Passive Investing: The Movie

Credit: http://www.flickr.com/photos/cheriejphotos/7158114527/sizes/m/in/photostream/It’s only 2 weeks into 2013 and I’m already swamped! These few weeks are absolutely packed for me, with work guzzling most of my brain fuel, and an upcoming work trip to Beijing. I’m also sticking with my 2013 goal schedule, as well as finding time to work on a free ebook (woot!) that will be making its way here soon, I promise!

So whenever life hits me with a gazillion things to do, I usually take things a little slower, kick back and do something chill like watch a movie. But because I’m a huge financial nerd, I get my kicks watching stuff like Passive Investing – an awesome 54-minute video on passive investing (duh) and why it rocks.

While there’re tons of books and articles written on the subject, I believe that this is the first time someone has made an entire documentary on it. The PF community has already been excitedly sharing it for a month or so now (yeah, I know, I’m a little late in the game.. my bad).

It features some of the biggest, badass (in a good way) names in the index investing industry, such as John Bogle, Kenneth French, William Sharpe, Burton Malkiel, and Rick Ferri. The production is pretty high quality, and there are summaries at the end of each chapter in case you get too distracted by the super strong British-newscaster accent.

So grab some popcorn, snuggle down on the couch, and enjoy 🙂

A caveat: While I agree with most of the concepts presented, I don’t fully agree with everything in the film. One of my biggest bugbears is their assertion that the Capital Asset Pricing Model (CAPM) is the “mathematical foundation of passive investing.” I won’t go into a snooty academic diatribe about the the flaws of CAPM here, but it suffices to say that you don’t need CAPM to hold in order to show that passive investing is still the best way to invest for most people.

Other than that though, the film is excellent. I also love how they display all the logos of actively managed funds throughout the film, subtly dissing the crap out of them without actually naming any names. It’s a little more subtle than my usual practice of pointing and loudly jeering at fund management ads displayed on the subway, causing people around me to move slowly away from me and whisper under their breath. I can only assume that they must be talking about how wise I am.

If you’re looking to learn a little bit more about passive investing but aren’t inclined to read a book, you could totally start here. It could be the most profitable 54 minutes you’ve ever spent. 🙂

Image credit: cheriej

The Great Index Unit Trust Hoax

Whenever I check into a hotel, I get really fascinated by just how crazy expensive some of the items in the minibar are.

One time when I was on vacation, I felt a little hungry so I lumbered over to the minibar and pulled out a pack of cashew nuts – just the regular kind you’d find at any convenience store. Just to be safe, I checked the prices before I tore the pack open, and involuntarily yelled: “NINE DOLLARS FOR A PACK OF TWELVE NUTS?! ARE YOU OUT OF YOUR FRICKIN’ MIND???”

It’s absolutely crazy how people are perfectly willing to pay several times the price for the EXACT SAME PRODUCT – a product that they could have gotten much cheaper elsewhere. We see this everywhere: a Nike sneaker vs a non-branded one, Tropicana orange juice vs a house brand, and beer that costs $12 in a restaurant and $2.50 in the supermarket.

A pack of nuts from the minibar might do a little damage to your wallet, but it’s nothing compared to the damage a unit trust (also known as a mutual fund for my American friends) could do to your long-term wealth.

Costs Matter

I’m not even going to discuss actively managed unit trusts with their high management costs. Nobody takes those seriously anymore – There’s more than enough research that shows that as a whole, actively managed unit trusts are a terrible choice compared to index funds.  Check out here and here.

Today, I’ll just uncover a pricing anomaly I like to call The Great Index Unit Trust Hoax, which involves 2 unit trusts being sold to Singaporean investors. Both charge exorbitant amounts to essentially help you invest in portfolios that you could have easily put together yourself… at a fraction of the cost.

To Infinity… and Beyond!

Exhibit A is the Infinity US 500 Stock Index Fund, which is supposed to help you track the return of the S&P 500. To accomplish this, it hits you with a whopping 0.98% expense ratio.  Now 0.98% may not sound like too much of a big deal, but try compounding that over 30 years and you’re talking about a difference of tens of thousands of dollars of extra cash that’s coming out of your pocket.

