Are you ready to navigate the complex world of investments? Want to learn how to invest wisely like Warren Buffett and understand the wisdom of Benjamin Franklin in investment matters? Curious about the realities of the stock market, the importance of low-cost index funds, or the potential risks and rewards of ETFs? How about uncovering the industry secrets of mutual fund returns? Dive in to understand the dynamics of the financial market system for successful investment, and secure your financial success.

The Little Book of Common Sense Investing

Imagine the Gotrocks Family, an affluent clan who owned every stock in the United States. They reaped the rewards of investing, enjoying the dividends and earnings growth from the thousands of corporations they owned. Their wealth, like the best sourdough starter, grew and compounded over time. However, smooth sailing never makes a skilled sailor, right?

Enter the Helpers, smooth-talkers who convinced some "smart" Gotrocks cousins they could earn more than their relatives. These Helpers juggled shares between family members, collecting commissions for their "services". But the Gotrocks soon noticed their wealth's growth slowing down. The Helpers, it turned out, were feasting on their returns. 

To add insult to injury, the family now also had to pay capital gains taxes due to the stock-swapping. The smart cousins realized their plan had backfired. They hired more Helpers, expert stock-pickers, to help them choose the right stocks. But alas, this only led to more fees and less wealth for the family. 

Their story may seem like a cautionary tale against trusting outsiders, but it's much more than that. It's a lesson on the foolishness of our complex financial market system and the importance of understanding how the stock market truly works before you dabble in it.

The moral of the Gotrocks story is simple: Successful investing comes from owning businesses and reaping the rewards provided by their dividends and earnings growth. The more you engage in financial intermediation, the less net return you receive. 

Legendary investor Benjamin Graham once noted that in the short run, the stock market is a voting machine, but in the long run, it is a weighing machine. In the short run, people might manipulate the stock price intentionally or unknowingly but in the long run, only the worthy stocks win.

So, remember to focus on your dividend returns and the operating results of your companies, rather than the daily fluctuations of the stock market. After all, as the Gotrocks Family learned the hard way, the key to wealth isn't about outsmarting others—it's about smart investing.

Could the Gotrocks Family's Investment Missteps Teach You the Secrets of Smart Investing?

Over the past 90 years, the Standard & Poor’s 500 Index, composed of the 500 largest U.S. corporations, has been the accepted stock market portfolio. 

However, in 1970, a more comprehensive measure of the U.S. stock market was developed, the Dow Jones Wilshire Total Stock Market Index. This index, which includes approximately 3,599 stocks, is the best measure of the aggregate value of stocks and a measure of the returns earned in U.S. stocks by all investors as a group.

Indexing is achieved by buying a portfolio that owns shares of every business in the U.S. and holding onto it indefinitely. This idea, though simple, guarantees victory in the investment game, as opposed to most investors who tend to lose. When it comes to problem-solving, Occam's razor suggests choosing the simplest solution. 

Indexing has proven to be an efficient investment strategy. Over the past 15 years, an impressive 90% of actively managed mutual funds have underperformed their benchmark indexes. This index superiority, therefore, makes index funds an optimal choice for long-term investment. 

Investors often fail to earn the returns that corporations generate due to the costs of investing. These costs include management fees, portfolio turnover, brokerage commissions, sales loads, advertising costs, operating costs, and legal fees. Over time, these costs can significantly erode investment returns. 

For instance, assuming a stock market return of 7% per year over 50 years, an investment of $10,000 in the stock market would grow to $294,600. However, assuming an average mutual fund operated at a cost of 2% per year, the net annual return of the fund would be 5%, and the value of the investment after 50 years would be just $114,700. 

The past record confirms that owning American businesses through a broadly diversified index fund is not only logical but also incredibly productive. Thus, investors should choose the simplest of all solutions—buying and holding a diversified, low-cost portfolio that tracks the stock market. 

Unlocking Investment Success: The Power of Low-Cost Indexing

Investors often make the mistake of focusing heavily on past fund performance when choosing investments. However, past performance doesn't guarantee future success. In fact, focusing on it can be counterproductive. A crucial factor often overlooked is the cost of owning mutual funds. Costs include the fund's expense ratio, sales charges, and transaction costs due to portfolio turnover. 

