A Nation Of Savers Is Now A Nation Of Investors

Income disparity in the United States started to grow in the 1970s[i]. Deemed the “great divergence” by Nobel Laureate Paul Krugman, this trend commenced around the same time that the United States government introduced the ERISA program[1] in 1974. While ERISA supports various types of employee benefit plans, it is most notably responsible for creating the Individual Retirement Account (IRA)[2]. The IRA has effectively turned a nation full of savers into a nation of investors.

Prior to ERISA, individuals primarily invested in United States government-issued savings bonds and Certificate of Deposits (CDs). Lingering stories of the Great Depression left many distrusting the stock market. Unstable inflation and high interest rates pressed banks to pay around 10 percent on CDs, making them seem to many like outstanding investments. However, once ERISA was implemented, the IRA incentivized many to explore other options, such as stocks, corporate bonds and mutual funds. At the same time, the Securities and Exchange Commission (SEC) deregulated brokerage firm compensation, effectively lowering transaction costs, which made investing in the stock market significantly cheaper for individual investors. In the wake of this reform, low cost brokerage firms such as Charles Schwab and mutual fund companies such as Vanguard launched. Soon after, the 401k[3] was established.

Fast-forward ten years to 1990. Inflation is controlled and interest rates are declining. Individuals that once saved through CDs and savings bonds are seeing diminishing rates of return while those invested in the stock market have just witnessed one of the greatest bull markets in recent history. Households that used to save money in banks join the parade and begin to buy stocks and mutual funds. Individual investors are beginning to use the Internet to trade stocks, research companies and track performance. Financial media outlets are becoming more popular. Former savers have officially transformed into investors, many of whom are largely obsessed with the stock market.

 

Notice how after 1990, stock valuations (reflected by the Cyclically Adjusted Price-to Earnings Ratio) inflated because of the new demand for stocks created by former savers.

Wall Street Scores a Big Win

The transition of capital from the government and commercial banks into the hands of investment bankers and corporations essentially shifted power where the interests of Wall Street became priority to those of the general population. Increased participation in the stock market and the willingness of investors to pay more for shares gave investment bankers the power to raise a larger sum of money for their corporate clients, at a cheaper rate. These larger sums of money effectively gave wealthy business owners, executives, high-level managers and large shareholders more power, as they can use the money however they want, occasionally doing things that benefit themselves more than the company.

While the general population benefits from cheap goods and increased hiring, Wall Street benefits from higher profits. However, corporations weren’t always so profit hungry. In the years following World War II, a high nationalistic spirit unified the country and pushed business leaders to act “socially responsible.” At this time, many large corporations such as IBM, General Motors and American Airlines took pride in their ability to hire American workers and help strengthen the workforce. During the late ’50s and early ’60s, free-market theorists such as notable economist Milton Friedman[4] began to argue that companies should act in a way that prioritizes shareholders and with time, corporate America listened, specifically adhering to the goal of maximizing shareholder wealth.[5]

“Maximizing shareholder wealth” has become a frequently repeated saying heard around corporate America. Since the most direct way to maximize shareholder wealth is through stock price, management does everything in their power to satisfy the market’s expectations. Essentially, this goal is so deeply ingrained that management may prioritize short-term stock price performance before the long-term profitability of the company.

The uniform adherence to this idea is not the only factor contributing toward management decisions. In fact, high-level management and executive’s compensation is often tied to stock price — the higher the company’s stock price, the more these individuals get paid[6]. By focusing on short-term stock price, rather than long-term profitability, management is distracted from what truly matters: creating the maximum value for the most amounts of people.

So, the question persists: what can individuals do to close the gap on income inequality? So far from our discussion, you may think that withdrawing from the market is one solution. Well, it isn’t. In addition to restricting economic growth, withdrawing from the market would only hurt because other investments have historically underperformed equities (we will discuss this later), and for good reason: stocks are one of the few investments that realize a company’s growth. An investor who ignores the stock market is like an athlete who doesn’t train or a bodybuilder that doesn’t eat protein. Instead of withdrawing from the market, individual investors must expose themselves to equities and learn the correct ways to invest.

The truth is that investing in the stock market is only becoming more important. The global financial crisis pressured the United States government and regulatory organizations to mold our environment into a shape we haven’t yet seen before. In addition to greater uncertainty, low interest rates and the expectation that inflation won’t be a future problem are making it difficult for individuals to preserve wealth by investing in fixed-income alternatives such as bonds.

Social Security Provides Little Security

Up until today, ignoring the stock market hasn’t presented much of a problem because investors were somewhat able to battle inflation through investing in fixed-income securities and receiving retirement assistance from governmental programs such as Social Security. However, today things are different. Not only do bonds yield little return, but also, the Social Security program seems on the brink of collapse. Without the help of these benefit programs, investors and savers might have to refigure their retirement.

