Weston Wellington from Dimensional Fund Advisors in his latest Down to the Wire commentary has provided a fascinating case study about an unlikely millionaire in the USA reminding us all of the power of compound interest.
The Millionaire Next Door
The Chicago Sun-Times recently reported that Grace Groner, a long-time resident of Lake Forest, Illinois, passed away in January at age 100, leaving a $7 million bequest to her alma mater, Lake Forest College. Although Groner lived in one of the country's wealthiest communities, she hardly fit the profile of a trust-fund socialite. An orphan at age twelve, she was cared for by neighbors and attended college, earning an English degree in 1931. She went to work as a secretary for nearby Abbott Laboratories in Chicago where she worked for forty-three years. She never married, never owned a car, and lived for much of her life in an apartment before moving to a tiny one-bedroom house willed to her by a friend.
Her $7 million estate was the fortuitous result of a lifetime characterized by frugality, simplicity, and a large dose of good luck. She had purchased three shares of Abbott stock for $60 each in 1935, reinvested the dividends, and never sold them. Over the subsequent seventy-five-year period, her three shares multiplied to well over 100,000, and her $180 initial investment grew over 38,000-fold to approximately $7 million.
This story brings a smile to almost everyone's face and offers a number of investment lessons as well.
Compound interest is a wondrous thing over long periods. To turn $180 into $7 million over 75 years requires an annualized return of 15.13%. By comparison, a similar investment grew to $3,046 in one-month US Treasury bills, $389,669 in the S&P 500 Index, and $10,435,007 in US small cap value stocks. (Annualized returns were 3.84%, 10.78% and 15.75%, respectively.) Over the long run, a little extra return goes a long way.
Maintaining an investment strategy requires discipline, detachment, or some combination of both. Ms. Groner had ample reason over seventy-five years to question the wisdom of holding Abbott shares, and by extension, equity investments of any kind. The shares lost roughly one-third of their value in the bear market of 1937, for example, and did not exceed the mid-$50 share price of March 1937 until March 1944. She continued to hold her shares despite plunging stock prices in 1962, 1970, 1974, 1982, 1987, 1990, 2002, and 2008.
In the wake of the recent financial crisis, lecturing investors on the possibility of so-called "black swan" events has become a popular pastime for authors and financial journalists. There is certainly some truth to their observations; as Gene Fama pointed out in his Ph.D. thesis published in 1965, stock returns exhibit extreme outcomes much more frequently than that predicted by a normal probability distribution. Ms. Groner's experience illustrates how some unanticipated "black swan" events can be remarkably good.
Could you recognize a great growth stock even if you owned it? It could be harder than you think. The most striking characteristic of Abbott's share price behavior over the past seventy-five years is how long periods of trendless or below-average performance are punctuated by brief episodes of sensational results. As an example, the 1950s were a rewarding decade for equity investors, and the Dow Jones Industrial Average more than tripled in value. But Abbott shares rose only 22.7%. How many of us would have had the patience to continue reinvesting dividends into an "obvious" loser after such a long drought? The same argument applies to holding an asset class such as small cap stocks or real estate after a prolonged period of weak relative results.
Should we seek to emulate Ms. Groner's success by making a bet on a single company? Probably not, particularly if we are seeking to use our portfolio to fund retirement expenses. Although we may admire her habit of thrift, most of us would have a hard time riding the bus for decades and wearing second-hand clothes while maintaining a multi-million-dollar portfolio. If her investments had done poorly, the loser would have been Lake Forest College, not Ms. Groner's lifestyle.
A major factor in Ms. Groner's success is a happy accident of geography. She was raised in Lake Forest and went to work for a firm in nearby Chicago that turned out to be one of the biggest winners in the entire US equity universe. For the fifty-year period ending in 2009, for example, only seven stocks had higher rates of return: Altria Group, Kansas City Southern, Loews, Walgreen, RadioShack, Dover, and Johnson & Johnson. But if she had chosen to work instead for other industrial leaders of the time such as DuPont, National Steel, or Nash Kelvinator—all components of the Dow Jones Industrial Average—the outcome would have been sharply different.