But hold on – there’s another, cheaper way for you to track the return of the S&P 500 on your own. You could buy an ETF from Vanguard, which gives you the EXACT SAME RETURN, while charging a mere 0.05% expense ratio. This makes the Infinity unit trust almost 20 TIMES MORE EXPENSIVE than the Vanguard ETF. Yeah, I know.

Home Sweet Home… For 4x The Price

Okay, I hear you say, so maybe that’s a problem unique to the USA.

Oh wait, it’s not.

Presenting Exhibit B, the patriotically-named unit trust MyHome Fund run by Singaporean asset management company Nikko AM. It invests in 1) an ETF tracking the Straits Times Index and 2) the ABF Singapore Bond Index Fund ETF. They’ll charge you a ridiculous expense ratio of 1.2% for all their hard work.

But wait! Did you know that you could totally log onto your online brokerage and invest in 2 ETFs which track the EXACT SAME THING for a fraction of the cost? Namely:

1. SPDR Straits Times Index ETF (SGX Ticker: ES3) – Expense ratio: 0.30%

2. ABF Singapore Bond Index Fund ETF (SGX Ticker: A35) – Management fee + trustee fee: 0.20% (I couldn’t find an exact figure for the total expense ratio on their website – those sneaky bastards – but it shouldn’t  be too far away from the sum of these 2 fees).

Total weighted expense ratio: 0.28%

Ta-daahh! You’ve constructed the exact same product, at a quarter of the cost. And that’s not taking into account sales charges, redemption charges, front-end charges, admin charges, and hire-an-attractive-banker-to-convince-you-to-part-with-your-money charges.

Do Yourself a Favor

My point here is to always, always, read the fine print. The finance industry loves to play down details like these because it means higher commissions for them – commissions that come right out of your pocket.

If you plan on investing passively, do yourself a favor and skip out on the unit trusts. You’re way better off buying the equivalent ETFs instead. Of course, there are a few disadvantages in buying ETFs (eg brokerage commissions, currency exposure, inability to invest in small amounts), but they can be easily circumvented (eg investing regularly using no-minimum commission brokers,  or in the case of the STI ETF, setting aside an amount every month until you can afford one lot). None of the disadvantages of ETFs justifies the tens of thousands of dollars you’re giving up in expenses if you invest in unit trusts.

It would be totally awesome if a reputable fund provider like Vanguard would set up an index fund in Singapore (are you reading this, John Bogle?), which would eliminate all the disadvantages in the para above, and yet charge a reasonable expense ratio that doesn’t require us to give up our first-born child.

In the meantime, stay smart and read the fine print. Save your money for those overpriced cashew nuts from the minibar. At least they’re tasty.

The Top 10 Investor Errors (And How You Can Overcome Them)

Have you ever checked out the finance section of your local bookstore? That’s usually the first place I zoom into, because I’m nerdy like that. The first thing you usually see is a SEA OF PURPLE in that hugeass shelf of Rich Dad, Poor Dad books. Don’t ask me why, but the gaudiness kind of turns me off. And then there are the shelves and shelves of books on awesome investment strategies: value investing, day-trading, swing-trading, volatility arbitrage, investing in wine/land/oil/Oompa-Loompa sex slaves..

For the amount of ink that’s been spilled to write about these sexy strategies, the hard truth is that 90% of investors will never be successful at any of them, because of their own inherent biases.

Barry Ritholtz wrote this great article on the Top 10 Investor Errors which I thought I’d share with you. If you’re just starting out in investing, or are thinking of doing so, I highly recommend that you read it – it’ll put you ahead most investors who don’t have a clue about the game that is being played around them.