Looking back, it seems clear that Social Security was never sustainable. Actually, one can argue that it was only meant to be a short-term fix.

Social Security was introduced during the Great Depression as a part of Franklin Delano Roosevelt’s “New Deal” (the second version) to incentivize older employees to retire and make space for younger workers. The first recipient of Social Security was a woman named Ida May Fuller who contributed $24.75 to the program from 1935 until her retirement in 1940, where she received her first monthly check for $22.54. This means that Ida essentially made her money back on her first monthly check. Sure enough, Ida lived a long time (to age 100) and collected over $22,800 in payments.

Today, over 55 million retirees collect monthly Social Security checks, which make up 38 percent of all retirement income[ii]. The fact is that Ida May Fuller is only one example. It seems obvious that Social Security was doomed from the start as its benefits were in no way sustainable.

While no one can predict the future, it is important for individuals to start putting more thought into retirement and how their need for income will change. Since retirees will not be able to rely solely on Social Security, retires will be either forced to work longer or live on less money. Since equity is the only highly liquid investment that facilitates true growth, learning the right way to invest is of utmost importance as doing so can effectively build up enough wealth for one to retire under respectable means.

Those Who Choose Not to Take the Journey

Those who choose not to take the journey invest in passive strategies and realize average performance not always because they don’t want to be better than average, but instead, because they believe that outperforming is if not impossible, extremely difficult.

These investors believe that the stock market is informationally efficient, meaning that a company’s stock price is an unbiased estimate of its intrinsic value, or the true value determined by all information currently available to the public. Efficient market proponents argue that stock price movements are random, unpredictable fluctuations and therefore, believe that it is difficult to consistently outperform the market because any random above average profitable opportunities will be rapidly closed by profit hungry investors called arbitrageurs[7][8].

Why Mutual Funds Have Trouble Outperforming its Benchmark

Efficient market proponents believe that markets are inefficient because mutual funds haven’t been able to consistently outperform the market (remember the recent Standard and Poor’s study). Just because mutual funds haven’t yet proven they can deliver superior results doesn’t mean that individual investors can’t. One reason that many managed mutual funds[9] have trouble outperforming the market is that managed mutual funds themselves make up a large portion of the market!

Data from the Investment Company Institute shows that there is over $30 trillion invested into mutual funds worldwide. In the United States alone, 54 million households (43% of all United States investors) invest over $15 trillion into mutual funds[iii]. Because mutual funds manage so much money, fund managers are restricted to behaving in certain ways.

While there is no doubt that mutual funds are led by bright managers who realize the benefits from its economies of scale and easy access to information, many funds are restricted to owning more than a certain percentage of a single company, making it difficult for the fund to concentrate its money in top quality investments[10]. Making things more difficult is that institutions have a lot more money to manage than individuals. This means that they must spread their money throughout many securities because a $3 billion dollar managed mutual fund (an approximation of the size of a fund that invests in small to medium size companies) that holds 20 securities would mean that it invest $150 million in each small to mid-size company (purchases would put tremendous upward pressure on stock prices and break restrictions).

According to the Investment Company Institute (ICI), the median number of securities a mutual fund holds is 100[iv]. These holdings generally have similar characteristics since funds follow a specific strategy and measure performance against its relevant benchmark. A fund that holds a large number of securities and follows a specific strategy almost by definition mimics the very index it is trying to beat. While diversification can help reduce risk, there is such a thing as too much of a good thing. In this case, too much diversification hinders the chances of mutual funds to outperform its benchmark.

The size of mutual funds may also prevent managers from finding profitable investment opportunities, especially in small companies. When a fund gets flooded with money, managers often find it difficult to maintain the fund’s investment strategy while simultaneously finding quality investments (that is, if they choose to keep the fund open to new investors). Managers have two options: one, to invest in a larger variety of securities, or two, to increase the size of its current positions. Coming up with new investment ideas while sticking to its strategy is often difficult and investing more money in current positions may inflate stock prices (especially in smaller companies), if not break restrictions. The lack of options often pressure mutual fund managers to invest in poor quality stocks. This is why studies have concluded that the larger the mutual fund, the less likely it is able to outperform its benchmark[v].

Impediments don’t only prevent mutual funds from finding quality investment opportunities (or avoiding poor quality stocks) but also, prevent them taking advantage of cyclical behavior. Later we will learn that markets are cyclical and that investors are best off buying when stocks trade at bargain prices (when the markets drop). The problem occurs when the markets drop and investors panic and tend to redeem their shares after the fund has experienced large losses (the worst time to do so). Because mutual funds must use its cash to satisfy redemptions, the fund is largely unable to purchase stocks at bargain prices.