The moral of the story: Albert Einstein may or may not be the source of the quotation, but it appears that compounded interest truly is the "eighth wonder of the world."
John Keilman, "A Hidden Millionaire's Gift," Los Angeles Times, March 6, 2010.
David Roeder, "One Woman, Three Abbott Shares Equals $7 Million," Chicago Sun-Times, March 7, 2010.
Eugene F. Fama "The Behavior of Stock-Market Prices," Journal of Business 38, no. 1 (January 1965): 34-105.
Center for Research in Security Prices, University of Chicago.
Regulars to this site will know that we favour an approach to investing based on index style trusts. One of the preferred providers of those trusts is Dimensional Fund Advisors originating from the USA. Dimensional offer more than what might be phrased plain vanilla index funds as they incorporate leading scientific research completed by Professors Fama and French in the early 1990s which has been referred to as the three factor model.
This is a major reason for preferring to use Dimensional trusts in our client portfolios. However another significant issue is the approach Dimensional takes to applying their investment philosophy through careful trading.
Jim Parker outlines an element of this approach in a recent article - The Flexible Shopper. Following is a reproduction of Jim's article highlighting Dimensional's careful approach.
March 2010 - The Flexible Shopper
Experienced negotiators know that the balance of power rests with the party who is prepared to walk away from the table. By contrast, those eager to reach a deal often make the biggest concessions. So it is with investing.
A financial market is like a giant electronic bazaar, filled with millions of participants haggling over the prices of individual securities. These people are all driven by varying needs. And that is where it gets interesting.
For instance, index managers who manage portfolios to a nominated benchmark will often sacrifice transaction costs, turnover and price to keep their "tracking error" as low as possible.
At the other end of the scale are managers whose convictions about particular securities can be so strong that they will treat as secondary the prices they pay, the turnover they generate, the transaction costs and the taxes.
In between is a third type, a participant who is neither sweating on matching an index nor infatuated with a particular security. Not pushed to trade, this manager has the advantage of being able to walk away from the negotiation.
This third type of manager is agnostic about one stock over another if both fit the desired characteristics of the portfolio. And with a wide variety of stocks to choose from, he doesn't have to buy a particular security at a particular time.
This gives him great flexibility so he can afford to wait for the market to come to him. In technical terms, he is not compelled to cross the "spread" that separates the highest price that someone is prepared to pay for a security from the lowest price that someone is prepared to sell it for.
This is the approach that Dimensional takes to investing. Being neither an index nor a traditionally active manager gives Dimensional unique advantages in the intense real-time electronic negotiation of global markets.
Those other participants that are compelled to trade are known as "liquidity seekers". This means their sense of urgency about trading a security is such they will pay a premium to "liquidity providers" like Dimensional.
A liquid market is one with lots of buyers and sellers. So naturally, the liquidity premium will be higher in those parts of the market where there are not many participants and where stocks are harder to trade. These are precisely the parts of the market that Dimensional specialises in.
So what is the evidence that Dimensional is earning a premium from its approach to trading? The table below tells the story. It is from in-house research carried out by Dimensional research vice president Sunil Wahal, an expert on market micro-structure. It is a study of all the US equity trades Dimensional made between January 2007 and October 2008.
This shows Dimensional over this period paid on average 15 basis points below the best ask price when it was buying stock and earned on average 13 basis points above the best bid price when it was selling stock. These price improvements were even better in small cap stocks.
The take-out for ordinary investors from all this is that Dimensional's patient, flexible and opportunistic approach to trading — its freedom to walk away from the negotiation — is a real source of added value.
And that flexibility grows out of the firm's investment philosophy. While it does not hold strong convictions about individual stocks based on earnings forecasts, neither is it focused on tracking an index.
Dimensional works with the market, keeping its transaction costs low and using its trading expertise in less liquid stocks to earn a liquidity premium.