The Top 10 Investor Errors:

1. High Fees Are A Drag on Returns
2. Reaching for Yield
3. You (and your Behavior) Are Your Own Worst Enemy
4. Mutual Fund vs ETFs
5. Asset Allocation Matters More than Stock Picking
6. Passive vs Active Management
7. Not Understanding the Long Cycle
8. Cognitive Errors
9. Confusing Past Performance With Future Potential
10. When Paying Fees, Get What You Pay For

At the risk of sounding like I’m under the influence of Error #8 (Cognitive errors – one of which is: “We selectively perceive what agrees with our preexisting expectations and ignore things that disagree with our existing beliefs.”), I’d like you to consider that a passive, low-cost, index-based, diversified and automatic (PLIDA) investment strategy will help you to overcome 9 out of 10 of these errors – pretty much everything except error #10 (because you don’t need to pay for a financial advisor). Check out my previous posts on investing if you need a quick refresher on a PLIDA strategy.

So how will PLIDA help you to be more baller than 90% of investors out there?

1. Investing in low-cost ETFs is – by definition – a low-cost strategy, which eliminates errors 1, 4 and 6. “Fees are an enormous drag on long-term performance… Typical mutual fund or adviser fees of 2 to 3 percent may not sound like a lot, but compound that over 30 or 40 years, and it adds up to an enormous sum of money.”

2. A diversified portfolio of index-tracking ETFs will take care of your asset allocation for you, eliminating errors 2, 5 and 7. When you’ve got a good mix of assets (say stocks, bonds, and real estate, diversified geographically), at least one of them will perform well at any given point, regardless of whether you’re in a bull or bear cycle.

3. An automatic investment strategy of dollar cost averaging, (investing the same amount of money at regular intervals while ignoring the price) will let you overcome the cognitive biases of trying to time the market, eliminating errors 3 ,8 and 9. Here, you don’t care about whether the stock market did well or whether the Fed is going to raise interest rates or what Ben Bernanke had for lunch today. You would calmly and surely stick to your strategy of investing, buying more when others are fearful (and prices are low) and less when others are greedy (and prices are high).

Meanwhile, back at the bookstore…

Go back to that finance section at the bookstore and try to find a book that’s written about PLIDA. Chances are, you won’t find that many. Not many people care to learn about the one strategy that offers them the highest chance of success. Instead, they prefer to bury themselves in their copy of Make Big Money And Retire Early By Investing With Covered Calls, and continue to delude themselves. How about you?

Why Whole-Life Insurance Is Like Picking Your Nose

There are some things that I would never pay someone to do for me. Like brushing my teeth. Or reading. Or organizing my iTunes library. Or picking my nose. Even if there was someone offering  these services on Craigslist, I wouldn’t pay him a dime because 1) he’s probably expensive as hell and 2) he would probably do a shitty job. Like I have serious doubts that a Professional Nose Picker would be able to offer as much nose picking satisfaction than what I would have been able to do myself.

Now think of an insurance company as a dentist offering additional professional nose picking services on the side. I’d pay him to protect my teeth – that’s his job. But hell to the no on the nose-picking services. He’d be expensive, and I could totally do it way better if I did it myself.

Whole-life insurance plans (also commonly known as “investment-linked plans”) is kind of like a professional nose-picking service. My insurance company’s job is to protect my family against the risk of a huge anvil plastered with the words “ACME” falling on my head. But it has no business poking its head in my investments, which should be growing as time goes by so that I can buy my own badass anvil protection.

But the sad fact is, most insurance agents are incentivized to sell you whole-life investment-linked plans, or a similarly pricy product. The result? Most Singaporeans blindly listen to them, because we assume that they’re “professionals”.

But the professionals may not always have your best interests at heart (Think of all the doctors who prescribe unnecessary -and costly- treatments because it helps to line their pockets, but that’s another rant I have altogether). There’s a better way to do this: Buy Term and Invest the Rest (or BTITR for short, because Singaporeans love acronyms).

So why BTITR?

1. It’s simple

Term insurance is the simplest form of insurance that exists. You pay monthly/annual premiums for a period of time, and if you die/get injured/get killed by Loki’s Chitauri army before the Avengers save you, your insurance company pays you a helluva lot of money. It’s simple – you’re not mixing your savings, or investments, or speculation, or livelihood, into your protection needs. Contrast this with whole-life insurance, where you have to worry about where you’re gonna invest your premiums, how your funds are doing, and argue with your agent on the administrative fees. Way too complicated.