High costs eat into returns. For example, high-cost funds tend to remain high-cost, and the same goes for low-cost funds. The average-cost funds also persist in their category. Funds with high turnover rates also have higher costs, further reducing returns. 

Let's take a look at some numbers: the average annual return of the lowest-cost funds over the past 25 years was 9.4 percent while the highest-cost funds only returned 8.3 percent annually. That's a 1.1 percent difference, just from minimizing costs.

Now, if you're convinced that costs matter (and they do), why limit your search to actively managed funds? Traditional index funds had the lowest costs of all: expenses averaging just 0.1 percent during a recent period. The gross return of the S&P 500 Index fund was 9.2 percent per year; the net return, 9.1 percent. 

Dividends are also a significant part of long-term returns. Since 1926, they've contributed an average annual return of 4.2 percent. That's a big deal. However, mutual fund managers often downplay dividends because their management contracts usually base advisory fees on a fund's net assets, not on its dividend income. As a result, a staggering proportion of equity fund dividend income is consumed by expenses. 

In actively managed growth funds, expenses can consume 100 percent of fund income. In actively managed value funds, expenses can eat up 58 percent of dividend income. In contrast, for comparable value index fund expenses, only a meager 2 percent of fund income is consumed in 2016; for a low-cost growth index fund, just 4 percent. 

Given the power of compounding dividends over the long term and the relative stability of corporate dividend payouts, it's clear that costs matter a lot in fund investing. To maximize returns, focus on the lowest cost funds and don't overlook the importance of dividends.

Are High Mutual Fund Costs Eating into Your Investment Returns?

Mutual fund returns often fall short of the market, with industry insiders like Peter Lynch, Jon Fossel, James Cramer, and Clifford Asness agreeing that the typical equity mutual fund's returns are generally inadequate compared to simply owning an index fund based on the S&P 500. 

The reality is worse than it appears, as in addition to high costs for fund manager services, shareholders also bear an extra cost due to the timing of their investment inputs and withdrawals.

Over the last 25 years, the average mutual fund's return was 7.8% per year, 1.3% less than the S&P 500's return. However, the average fund investor's return was much lower at approximately 6.3%. This discrepancy is due to the fact that money generally flows into most funds after they perform well, and outflows occur when performance dips. 

The index fund investor, though swayed by the rising market, still earned a return of 8.8%, only 0.2% short of the fund return itself. Thus, while the S&P 500 Index provided an annual return of 9.1% and the average equity fund earned an annual return of 7.8%, the average fund investor earned only 6.3% a year. This considerable gap is a result of costs, adverse fund selections, and poor timing.

The index fund offers a solution to these issues. It not only has low expenses but also eliminates the tempting yet under-performing fund choices. By focusing on long-term performance and ignoring short-term market noise, investors can hold onto the index fund through market highs and lows. 

Moreover, most managed mutual funds are shockingly tax-inefficient due to the short-term focus of portfolio managers, who often engage in frenetic trading. The traditional index fund, on the other hand, adopts a buy-and-hold strategy, which significantly reduces transaction costs and tax burdens. The winning formula for investing success, therefore, is to own the entire stock market through an index fund and stay the course.

Unveiling the Mutual Fund Mirage: Why Index Funds Outperform their Glitzy Counterparts

While the long-term success of the market relies on business realities like dividend yields and earnings growth, the last four decades have seen market returns exceeding business returns more than any other period in U.S. history. 

This is due to speculative return, which accounts for 25% of the market's total annual return since 1974. This return is a result of investors revaluing stocks, causing the price/earnings multiple to triple.

However, we need to be cautious. The future may not be as rosy as the past four decades. The combination of a current high price/earnings ratio and lower expected earnings growth suggests that we may face an era of subdued returns in the stock market.

Investors have enjoyed extraordinary returns over the past four decades, but expecting the same level of speculative return in the future is unrealistic. The market's future momentum will rely more on the actual earnings growth of businesses rather than the expansion of price/earnings multiples.

The return on a balanced stock/bond portfolio is also likely to be lower in the future. Combining expected future returns on stocks and bonds suggests a gross nominal annual return of 3.6% over the coming decade, before investment costs. This falls well below the long-term average return of 7.8%.