 

Markets Are Not Perfectly Efficient or Completely Inefficient

To be honest, I never even entertained the idea that markets are perfectly efficient. While in business school, I learned about an economist named Eugene Fama who discovered that there are four factors that contribute to efficient markets[11]:

· Number of Participants: The more or greater proportion of rational investors, the more efficient a market is.

· Availability of Information: In efficient markets, information must be widely available and easily accessible.

· Impediments to trading: Less trading restrictions will allow arbitrageurs to quickly close profitable opportunities

· Transaction and information costs: Lower transaction costs drive price to better reflect fundamentals

While I can understand that information is easily accessible and transaction costs are low, I could never grasp that investors are rational. Additionally, I learned that there are impediments to trading that prevent large institutional investors from closing some profitable opportunities. Fama understood this, and even more so, understood that different markets incorporate different levels of informational efficiency. This led him to propose two alternatives: weak form and semi-strong form.

Weak form market efficiency: Prices reflect all historical market information such as past prices. Under this form of efficiency, investors would not be able to predict future trends through past price data.

Semi-strong form market efficiency: Prices reflect all publicly available information such as earnings forecasts, and therefore, analysts would not benefit from conducting analysis on company fundamentals.

Strong-form market efficiency (Perfectly Efficient): Security prices reflect all information, both publically and privately available. Proponents of strong-form market efficiency believe it is impossible to consistently outperform the market through any means.

Proponents of semi-strong and strong form market efficiency incorporate a passive investment strategy because they believe it is impossible to gain an edge over the market. Proponents of weak-form market efficiency tend to try to beat the market through analyzing company fundamentals. Investors who believe that the market is inefficient will analyze company fundamentals, past prices and data reflecting investor behavior.

In October 1999, Microsoft was trading at around $60 per share. Six months later, Microsoft was trading at $20. Strong-form efficiency proponents would argue that the market was correct in pricing Microsoft both times (highly unlikely). Microsoft isn’t the only example. What about the behavior during the global credit crises in 2007 and 2008? Don’t get me started!

Overall, it is safe to say that, markets are not perfectly efficient, nor completely inefficient. If the markets were extremely inefficient, above average performance wouldn’t be so rare and if the markets were perfectly efficient, stock prices wouldn’t fluctuate so much.

Throughout this book, I argue that there are some areas of the market that are not as efficient as Fama suggested (even in his weak-form) because impediments to trading prevent arbitrageurs from closing profitable opportunities. In these markets, it is possible for individuals to devise a strategy that can consistently outperform the market. I also argue that since investors are not always rational, individual investors can take advantage of periods of extreme behavior in the general stock market.

The Treasure Map

Investors who try and outperform the market support their efforts with historical observations that proponents of efficient markets call anomalies. We can think of anomalies as a treasure map because if found to still exist, should point to profitable opportunities that investors can take advantage of. There are three anomalies that are believed to still exist (all three have been observed in both domestic and international markets):

Small Company Effect: Historically, smaller companies have outperformed larger ones[vi].

Value effect or Ignored Stock Effect: Ignored stocks tend to be cheaper[12], and more often than not, outperform ones that are more popular and expensive[vii].

Low Volatility Effect: Recent research[viii] has shown that since 1969, stocks exhibiting less than average volatility have outperformed those that experienced high volatility[13].

The reason these opportunities are not quickly closed by profit hungry investors is because there are impediments that prevent them from doing so. Recall that institutional investors[14] are generally considered “smart money’. This is because institutions are the ones who are believed to take advantage of these profitable opportunities. Well, institutions might be smarter, but many are exposed to regulations, incentives and pressures that prevent them from taking advantage of these anomalies.

Since institutions are unable to close these opportunities, individual investors can. Throughout the rest of the book, we will discuss these exact impediments and how we can take best take advantage. Additionally, as street-smart investors, we will learn to sense extreme behavior and take advantage. By gaining knowledge of the market and being aware of behavioral tendencies, we can give ourselves more opportunities to take advantage of profitable opportunities that due to institutional impediments and irrational thinking, still exist.

[1] The Employee Retirement Income Security Act (ERISA) seeks to protect the interests of employee benefit plan participants by establishing minimum standards for pension, health and retirement plans.

[2] The Individual Retirement Account, or IRA, allows individuals to invest a specific sum of money in all sorts of investments, including publically traded securities such as stocks and bonds. Traditional IRA contributions, which are currently capped at $6,500 per year or less, depending on age, can be deducted from pre-tax income to reduce both state and federal taxes. However, with Traditional IRAs, earnings and withdrawals are taxed at ordinary income tax rate. Roth IRA contributions, also capped at $6,500 per year or less, depending on age, cannot be deducted from pre-tax income to reduce taxes, but earnings and withdrawals are tax-free.