2. It’s cheap

The premiums for term insurance are often around 10x less than those for whole-life insurance. You’re paying for the simplest protection needs – so there really isn’t much administration that needs to go into servicing your plan, which translates into a cheaper premium.

Tan Kin Lian (presidential candidate that got an embarrassing number of votes at the last Singapore presidential election, but gives really good financial advice on his blog nonetheless) estimates that you would pay only $10,800 over 30 years for term insurance, compared to $180,000 over 30 years for a whole life insurance plan with the same coverage. This table also compares how much cheaper your premiums will be for term vs whole life.

3. You get way better returns by investing on your own

This is my favorite part. Instead of spending a bomb on whole life insurance, buy term insurance instead, take the amount you saved and invest it in a low-cost index fund.

Using conservative assumptions, Tan Kin Lian shows pretty decisively that you would end up with more money by investing on your own instead of relying on an insurance company to invest on your behalf. To give you an idea of the figures, you’d end up with around $390,000 if you’d invested on your own after 30 years, vs approximately $270,000 if you’d relied on the insurance company to invest for you. And the difference is even greater if you extend the coverage period.

Why the difference? The key is that 15-20% of your premiums go into administrative fees and commissions for servicing your account in a whole-life insurance plan. And for the remaining 80% that does get invested into unit trusts (or mutual funds, as they call ’em in the US), you’re charged an annual “management fee” of 1-2% of your funds. After all of these fees, your whole-life insurance plan should return approximately 2.5% per annum, if you’re lucky. Contrast this to the return of an index fund like the STI ETF, which should return at least 5% per annum even if you’re conservative. The difference between 2.5% and 5% may seem puny, but extend that outperformance to 30 years and that translates into a whopping $120 grand.

So don’t be a pansy. Buy term and invest the rest, and have fun picking your own nose.

How Not To Suck At Investing

Here’s the problem about investing – we know that it’s good for us, but most people suck at it. We all have an uncle somewhere who lost his entire retirement savings by betting on Asian stocks in 1997, tech stocks in 2000, or financial stocks in 2008. He held on to his portfolio as the market plummeted, losing thousands of dollars every day, until he couldn’t take the pain anymore and got out.. only to see the market climb back up again. On the flip side, we see research that says individual investors pulled more money out of the stock market…. only to watch the Dow march higher and higher. (as reported in the WSJ)

There are thousands of reasons why people suck at investing – behavioral biases, having way too many choices, overconfidence, etc – but I think the number one reason is that people just have the wrong idea of what investing actually is. Here’s what runs through most people’s heads when someone tries to talk to them about investing: “Investing… how to get rich! Picking stocks. What stocks do I pick? Maybe Facebook. Or Apple. Hope the price rises by like 10x next year and I’ll be RICHHHHHH. Ca$$$h money baby!!” Zomg. Kill me now.

Newsflash dude: Investing isn’t about picking stocks. I’ll say that again: Investing isn’t about picking stocks. Now say it to yourself three times every night before you go to sleep.

Okay I’m hearing the crowd of angry “investors” outside my door, armed to the teeth with pitchforks and torches right now: What?! It’s not about picking stocks?  But Warren Buffett, the world’s greatest investor, says we should pick good businesses at cheap prices, and hold them till like, FOREVER. And then we’ll be rich!! True, you could totally do that successfully… if you were Warren Buffett. He owns Berkshire Hathaway, a company of full-time, well-trained researchers and analysts who spend their entire careers searching for good companies to buy. He has contacts with Fortune 500 CEOs and can meet with them whenever he wants. He understands things about the businesses he buys that no individual investor can even dream about. Now if you think that simply picking up a book entitled “How to Pick Stocks Like Warren Buffett” and flipping through a few annual reports is going to make you a superstar investor… think again.

