I. The no-brainer step: investing in index funds:
1. The S&P 500 index beat approximately two-thirds of professional managed portfolios in the 1980s and 1990s. Index funds have regularly produced rates of return exceeding those of active managers by close to 2%.
Two reasons:
a. Much lower management fees: public index funds typically charge a fee of 0.2%, while actively managed public mutual funds charge annual management and market expenses that on average are 1.5%.
b. Less trading costs: index funds trade only when necessary, whereas active funds typically have a turnover rate close to 100%, and often even more. Such turnover probably costs the fund at least another 0.5-1% of performance a year.
2. Index funds are also relatively predictable. When you buy an actively managed fund, you can never be sure how it will do relative to its peers. When you buy an index fund, you can be reasonably certain that it will track its index and that it is likely to beat the average manager handily.
3. The index fund has another attraction for small investors. It enables you to obtain very broad diversification with only a small investment. It also allows you to reduce brokerage charges.
4. Many people incorrectly equate indexing with a strategy of simply buying the S&P 500 index. The S&P 500 omits the thousands of small companies that are among the most dynamic in the economy. Thus, I now believe that if an investor is to buy only one U.S. index fund, the best general U.S. index to emulate is the broader Wilshire 5,000 – Stock Index – not the S&P 500.
5. Moreover, investors can reduce risk by diversifying internationally. E.g. Morgan Stanley Capital International (MSCI) index of European, Australian, and Far Eastern (EAFE) securities, and the MSCI emerging markets index.
6. There are index funds holding REITs and bonds.
7. Keep in mind: I am assuming here that you hold most if not all of your securities in tax-advantaged retirement plans. Certainly all of your bonds should be held in such accounts. Furthermore, you may want to alter the percentages somewhat depending on your personal capacity for and attitude toward risk.
II. The do-it-yourself step: potentially useful stock-picking rules
1. Indexing is the strategy I most highly recommend for individuals and institutions. For those who insist on playing the game themselves, I proposed four rules for successful stock selection.
2. Rule 1: Confine stock purchases to companies that appear able to sustain above-average earnings growth for at least five years. Consistent growth not only increases the earnings and dividends of the company but may also increase the multiples that the market is willing to pay for those earnings.
3. Rule 2: Never pay more for a stock than can reasonably be justified by firm foundation of value. Although I am convinced that you can never judge the exact intrinsic value of a stock. I do feel that you can roughly gauge when a stock seems to be reasonably prices. The market price-earnings multiple is a good place to start: you should buy stocks selling at multiples in line with, or not very much above, this ratio. My strategy, then, is to look for growth situations that the market has not already recognized by bidding the stock’s multiple to a large premium. Some people call this a GARP (growth at a reasonable price) strategy. Buy stocks whose P/E’s are low relative to their growth prospects.
4. Rule 3: it helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air. People are emotional – driven by greed, gambling instinct, hope, and fear in their stockmarket decisions. This is why successful investing demands both intellectual and psychological acuteness. Stocks are like people – some have more attractive personalities than others. The key to success is being where other investors will be, several months before they get there.
5. Rule 4: Trade as little as possible. My own philosophy leads me to minimize trading as much as possible. I am merciless with the losers, however. With few exceptions, I sell before the end of each calendar year any stocks on which I have a loss. The reason for this timing is that losses are deductible for tax purposes, or can offset gains you may already have taken.
III.The substitute-player step: hiring a professional Wall street walker
Instead of trying to pick the individual winners (stocks), pick the best coaches (investment managers). But be very careful:
1. Many fund advertisements are quite misleading. The number one ranking is typically for a self-selected specific time period and compared with a particular (usually small) group of common stock funds.
2. It is simply impossible for investors to guarantee themselves above-average returns by purchasing those funds with the best recent records because there is no consistent long-run relationship between performance in one period and investment results in the next.
3. If you have to pick a fund, use the Morningstar mutual-fund information service, which is one of the most comprehensive sources of mutual-fund information an investor can find. The reports indicate whether the fund has nay sales charges (load fees) and shows the annual expense ratios for the fund and the percentage of the fund’s asset value represented by unrealized appreciation. If you buy actively managed funds you should look for no-load, low-expense funds with little unrealized appreciated to minimize future tax liability.
4. A Primer on Mutual-fund costs. There are two broad categories of costs: “load” fee charged when you buy or sell shares and “expense charges” that are taken out of your investment returns each year.
Loading Fees:
a. Front-end load: a commission charge that is paid when you purchase fund shares. Front-end loads are often as high as 5.75%. So-called low-load funds charge only a 1 to 3% sales charge. Best of all are no-load funds, which have no front-end sales charges at all.
b. Back-end loads and exchange fee. Back-end loads are charges incurred when you redeem fund shares. The charge could be as much as 6% of the value of your redeemed shares if you sell out in the first year, with a declining percentage charge in subsequent years.
Expense charges:
a. Operating and investment management expenses. A fund’s expense ratio expresses the total operating and investment advisory fees incurred by the fund as a percentage of the fund’s average net assets. These expense ratios range from less than 0.2% to 2%. Beware the loss leader come-on. Some new funds temporarily waive all fees to enhance the advertised current yield. Investors should be alert to the fact that they will be socked for full expenses as soon as the introductory “come-on” period ends.
b. 12b-1 charges: these are fund-distribution expenses charged not as a front-end load but rather as a continuing annual charge against fund assets. The “12b-1” refers to an SEC rule that permits these charges. More than half of the publicly offered mutual funds have 12b-1 fees.
IV.The Malkiel step
1. Sometimes, close-end funds have attractive discounts. During the late 1970s, the discounts ran as high as 40%. My own explanation for the discounts ran in terms of unexploited market inefficiency and I urged investors to take full advantage of the opportunity for as long as it lasted.
2. Discounts have narrowed significantly on U.S. closed-end funds. I think the fundamental reason for the narrowing is that our capital markets are reasonably efficient. The market may mis-value assets from time to time, creating temporary inefficiencies. But the financial laws of gravity will eventually take hold and true value will out.
3. If discounts of 20% or more exist, it is time to buy closed-end funds.
A Random Walk Down Wall Street - The Get Rich Slowly but Surely Book Burton G. Malkiel
http://people.brandeis.edu/~yanzp/Study%20Notes/A%20Random%20Walk%20down%20Wall%20Street.pdf
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