Saturday, July 7, 2012

Mutual Funds, Efficient Markets, and Mispricing

John Bogle is the founder of the Vanguard Group and author of numerous books and papers on investing and the mutual fund industry. Among his more noteworthy titles are Common Sense on Mutual Funds and The Little Book of Common Sense Investing. The latter can be found on the Unrepentant Capitalist bookshelf.  I like small books with small words.  My copy can be found next to Hop on Pop.

Bogle is famous for saying that the stock market is one ‘giant distraction’. His basic message is that the stock market generates a lot of unnecessary attention and much of the mutual fund industry is a waste of time and money.  Bogle says people would be better off investing in index mutual funds with their very low fees and minimal tax implications.  An S&P 500 index fund (most of the big mutual fund companies have them) is a mutual fund is made up of all the companies in the S&P 500.  There are Russell 2000 funds, FTSE 100 funds; name a popular index, and there's an index mutual fund that mimics it.  Index funds don't have large teams of highly compensated fund managers and analysts looking at stocks, there's very little buying and selling of stocks except for the occasional adjustments made when companies fall out or are added to the index in question.  Net result, management fees are extremely low versus the typical actively managed mutual fund.

Bogle argues that most individual investors lack the skill and time to be successful stock pickers, and that successful investors like Warren Buffett, Benjamin Graham, and Peter Lynch are extraordinarily rare people.The vast majority of fund managers can’t beat the S&P 500 (and they have lots a resources and Ivy League educated manpower at their disposal) so what chance does the little guy have?  To be fair, there are some very sharp small investors out there who do very well in the stock market. But the vast majority aren’t nearly as good as they think they are.  Bogle’s advice: invest in a broad market index fund, reinvest the dividends, hold for a long time, and pocket your 8% per year*.  He also says the much of what’s out there for purchase—trading tools, research, management fees, etc—is a waste of money, and that many employed in the mutual fund business should get real jobs that actually contribute to the economy.

I think Bogle and his philosophy are spot on, and I think following his advice makes sense.  Put your money in an index fund, reinvest the dividends, repeat.  Steer clear of high flying (and high fee) actively managed mutual funds.  I also agree with Bogle's position on the excesses of the mutual fund industry.  The public's general ignorance on the true performance of most actively managed mutual funds plus the opposing forces of the efficient market and the constant search for mispricings will keep the industry safe for quite awhile.

Our stock market is called 'efficient’ in that stock prices generally reflect all relevant public info about the stock at any given point in time. There are so many eyeballs watching (and voting via their buy or sell orders) that stock prices are always adjusting to reflect the public’s collective thinking about the correct price for the stock.  If good or bad news about a company hits (a new product is launched, a class action law suit is filed, a promising new drug receives FDA approval, etc.) the stock price quickly adjusts up or down in response.

Lots of mutual funds with lots fund managers and analysts = lots of eyeballs.

Mispricing happens when something is not priced correctly vis-à-vis the market. Mispricing can occur for a variety of reasons, but unequal information is a common cause. Unequal information means buyers and sellers are not equally informed about the true market price of an item in question.  An early 60’s VW pickup taking up space in a farmer’s barn is mispriced when the farmer sells the truck to a city slicker for $500. The farmer doesn’t realize these old trucks, in decent condition, can fetch 10 times this amount. By the way, if anyone out there knows the whereabouts of such a truck, the Unrepentant Capitalist has cash.  Mispricing generally doesn’t happen in the stock market because there are tons of people poring over financial statements, earnings projections, industry studies, etc.

Image what would happen if people pulled out of actively managed mutual funds en masse.  Fund managers and analysts quit (or are fired) in droves.  Lots fewer eyeballs watching things.  Over time, and with a much smaller universe of eyeballs, things aren't watched closely and some prices drift up or down too far....they become mispriced. If people start making money off mispriced stocks, people start moving back into the industry.  Seems to be a feedback loop that keeps a certain number of people employed watching stock prices.  Just a thought.

I think for most people, the stock market is the right place to put your money.  But, if you're very knowledgeable about a particular niche market, antique furniture, vintage cars, etc. you've got the opportunity to put mispricing to work to make yourself some money.

*The 8% cited is a long term historical average for the S&P 500 that includes stock price appreciation and reinvested dividends. Some years you’re up 20%, other years you’re down 10%, but over the long haul, 8% is a reasonable expectation.

"You're offering me how much for my old pick-up?"

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