So investing isn’t about picking stocks. Rather, it’s about putting your money in assets that will grow over time and will generate an income for you. That’s it. Sure, you could plough your money into Facebook or Apple or whatever the hot stock is at the moment, but is there a chance that it could plummet to zero in 10 years? Of course. Companies fail all the time – all it takes is one CEO scandal, one accounting fraud, one new player on the market (think about what Google did to Yahoo), and your company, once the darling of all the investment pundits, is filing for Chapter 11. I’m not saying that individual stocks are bad investments – of course there are many that have a long history of excellent returns – but there’s another asset that provides awesome returns, with way lower risk than any single high quality stock you can find out there. It’s called the stock market. (cue dramatic music – bom bom bomm!!!).

Think about it – companies fail all the time, but it’s impossible for the stock market to go to absolutely zero, unless we get annihilated by a huge alien spaceship, in which case you have bigger things to worry about. The stock market literally comprises of thousands of stocks, and thus for it to go to zero would involve all the companies in it to go bankrupt – ie: extremely unlikely. Remember back in Finance 101 when they used to tell you that diversification is the key to successful investing? Well, buying the entire market effectively diversifies away the risk of any individual company. It’s not entirely riskless (to my financial nerds out there, you still have “market risk” to deal with), but it’s a whole lot less risky than owning any particular stock.

Another thing – the stock market has an impressive track record that’s freakin hard to match. I can’t think of any individual stock that has been around for the entire duration of the stock market’s 200-ish year old history, with a historical return of 7 – 9% per year, depending on who you talk to.

Okay, I’m hesitant to make the ginormous claim that the stock market always goes up – there have certainly been periods where the stock market has fallen, or stayed stagnant – but give it sufficient time (10, 30, 50 years-ish), and there’s a pretty high chance that it is likely to go up. Why do I think so? Three reasons:

1. Inflation – For most developed economies, prices rise. I don’t think we’re going to go back to those times where McDonald’s serves $5 extra value meals 24-hours a day. (no, those lunch hour deals dont count – I swear they cut the patties in half). Prices of things rise over time, including the prices of your stocks.

2. Survival – the stock market will always be comprised of awesome, solvent (ie: non-bankrupt) companies. If a company goes bankrupt, its stock is automatically removed from the stock market index, and replaced by another. Crappy companies get cut out, and replaced by better, sexier companies. Apple may be the most valuable company in the world right now, but in 30 years it could be bankrupt, and replaced by another trendy company where its fashionable for top management to wear tight-fitting black tees. Owning the stock market index ensures that your portfolio always comprises of the best companies in that market. It’s like being able to fire that one douchey, useless employee in your company, without the guilt or death threats.

3. Population growth – Let’s face it, even with the explosion of investable assets today, stocks remain the de facto investment vehicle of choice to most investors. They aren’t as sexy as fixed income or exotic options (I believe the job posting of “equities in Dallas” is still a laughing stock in the IB world), but nothing trumps the liquidity, the ease, and the transparency of the stock market. And as the world gets larger, more educated, and richer, guess where’s the first place they’re going to plonk their money into? That’s right – the stock market. And Economics 101 teaches you that as demand rises… so will the price.

Notice that everything I mention here is about really large, long-term macro trends. In all likelihood, prices will rise, good companies will replace bad ones, and the world population is going to get larger. I haven’t even talked about the number one economic reason why I think the stock market will rise: Because it’s comprised of businesses. Hundreds and thousands of businesses that earn more every year, year after year. Essentially, buying the stock market means putting your money behind the fact that business will continue throughout the world. And in my opinion, that’s a pretty strong bet, discounting the scenario that the world dissolves into anarchy and we all degenerate into Fred Flintstones. (Always wanted to try those cars with no floors that let you walk everywhere)

So how would you be able to own the entire stock market? It used to be ridiculously expensive to own the entire market because you would have to buy thousands of shares, but now you can do it with a low-cost index fund or ETF (but I’ll leave that for another time).

But don’t take it from me, take it from Warren Buffett, who mentioned that a low-cost index fund, is probably “the best investment that most people can make.” So you may not be able to invest like him, but you sure as hell could take his advice. Think about it 🙂

Should I Buy 16 Exxon Mobils, or a Lump of Gold?

