Another reason for indexing

Another good reason for indexing: When “market professionals” make a bet on a part of the market to outperform the rest, they’re often wrong. Here’s a Wall Street Journal article on why bond mutual funds let investors down. In short, “Most intermediate funds held far fewer of the safest bonds than were in the index.” And if you held a fund based on the index, you weren’t making a gamble on which bonds would do the best (an ill-fated gamble, it turned out). My favorite bond index fund: The Vanguard Total Bond Market Index fund.

Have you already missed the bottom?

A popular, but flawed, way of trying to benefit from the ups and downs of the stock market is to sell out at the top and buy in again at the bottom. This is known as “market timing” and it’s very difficult to make any money doing it.

The problem is that no one knows when a bottom or top occurs until long after the fact. Therefore, when the stock market rallied in March, unless you were already holding stocks you were too late to buy in at the bottom. How do you react to all this? My favorite strategy is “buy and hold.” If you don’t try to sell out at the top you don’t have to worry about when to get back in. My prediction: Within two years, the stock prices of March 2009 will look extremely attractive. “Market timers” will kick themselves for not having gotten back in then.

One warning: If you “buy and hold,” there will be times when you wish you had sold out. It’s not for the faint of heart. However, for those willing to stay in the market long term, the rewards can be substantial.

It’s not a Ponzi scheme

Add this to the list of reasons why “buy and hold index funds” is a relatively good investment strategy: It’s not a Ponzi scheme.

A bit of explanation: In a Ponzi scheme, a shady operator takes in money, claiming to invest it. It pays off handsomely at first, it seems — but the payoff is illusory because it comes from scamming in new investors. Their money pays off the first investors, but now the Ponzi operator has to go find still more investors to keep up the appearance of a good return.

A Ponzi scheme was limited to scamming small-time ill-informed investors, or so we thought until Bernard Madoff was caught in a $50 billion Ponzi scheme that took in wealthy upper-crust clients. And that brings me to the point. If you buy and hold reputable index funds you can expect to make money over the long haul. You will have some bad years, like 2008. But you’ll never lose it all to a scam.

The “black swan” flies again

For the average investor, it’s hard to beat “buy and hold” over the long term, even though there will be times — such as now — that other strategies will look attractive. One such strategy is the “black swan” strategy popularized by Nassim Nicholas Taleb. The strategy is named in honor of the once-received wisdom that black swans were impossible — until black swans were discovered in Australia.

Taleb’s strategy essentially involves betting that rare events (financial “black swans”) will eventually happen, and being positioned to take advantage of those rare events. This year, that strategy has worked out well, producing returns of more than 50 percent.

So, should we all jump on the black swan bandwagon? Here’s why we shouldn’t:
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Sound advice in a crash

Those who make big sudden changes in their portfolios almost always regret it. Example: If you sold right after the 1987 crash, you lost 24 percent. If you held on two years, until September 1989, you got it all back. So take a deep breath and think hard before doing anything.

The enduring wisdom of “Buy and Hold”

In my book, I recommend not investing in the stock market until you have your financial house in order and are willing to let the money stay in the market. And once you’ve reached that point, you buy and hold.

Recent events again confirm the wisdom of this position. Those who tried to flee the market meltdown of fall 2008 were, in general, too late. The panicked news coverage followed the worst declines. So an investor who read the coverage and then pulled out was “selling low.” That same investor, who won’t get back into the market until things look more optimistic, will at that time be “buying high.”

Do you see the pattern? “Buy high, sell low.” That’s a sure route to ruin. When all this turmoil clears, count on it: Those who do the best will be those who followed the sound advice of “buy and hold.”

And, one more thing: Suppose someone sold after the first ten percent of a market decline, and then bragged about having missed the worst of the decline after the market went down another ten or 20 percent. That bragging would turn to regret over longer periods of time, if history is any guide.

A plainmoney guide to the meltdown

Wall Street is going crazy, but how can you make sense of it all? Here is plainmoney.com‘s simplified guide in ten easy steps:

1. It starts with the old-fashioned savings and loan association, like the Bailey Building & Loan in the classic movie It’s a Wonderful Life. That savings and loan association would accept deposits from people, loan them out on mortgages, and all was well. (Stay with me; this is going to be easier than you think.)

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A failure of deregulation?

Is the current meltdown a failure of deregulation and private markets? Consider these important facts and then make up your mind:

  • Fannie Mae and Freddie Mac were the key players.
  • Fannie and Freddie are GSE’s — that is, government-sponsored enterprises. That means they were, uh, sponsored by the government. Not only that, they were chartered and regulated by the government.
  • Fannie and Freddie took huge risks with an implicit guarantee that the taxpayers would pick up the tab if they failed. That implicit guarantee has now become explicit.

There’s an easy narrative that says “We didn’t regulate.” In the case of Fannie and Freddie, that’s simply wrong.

Maybe in the future we will regulate players like Freddie and Fannie better than we did.  I hope so. Make no mistake about it though: Fannie and Freddie were government chartered and government regulated. They were not private and they were not deregulated. (Plenty of people took stupid risks with the securities that Fannie and Freddie enabled, but that’s another story.)

One more important note: This is not really a partisan point. Here, for example, is a columnist who favors Sen. Obama for president and recognizes that deregulation is not the source of the current financial troubles. And the Washington Post, hardly a bastion of conservatism, has a thoughtful piece showing how the 2008 meltdown was a failure of distorted markets, not free markets.

“Conservative economic theory” sillies

The Wall Street Journal columnist Thomas Frank has come up with something he calls “conservative economic theory,” apparently placing the term in the mouth of a source on the subprime mortgage fiasco.

Like many people outside the field he assumes there’s a conservative economic theory and a liberal economic theory — overlooking the large analytical core shared by all economists. What does that core say about the role of mortgage originators in the subprime affair?

Simply this: that self-interested private firms disregard the costs they place on others. (See “externalities.”)

Therefore, if you want firms to be careful about costs, you make sure they pay the relevant costs. In the subprime mortgage affair, mortgage originators faced simple incentives to write as many mortgages as possible, short of outright fraud. They received origination fees for doing that while being relieved of liability if the owners later defaulted. Naturally, the law is complicated, but mortgage originators who simply reflected the overall market’s bad judgment — as opposed to committing fraud or misrepresentation — aren’t in much trouble.

Put yourself in the position of a mortgage officer. The housing market is hot and a ready market exists to buy up the loans you write. Are you going to inquire deeply into whether the borrower will pay it back? I didn’t think so.

It’s not a failure of economic theory, “conservative” or “liberal” or otherwise, when people respond rationally to perverse incentives. The task for reform is simple in concept: correct the incentives (as opposed to lamenting greed or making broad pronouncements about non-existent schools of thought).

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