SCAMwatch - a website published by the Australian Competition & Consumer Commission - has highlighted 3 top scams to watch out for over the Easter period:
1. Fundraising activities
Easter is often a time for charitable fundraising, especially for children’s charities. Scammers often pretend to work for well-known and well-regarded charity organisations. Scammers may approach people in the street, by knocking on the door, by telephoning or by sending spam emails.
2. Malicious software and viruses
Scammers use bogus emails designed to spread malicious software and viruses onto your computer. Usually this scam involves using catchy titles and headings to entice you to open the email, such as 'your friend has sent you an Easter card'.
3. Bogus holiday and accommodation scams
Easter is a time when many families take vacations. The scammer commonly offers heavily discounted holidays and/or accommodation rates through unsolicited emails and/or telephone calls. This scam usually involves full or significant up-front payments, commonly through cash money wire (which is untraceable).
The site suggests yo employ the following strategies to protect against these scams:
Charity scams:
If in doubt, find the name of the charity yourself and donate directly to them.
Don’t rely on any phone number or website address given by the person who first called, visited or emailed you, because they could be impersonating a legitimate charity. Instead find the contact details of the charity through an internet search.
Never give out your personal or credit card or online account details unless you made the phone call.
If a collector makes a face-to-face approach, ask to see identification.
Malicious software and viruses:
Don’t open up any emails, including links and attachments, if you don’t recognise the email address or the sender’s name.
Avoid questionable websites. Some may automatically download malicious software onto your computer.
Keep your computer protected with the latest anti-virus and anti-spyware software, and remember to use a good firewall.
If you think your computer has been infected, you may need to have the computer checked.
Bogus holiday and accommodation scams:
If it sounds too good to be true, it probably is!
Contact the accommodation provider to confirm the availability of the accommodation.
If you receive an unsolicited call, never provide your credit card details or other personal information. Instead, get the caller’s details and say you will call them back after you have checked the offer.
Index Funds Advisors in the USA provide those contemplating a switch to an Index based approach to investing some excellent resources to consider - www.ifa.com . Unfortunately the material is US based but the same principles are definitely applicable to Australian based investors.
Their latest contribution is a visual presentation posted on YouTube of quotes from experts supporting the approach:
Financial education consultant, Scott Francis, joins Warren Boland on his Weekends with Warren ABC radio program every fortnight. In his latest segment Scott discussed the challenges of buying your own home in current market conditions where house prices are the most unaffordable they have ever been.
Users of our website, through our User Voice feedback forum, have requested that we regularly update the graphs outlining the performance of the Dimensional trusts that we use in building portfolios for clients. In response to this feedback we have updated these graphs to reflect performance up to the end of June 2009.
Commentary:
The graphs show a flat month for all asset classes.
Over the long run, the graphs continue to clearly show the existence of the risk premiums (small, value and emerging markets) that the research tells us should exist:
Australian Share Trusts - 7 Year returns
7 Yr Return
to Feb 2010
Premium over ASX 200
Accumulation Index
ASX 200 Accumulation Index
15.58%
-
Dimensional Australian Value Trust
18.80%
3.22%
Dimensional Australian Small Company Trust
22.41%
6.83%
International Share Trusts - 7 Year returns
7 Yr Return
to Feb 2010
Premium over MSCI World (ex Australia) Index
MSCI World (ex Australia) Index
3.64%
-
Dimensional Global Value Trust
6.80%
3.16%
Dimensional Global Small Company Trust
7.91%
4.27%
Dimensional Emerging Markets Trust
17.94%
14.30%
NB - These numbers are average annual returns for the 7 year period which are slightly higher than the annualised returns.
For anyone new to our website, it is important to point out that we build investment portfolios for clients based on the best available academic research. Take a look at our Building Portfolios and Our Research Based Approach pages for more details. In our view, this research compels us to use the three factor model developed by Fama and French. In Australia, the most effective method of investing using this model is through trusts implemented by Dimensional Fund Advisors (www.dimensional.com.au). We do not receive any form of commission or payment from Dimensional for using their trusts. We use them because they provide the returns clients are entitled to from share markets.