Everyone’s caught up in the gold bug these days. They see the meteoric rise in gold (check out the chart below) and their palms get all sweaty, they start breathing heavily, and they yell “GOTTA HAVE THAT AWESOME SHINY STUFF, AHHHHHHHH!!” Gold has risen a whopping 500% since 2000, especially during the last couple of years when everyone got really scared that the world was coming to an end. (I never got the logic of that: the world is coming to an end, and you think a piece of pretty shiny metal is going to save you?)

Even my dad, who got me interested in finance in the first place, turned to me really seriously one night and said “Gold should be an essential part in everyone’s portfolio”. He cited numerous convincing reasons: it’s an inflation hedge, the US dollar is falling, it’s the world’s ultimate reserve currency, etc etc. I didn’t really know how to respond to that at the time – it’s really easy to get swayed by complicated, convincing arguments on why you should buy gold, or junk bonds, or tulips, or Moroccan camels.

And then I came across this awesome article in Fortune Magazine written by Warren Buffett, the world’s greatest investor. It’s an adaptation from his upcoming shareholder letter – if you’ve taken a basic Finance 101 class, you can totally appreciate the obvious, simple truths in it. I loved this one particular analogy:

“Today the world’s gold stock is about 170,000 metric tons. If all of this gold were melded together, it would form a cube of about 68 feet per side. (Picture it fitting comfortably within a baseball infield.) At $1,750 per ounce — gold’s price as I write this — its value would be about $9.6 trillion. Call this cube pile A.

Let’s now create a pile B costing an equal amount. For that, we could buy all U.S. cropland (400 million acres with output of about $200 billion annually), plus 16 Exxon Mobils (the world’s most profitable company, one earning more than $40 billion annually). After these purchases, we would have about $1 trillion left over for walking-around money (no sense feeling strapped after this buying binge). Can you imagine an investor with $9.6 trillion selecting pile A over pile B?”

Would you? I wouldn’t.

Today, you can put your money into hundreds of investments – A colleague complained to me once that there are just “waaaaay too many choices out there” – How do you choose? Personally, I find it a lot easier to make sense of the whole mess by taking Warren’s advice and looking at all the investment assets in the world as just three types:

1. Currency-denominated assets: Think bonds, money markets, CDs, or your simple POSB savings account. These are supposedly the “safest” kinds of assets to invest in, but you’re really losing money every day because of inflation.

2. “Bigger sucker” assets: Assets that never produce anything, but are purchased with the hope that another buyer will pay more for them in the future. I call these “bigger sucker” assets. Gold falls in this category, along with oil, internet stocks in the early 2000s, silver, cattle, lean hogs (no, seriously, you can invest in them), art, wine, country club memberships, and tulips during the 17th century. You buy them, and after the price rises, you can sell them to a bigger sucker who will pay more than you did. And yes, houses fall into this category too, if you don’t rent them out.

3. Productive assets: these are assets that produce more and more cash flow as time goes by. Think businesses (which produce earnings), stocks (a proxy for owning businesses since they pay you dividends), real estate (which earns you rents), factories, farmland, etc. Sure, the economy is pretty shitty right now, but is the Coca-Cola company going to stop selling Coke, or is P&G going to stop selling shampoos? Doubt it.

No prizes for guessing the best type of investment to put your money in. Hint: it’s not number 2, or whatever assets that’s hyped up at the moment. It could be tulips in the 17th century, or gold today, or Hello Kitty paintings in the Baroque style in the year 2050 (gawd, I hope not). Investments make a lot more sense when you just focus on the basics: when you invest in something, does it actually produce anything? Will it earn an income for you? If it does, you’re probably on the right track.

To my knowledge, there’s only one type of asset that has stood the test of time with 200 years of history, will allow you to invest in real, tangible productive assets, and is still doing amazingly well today. Ladies and gentlemen, stocks are the clear winner in this race. Name any other asset, and I’m willing to bet that they don’t have as long, or as awesome, of a track record as stocks have had.

Could gold outdo stocks in the next couple of years? Sure. But I’m pretty sure that a lump of gold the size of a baseball infield is not going to be more valuable than 400 million acres of farmland and sixteen Exxon Mobils in the long run, no matter how pretty it is.