[3] In the United States, a 401k plan is a retirement savings account where contributions (currently capped at $18,000) are automatically deducted from pretax income, reducing the amount investors’ pay on income taxes. The 401k plan differs from the IRA in that it is a profit sharing plan, where employers can “match” a portion of investor contributions.

[4] Nobel Prize-winning economist Milton Friedman is arguably the most renowned American scholar. He is known for his work on stabilization and monetary policy.

[5] A widely used management principle, called value based management promotes that management should first and foremost operate with the goal of maximizing shareholder value. This theory is highly debated amongst scholars and business owners.

[6] Executives are often compensated in three forms: base salary, bonus and stock options. Base salary is the executive’s fixed salary while bonus represents their annual performance figure that is recognized by the board. Additionally, executives and high-level managers might be awarded stock options. These options allow investors to purchase shares in the future at a fixed price. If the stock price rises over the course of an executives term, they can exercise options and purchase shares at a lower price than the rest of the market.

[7] As you may have realized, there is an internal contradiction in this argument. If investors are unable to consistently outperform the market, why is it instrumental that some investors try? If every investor believed that the market is efficient, they would stop trying to beat it, which would lead to markets becoming inefficient once again. The more investors that try to beat the market, the more efficient the market will become.

[8] Arbitrageurs are ones that seek arbitrage opportunities, or buying one asset in one market and simultaneously selling it for a higher price in another. Arbitrage opportunities result in risk-free profit and will occur until prices are equal throughout markets. In efficient markets, arbitrage opportunities won’t be around for individual investors to take advantage. Today, arbitrage opportunities are often closed within seconds through the use of high-speed computers.

[9] A managed mutual fund is a mutual fund that chooses its own investments rather than tracking a specific group of securities (index).

[10] Mutual funds can elect to be declared “diversified” or “non-diversified”. A diversified mutual fund cannot invest more than 5% in any one company (With respect to 75% of its assets) while a non-diversified fund must hold more than 12 securities. Mutual funds can only change their status by shareholder vote.

[11] While teaching at the Booth school of business at the University of Chicago, Professor Eugene Fama published an industry-changing study on market efficiency. Within his report he concludes there are three forms of efficient markets:

[12] In this case, a “cheap stock” refers to one with a below average price-to-book value. Price-to-book value measures how much investors are currently paying for $1.00 of company assets.

[13] Volatility reflects the amount that prices deviate from their historical average. In the stock market, high volatile stocks are those that experience large price swings.

[14] Institutional investors can be a mutual fund, hedge fund, pension fund, endowment, insurance company or large family office.

[i] Stone, C., Trisi, D., Sherman, A., & DeBot, B. (2014). A Guide to Statistics on Historical Trends in Income Inequality — Center on Budget and Policy Priorities. Cbpp.org. Retrieved from http://www.cbpp.org/cms/?fa=view&id=3629

[ii] Bls.gov,. (2001). Sources of retirement income: The Economics Daily: U.S. Bureau of Labor Statistics. Retrieved from http://www.bls.gov/opub/ted/2001/May/wk3/art03.htm

[iii] Burham, K., Bogdan, M., & Schrass, D. (2014). Ownership of Mutual Funds, Shareholder Sentiment, and Use of the Internet. ICI Research Perspective, 20(8). Retrieved from http://www.ici.org/pdf/per20-08.pdf

[iv] “The Origins of Pooled Investing.” 2014 Investment Company Fact Book. Investment Company Institute (ICI), n.d. Web. 1 Feb. 2015.

[v] Chen, Joseph, Harrison Hong, Jeffrey D. Kubick, and Ming Huang. “Does Fund Size Erode Mutual Fund Performance? The Role of Liquidity and Organization.” Does Fund Size Erode Mutual Fund Performance? The Role of Liquidity and Organization (n.d.): n. pag. Princeton University. Web. 24 Jan. 2015. <http://www.princeton.edu/~hhong/AER-SIZE.pdf>.

[vi] Asness, Clifford, Andrea Frazzini, Ronen Israel, Tobias Moskowitz, and LAsse Heje Pederson. “Size Matters, If You Control Your Junk.” By Clifford S. Asness, Andrea Frazzini, Ronen Israel, Tobias J. Moskowitz, Lasse Heje Pedersen. AQR Capital Management, 22 Jan. 2015. Web. 27 Feb. 2015.

[vii] “Market Efficiency, Market Anomalies, Causes, Evidences and Some Behavioral Aspects of MArket Anomalies.” Research Journal of Finance and Accounting 10th ser. 2.9 (2011): n. pag. Web

[viii] Baker, Malcom. “Benchmarks as Limits to Arbitrage: Understanding the Low Volatility Anomaly ∗.” Harvard University (2010): n. pag. Web.