When investing in actively managed funds, remember that fees and costs can consume a significant portion of your returns, especially in a future of potentially lower returns. High-cost actively managed funds seem to be an unfortunate choice for investors in such a scenario.

However, there are ways to improve your investment returns. Investing in a low-cost index fund or selecting funds with minimal costs and turnover can virtually guarantee investment success. On the other hand, selecting winning funds based on past performance or getting professional advice to pick market-beating funds have generally poor odds of success.

Can Low-Cost Index Funds Outperform Traditional Mutual Funds in the Long Run?

When it comes to selecting mutual funds, many investors rely heavily on recent superior performance. In 2016, over 150% of net investor cash flow went to funds rated four or five stars by Morningstar. 

However, a 2014 study by the Wall Street Journal found that only 14% of five-star funds in 2004 still held that rating a decade later. This illustrates the concept of Reversion to the Mean (RTM), whereby fund performance reverts towards the average or falls below.

A comparison of the returns of all actively managed U.S. equity funds over two sets of nonoverlapping five-year periods: 2006–2011 and 2011–2016, showed that RTM trumps persistence. Only 13% of top-performing funds in the first period remained in the top quintile for the subsequent five years.

These statistical findings challenge the common assumption that manager skill persists. Nassim Nicholas Taleb, author of 'Fooled by Randomness', asserts that a population entirely composed of poor managers will still produce a small amount of great track records, purely from luck. 

Investors should be wary of selecting mutual funds based on recent performance, as it often leads to disappointment. The principle of RTM exists not only in mutual funds’ returns, but in many aspects of our lives. As a rule, the stars produced in the mutual fund field rarely remain stars; often they turn out to be fleeting meteors. 

While investment advisers and brokers can offer valuable services like asset allocation guidance, tax advice, and consulting on financial markets, the evidence suggests that as a group, they can't be relied upon to add value by selecting funds that will beat the market. The rise of robo-advisers, providing low-cost, algorithm-driven advice, further underscores the shift toward simplicity and efficiency in investing.

Ultimately, the simplicity of low-cost index funds, which mirror the market, often outshines more complex strategies. As the investment landscape evolves, the principle of fiduciary duty—putting the client's interests first—gains traction, promising a brighter future for investors seeking reliable guidance.

Chasing Stars: The Perils of Relying on Past Performance in Mutual Fund Investing

In the world of investing, one thing is clear: low costs are good. This is why traditional index funds (TIFs), which own the entire stock market and have some of the lowest costs around, are often the best choice for investors. The proof is in the performance of the S&P 500 Index fund, which has consistently outperformed the average equity fund over the past 25 years.

The Monte Carlo simulation, a statistical method, also supports the superiority of index funds. This method assumes that index fund costs will be 0.25% per year and that the all-in costs of active management will be 2% per year. The results show that over one year, about 29% of active managers would outpace the index, and over five years about 15% would. After 50 years, only 2% of active managers would be expected to win. 

It's clear that index funds deserve an important place in your portfolio. In an era of subdued stock and bond market returns, fund costs will become more important than ever. The key to success is simplicity and parsimony. By focusing on low-cost index funds, you can avoid the costly pitfalls of active management and enjoy the steady returns of the broader market.

Of course, not all index funds are created equal. Some have low expense ratios while others have high ones. Even among the low-cost S&P 500 Index funds, there is a wide range of expenses. An intelligent investor will select the lowest-cost index funds available from reputable fund organizations. 

It's also important to note that indexing works across all market sectors. Whether in more efficient or less efficient markets, in U.S. markets or global markets, indexing has proven to be a successful strategy. However, betting on one winning sector and then another is a risky game. Instead, owning the traditional stock market index fund at rock-bottom cost is the ultimate strategy.

Bond funds also benefit from the same forces that create value for stock index funds: broad diversification, low costs, disciplined portfolio activity, tax efficiency, and focus on long-term strategies. Whether it's stocks or bonds, the power of indexing is growing, and investors are increasingly recognizing this fact. After all, the goal is not to beat the market, but to capture its returns. And for that, index funds are the best tool we have.

Are Low-Cost Index Funds the Ultimate Investment Strategy?

