shows that we're attracted to the familiar... "Whenever a stock, an industry, a market, a country, or an investing theme is familiar, you'll like it better. But familiarity is very dangerous."

2. The pattern you swear you see is probably an illusion.
The brain is built to detect patterns, even when confronted with an arbitrary occurrence. "A small streak of random luck looks to us like part of a longer pattern of reliable foresight." After someone learns a set of circumstances through which they made money, the brain will fire up with the pleasure chemical dopamine when those conditions occur again. "If you see something once, then twice, you automatically, involuntarily expect it a third time."

3. Everything is relative.
The brain will hook onto a number and then compare subsequent figures to the initial one, a phenomenon known as "anchoring and adjustment." Quoting Warren Buffett, who says he "always likes to look at investments without knowing the price, because if you see the price, it automatically has some influence on you."

4. Tune out the play-by-play.
If you're someone who obsessively monitors the prices of your holdings, watch out. Several studies by Princeton Nobel laureate Daniel Kahneman and other researchers have found that the more often people watch an investment move up and down, the more likely they are to trade in and out short-term -- and the less likely they are to earn a high return over the long term."

5. Beware of group-think.
"When the market gets really greedy or really fearful, basically everyone's brain starts to work the same way... That's why many people buy high and sell low." "To avoid following the herd, set your own financial policies and rules, and stick by them "The worst imaginable thing you can do is listen to Pied Pipers who tell you 'here are seven tricks to beat the pros at the game.' That game will make you miserable."

Bill Miller is an example of "why Value Investors shouldn't work for Investment Companies"

By definition, value investors buy assets for less than they are worth, and sell when they can get paid more than their assets are worth.

This process causes value investors to buy early and sell early - just because an asset is undervalued doesn't mean it can't become more undervalued and when it's overvalued, it can become more overvalued.

The above is made more significant in rising markets as value investors typically under-perform benchmarks in rising markets but outperform in declining markets. The longer holding periods of value investors makes up for temporary under-performances - making the long term performance of value investors generally better than average.

At the end of May, I posted some reasons why it will be tough for value investors to stay true to their discipline. The current trend is for investors, the media and most importantly INVESTMENT COMPANIES to evaluate performance on a quarterly basis, and on occasion, this causes investors to move money out of under-performing value funds.

There are many different value investing styles - all based on the premise of paying less (price) than what the asset is worth (value).

Bill Miller uses growth - companies he "knows" will grow their earnings sufficiently to make their current price a bargain (this is an approach of a minority of traditional "value" investors because they would say it's too hard to forecast growth in earnings even a few years into the future).

So, it’s my premise that VALUE INVESTORS CAN’T WORK FOR INVESTMENT COMPANIES whose only interest is the return on their capital (obtained by investor fees) not their investors' capital (return on investing).

Bill Miller’s current under-performance has to be causing outflows that are hurting Legg Mason’s fees and I’m sure he is bending to the pressure. They’d rather he match benchmarks all the time than under-perform even in the short term.

I don’t often predict the future (it’s “unknowable”) but I’d say it’s probable Bill will leave Legg Mason at the conclusion of his current contract.

New Book: Your Money and Your Brain

Humankind evolved to seek rewards and avoid risks but not to invest wisely, by Jason Zweig

In the introduction to Ben Graham's Intelligent Investor, Warren Buffett writes, "To invest successfully does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding the framework." This article and book will help you invest successfully.

"You buy high only to sell low. You try to time the market. You follow the crowd. You make the same mistakes again. And again. How come?"

"Your brain developed to improve our species' odds of survival. You, like every other human, are wired to crave what looks rewarding and shun what seems risky."

"To counteract these impulses, your brain has only a thin veneer of modern, analytical circuits that are often no match for the power of the ancient parts of your mind. And when you win, lose or risk money, you stir up some profound emotions, including hope, surprise, regret and the two we'll examine here: greed and fear."

"Our brains come equipped with a biological mechanism that is more aroused when we anticipate a profit than when we get one. "

"...learning the outcome of my actions was no big deal... Thus our seeking system functions partly as a blessing and partly as a curse. We pay close attention to the possibility of coming rewards, but we also expect that the future will feel better than it does once it turns into the present. "

"The anticipation of reward... is more important for memory formation than is the receipt of reward."

"your reflexive brain is highly responsive to variations in the amount of reward at stake, it is much less sensitive to changes in the probability of receiving a reward... When possibility is in the room, probability goes out the window. It's no different when you buy a stock or a mutual fund: Your expectation of scoring a big gain elbows aside your ability to evaluate how likely you are to earn it. That means your brain will tend to get you into trouble whenever you're confronted with an opportunity to buy an investment with a hot - but probably unsustainable - return."

"...we are often most afraid of the least likely dangers and frequently not worried enough about the risks that have the greatest chances of coming home to roost... the odds that U.S. stocks will lose a third of their value in a given year are around 2%. The real risk isn't that the market will melt down but that inflation will erode your savings. Yet only 31% of the people surveyed were worried that they might run out of money during their first 10 years of retirement."

"When people made their own choices, they were right 84% of the time. When the peer group all made the wrong choice, however, the individuals being tested chose correctly just 59% of the time... you go along with the herd not because you want to but because it hurts not to. Being part of a large group of investors can make you feel safer when everything is going great. But once risk rears its ugly head, there's no safety in numbers."

"Understanding how those feelings - as a matter of biology - affect your decision-making will enable you to see as never before what makes you tick, and how you can improve, as an investor."

Read the article, buy the book.

What you need to know about Morningstar Fund Star Ratings

Morningstar clearly influences individual investors in their selection of mutual funds. Studies have shown that more than 90% of all money flowing into mutual funds goes into funds with 4 or 5 star ratings.