Over the past decade, the world of investing has seen a significant clash between traditional index funds (TIFs) and exchange-traded funds (ETFs). Traditional index funds, developed over four decades ago, promoted long-term investment, broad diversification, and minimal costs. 

ETFs, on the other hand, emerged as a new breed of index funds designed for trading, dressed up to look like traditional index funds but geared towards short-term speculation.

The fundamental principles of TIFs focused on ensuring investors earned their fair share of market returns through broad diversification and low costs. ETFs, however, have introduced a trading frenzy, making them more suitable for short-term investors rather than long-term holders. 

While some ETFs that track broad market indexes can be beneficial if held for the long term, the vast majority are traded frequently, incurring high costs and taxes, leading to unpredictable returns.

The first ETF, known as the "Spider," was introduced in 1993, tracking the S&P 500 Index. Despite its potential for low-cost, tax-efficient investment, its primary users have been short-term traders, resulting in massive turnover rates and high trading volumes. 

ETFs have grown exponentially, accounting for half of the asset base of all index funds by 2017. They've become a force to be reckoned with, often constituting over 40% of the total daily trading volume on the U.S. stock market. The incredible growth of ETFs highlights the focus of money managers on gathering assets, the marketing power of brokerage firms, and the willingness of investors to favor complex strategies and aggressive trading.   

Investors often fall into the trap of chasing past returns of sector-specific ETFs, leading to poor investment outcomes. The data shows that most investors in these ETFs underperform the funds themselves due to emotional and frequent trading, combined with high expenses.

Traditional index funds have proven their worth by consistently providing long-term returns that surpass those of actively managed funds. The smart beta and factor-based ETFs claim to offer superior returns through complex strategies, but the evidence suggests otherwise. These strategies often fail to outperform the broad market in the long run and can be more expensive and risky.

The growth of ETFs has not only skyrocketed in number but also in diversity, with over 2,000 ETFs now available. However, investor cash flows into ETFs are exceptionally volatile, especially compared to the relatively stable cash flows experienced by TIFs. 

While the world of ETFs may seem enticing, investors would do well to remember the wisdom of the original TIF paradigm - broad market diversification, minimal cost, and long-term investment. Benjamin Graham, in his classic book "The Intelligent Investor," emphasized these principles, advocating for a diversified portfolio and rational long-term expectations. 

Traditional Index Funds vs. Exchange-Traded Funds: A Decade-Long Investment Battle

Asset allocation is the process of deciding how to distribute your investments across various asset classes like stocks, bonds, and other types of investments. It's key to understand that asset allocation is a principal determinant of your portfolio's returns. In fact, a 1986 academic study found that asset allocation accounted for 94% of the differences in total returns achieved by institutionally managed pension funds. 

Ben Graham, the author of "The Intelligent Investor", suggested a 50/50 division between stocks and bonds. However, this model isn't a one-size-fits-all solution. Your ability to take risk and your willingness to take risk both dictate your optimal asset allocation. 

As you age, your asset allocation should also change. For instance, younger investors can afford to be more aggressive due to their long investment horizon, while older investors might prefer a conservative approach. Graham's allocation guidelines are a good starting point, but they should be adapted according to your risk tolerance and investment horizon. 

An increasingly popular approach to asset allocation is the use of target-date funds (TDFs). These funds hold a diversified portfolio of stocks and bonds that gradually become more conservative as the fund approaches its target date, usually your expected retirement year. It's a "set-it-and-forget-it" strategy that works well for many investors.

Another crucial factor to consider in your asset allocation is Social Security. It forms a significant part of retirement income for most retirees and should be viewed as a bond-like asset in your portfolio.

Lastly, remember that asset allocation isn't a one-time decision. It should be reviewed periodically and adjusted based on changes in your investment goals, risk tolerance, and market conditions. In investing, there are no guarantees but with careful planning and consideration, you can navigate the complex world of asset allocation.

Can Benjamin Graham and John C. Bogle's Expert Insights Help You Master Asset Allocation?

Investing wisely is a feat that many aspire to achieve. While it may not be the most exciting strategy, most American families would benefit from owning their equities in an S&P 500 Index fund and their bonds in a total bond market index fund. Warren Buffett himself recommends this approach, stating that the majority of investors will gain superior net results through an index fund with minimal fees.