Morningstar has said from the very beginning that its star ratings are not predictive. In fact, it's fairly easy to find Morningstar analysts who suggest buying funds with low ratings or selling funds that get higher marks, but that hasn't stopped investors and financial advisers from wishing on their stars.

The consequences of large inflows of money into 4 and 5 Star funds include:

• Style change because the Manager takes on more risk often causing lower returns or star ratings changes because the fund moves to another style category
• Lower returns because the larger the amount of funds the Manager has to invest, the smaller the universe of potential investments
• Higher capital gains distributions and associated taxes as the portfolio's turnover increases and the money flows from the fund causing redemtions.

If you need help selecting funds that will maintain their 4 and 5 star ratings, tax efficiency and beat 90% of the other funds, or for a free portfolio review, contact Visible Investment Advisors

Why do smart people make big investment mistakes?

"Success in investing doesn't correlate with I.Q. once you're above the level of 25. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing." Warren Buffett

Investor mistakes can greatly reduce your returns. Below are some of the most common ones. Add additional ones through your comments.

• Selling a security to protect your gain only to see it make a huge advance afterward.
• Holding on to losing positions waiting for them to return to your purchase price so you don't have to realize a loss and admit that you made a mistake.
• Resist buying a hot stock, market sector (like oil), or mutual fund, until it reaches heights you never thought possible and then you buy in—just in time for an immediate reversal down.
• Losing money in the market and swear you'll never go back in.
• Falling in love and buying at any price.
• Hating a stock and not buying in at any price.
• Selling early and watching the price continue to go up and not buying in again.
• Feeling the stocks you know (local companies or large companies whose products you buy) are less risky?
• Overly confident in your ability to outperform the market.
• No calculating your returns or comparing them to appropriate benchmarks?
• Not taking into account the cost of trading or taxes.
• Delaying participating in your 401(k) or other retirement plan?
• Acting on stock tips.
• Believing that media and industry commentators give you information with your well being in mind.
• Staying out of the stock market becuase it is too risky.
• Keeping too much money in savings banks and CD's.

Please add your investment mistakes through the comments dialog below.

Charlie Ellis On Playing "The Loser's Game"

Charles D. Ellis, President of Greenwich Associates, wrote a seminal article entitled "The Loser's Game" in The Financial Analysts Journal for July/August 1975.

Ellis quickly offered a provocative and bold statement: "The investment management business is built upon a simple and basic belief: Professional managers can beat the market. That premise appears to be false."

He pointed out that over the prior decade, 85% of institutional investors had underperformed the return of the S&P 500 Index, largely because "money management has become a Loser's Game.…Institutional investors have become, and will continue to be, the dominant feature of their own environment … causing the transformation that took money management from a Winner's Game to a Loser's Game.

The ultimate outcome is determined by who can lose the fewest points, not who can win them." He went on to note that "gambling in a casino where the house takes 20% of every pot is obviously a Loser's Game."

Ellis went to the underlying economics of the matter: If equities provide an average return of 9% a year, and a manager generates 30% portfolio turnover at a cost of 3% of the principal value on both the sales and the reinvestment of the proceeds (a reduction in return equal to 1.8% of assets per year) and charges management and custody fees equal to 0.2% (low!), the active manager incurs costs of 2%. Therefore, he must achieve an annual return of +11% before these costs—that is, 22% above the market's return—just to equal the gross market return. (That 2% aggregate cost remains pretty much the same—although of a somewhat different composition—for mutual funds in 1997, 22 years later.)

While Ellis did not call for the formation of an index fund, he did ask: "Does the index necessarily lead to an entirely passive index portfolio?" He answered, "No, it doesn't necessarily lead in that direction. Not quite. But if you can't beat the market, you should certainly consider joining it. An index fund is one way."

In the real world, of course, few managers indeed have consistently been able to add more than those two percentage points of annual return necessary merely to match the index, and even those few have been exceptionally difficult to identify in advance.

Quotes from Charlie Munger

From the 2007 Wesco Financial Annual Meeting

• "Don't wrestle with a pig, you'll both get dirty but the pig will like it."
• "Charlie's favorite business analogy: the mouse who says 'let me out of the trap, I've decided I don't want the cheese."
• "You've earned your retirement."
• "To learn from a person, make then your friend - tie into their lives and personalities."
• "The first rule is don't fool yourself, and you're the easiest one to fool."
• "Always live below your financial means so you'll have money to invest."
• "Invest in such a way so that you'll never be in a negative position -avoid the use of debt."
• "Always seek the simplest most direct answer. Look at the problem backwards."
• "You guarantee failure when you learn everything from you own experience rather than learning from others."
• "To be a successful investor you need to understand your own psychology, if losing money makes you miserable, you should use a very conservative pattern of saving and investment."
• "To understand a business figure out what results it is achieving, why it is getting those results and what could happen to change what is causing those results. If everyone can understand this, then you'll have to pay a lot of money, so you'll have to determine if the price is worth it."
• "Americans are oversold on the benefit they receive from money managers and mutual funds. Save yourself a lot of time, money and worry and put your money into index funds."
• "Why should investors care if someone else is doing better or worse, when he rationally knows that in the long term his results will be superior by reason of lower costs and the long term effects of compounding."
• "In the process of not disappointing anyone, people must have the proper expectations and know what they are and are not getting."
• "Stick to basic principles and be alert for opportunity. There are not an unlimited number of opportunities."

Note: If you haven't attended a Wesco Financial Annual Meeting, I recommend you do so. They are held in the middle of May (a few days after the Berkshire Hathaway Annual Meeting) in Pasadena, CA.