However, the world of investing is often shrouded in uncertainty. We may not know what returns stocks and bonds will deliver in the years ahead or what future returns alternatives to the index portfolio might achieve. But despite these uncertainties, there are several common-sense realities we can cling to:

1. Start investing as early as possible and continue regularly.
2. Understand that investing entails risk, but not investing guarantees financial failure.
3. Recognize the sources of returns in the stock and bond markets.
4. Eliminate the risk of selecting individual securities by opting for total diversification offered by a traditional index fund.
5. Minimize costs and taxes.
6. Understand that beating or timing the market consistently is virtually impossible.
7. Accept that we cannot predict the future, but we can prepare for it.

These principles mirror the timeless wisdom of Benjamin Franklin, who advised saving for the future, controlling expenses, taking calculated risks, investing in knowledge, understanding the market, maintaining safety through diversification, and looking after your own interests. He also emphasized the importance of perseverance and frugality, which aligns with the investment mantra: "Stay the course."

To accumulate wealth, capitalize on the magic of long-term compounding returns and avoid the tyranny of long-term compounding costs. Avoid Wall Street's high-cost, high-turnover, opportunistic modalities and adopt Main Street's patient, steadfast approach.

Clifford S. Asness, managing principal of AQR Capital Management, echoes these sentiments, advising investors to diversify widely, keep costs low, rebalance in a disciplined fashion, spend less, save more, and be skeptical of "free lunches." Above all, he emphasizes the importance of sticking to the basics with discipline.

The late Dr. Paul Samuelson of MIT equated the creation of the first index fund by John Bogle to the invention of the wheel, the alphabet, and wine and cheese - a testament to their enduring relevance and utility. So, stick with the traditional index fund, and let the test of time prove its worth.


Warren Buffett's Investment Mantra

Investing is a long-term game where the rewards come from owning businesses and reaping the growth of their dividends and earnings. Engaging too much in financial intermediation can lead to less net return. 

The stock market, in the long run, will always favour the worthy stocks irrespective of short-term manipulation. Therefore, focus on the operating results of the companies you invest in and their dividend returns rather than the daily fluctuations of the stock market.

Indexing, or owning a portfolio that includes shares of every business, is a guaranteed victory in investment. This is because most investors lose due to costs of investing, such as management fees, portfolio turnover and brokerage commissions, among others. These costs significantly eat into investment returns over time. 

Past performance of funds does not guarantee future success, and focusing on it can be counterproductive. Costs matter a lot in fund investing, and high-cost funds tend to remain high-cost. A significant part of long-term returns come from dividends, which are often overlooked due to the focus on net assets in mutual funds.

The typical equity mutual fund's returns are generally inadequate compared to simply owning an index fund based on the S&P 500. Index funds not only have low expenses but also eliminate the tempting yet under-performing fund choices. They also adopt a buy-and-hold strategy, which significantly reduces transaction costs and tax burdens.

The principle of Reversion to the Mean (RTM) exists in mutual funds' returns, where fund performance reverts towards the average or falls below. Therefore, selecting mutual funds based on recent performance often leads to disappointment. 

Traditional index funds (TIFs) that own the entire stock market and have low costs are often the best choice for investors. The Monte Carlo simulation, a statistical method, supports the superiority of index funds. Bond funds also benefit from the same forces that create value for stock index funds: broad diversification, low costs and focus on long-term strategies.

Exchange-traded funds (ETFs) have introduced a trading frenzy and are more suitable for short-term investors rather than long-term holders. ETFs have grown exponentially, but most investors in these ETFs underperform the funds themselves due to emotional and frequent trading, combined with high expenses.

Asset allocation is a principal determinant of your portfolio's returns, and it should be reviewed periodically and adjusted based on changes in your investment goals, risk tolerance, and market conditions. Target-date funds (TDFs) are an increasingly popular approach to asset allocation. 

Finally, to accumulate wealth, start investing as early as possible and continue regularly, understand the sources of returns in the stock and bond markets, eliminate the risk of selecting individual securities, minimize costs and taxes, and be prepared for the future. Stick with the traditional index fund, and let the test of time prove its worth.

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