However, academic theory is nothing if it can not be implemented and provide the returns that are promised by the research. Therefore, we like to provide the historical returns of the funds that we use to build investment portfolios.
Please let us know if you have any feedback regarding these graphs by using the Request for More Information form to the right or via our User Voice feedback forum.
The press is littered with commentary about the growing housing affordability problem in Australia. Scott Francis in his latest Eureka Report article looks at some strategies to help break into the property market. He also throws in a brief discussion of whether it might be financially better to rent rather than own.
Jack Bogle is the founder of Vanguard Investment Group and is a vocal proponent on the superiority of index funds for investors. In the USA, Bogle has almost a cult like following. One of those followers is Taylor Larimore is a former IRS officer and retired chief of the Small Business Association's finance division in South Florida. He is co-author of two Bogleheads' books: The Bogleheads' Guide to Investing (Wiley, 2007) and The Bogleheads' Guide to Retirement Planning (Wiley, 2009).
Taylor was recently interviewed with the summary now posted on Morningstar's website. Even though Taylor's comments relate to the US market, they are extremely applicable to Australian investors, especially those who want a simple, no-fuss investment portfolio in retirement.
If you could sum up what you have learned during a lifetime of investing experience, what would you say?
My advice to be a successful investor is this: Save regularly, develop a personal asset-allocation plan, use a few broad market index funds, keep costs low (including taxes), avoid mistakes, strive for simplicity, and stay the course.
I hate to sound like a broken record but some more data has been recently published by Standard & Poor which provides evidence that an index based approach to investing will serve you well.
S & P have started to publish a bi-annual report looking at the investment performance of active managers as opposed to the benchmark S&P ASX200 and MSCI World ex Australia indices - Standard & Poor's Index Versus Active Funds Scorecard - Australia Year End 2009. Their second report has been published this week and provides the following conclusions:
Over a five-year period ending December 2009, respective benchmark indices have outperformed the majority of active funds across the different peer groups covered by the SPIVA Scorecard. In contrast for the 2009 calendar year comparative analysis of the annual returns shows that a majority of active funds have outperformed their benchmark across most peer groups.
The S&P/ASX 200 Accumulation Index has outperformed 63% of active Australian equity funds over a five-year time horizon. Data over one year and three years shows an equal split between active funds underperforming and outperforming the index.
A majority of active Australian equity small-cap funds have outperformed the S&P/ASX Small Ordinaries Index across all time horizons. Most notably, 73% of active small-cap funds outperformed the benchmark index over a three-year period.
The MSCI World ex Australia Index has outperformed 69% of actively managed international equity funds in the last five years. However, the index has outperformed only 24% of actively managed international equity funds over the last year.
There is some cause to cheer for active managers as the results suggest that 2009 was a much better year on average compared to the index. However the 5 year results still show that more than 63% of active funds under-performed over that period. That suggests that the performance from 2005 to 2008 must have been particularly poor.
There has also been some cause to cheer for small company funds showing a strong record over 5 years.
Five years is still not a very long window but you would expect that over even longer periods active managers perform even worse. The latest report is even further evidence that an active approach to investing increases the probability that you will perform worse than the average investor return - i.e. the index.
A Clear Direction's approach is to use index funds as they base and add to that small and value exposures. Over the 5 years these exposures have provided after fee premiums of:
Australian small company exposure1.44% Australian value exposure0.87%
Over 7 years these premiums are even greater.
The results suggest the approach we are employing is positioning client portfolios well above the returns being provided by active managers.
The big players in the investment world continually remind us that it is through their research and expertise that investors will be able to achieve superior investment performance. We are often reminded of this when we switch on the TV or open the newspaper. Sadly the result is far from this with the active management approach often not providing the results investors deserve. (Take a look at Our Research Based Approach report for more details.)
Our goal at A Clear Direction has not only been to work with individual clients to manage their investment portfolios but also provide general educative information about the investment process. One area we have not yet developed is the provision of multi-media information to assist investors with understanding the best approach to investing.
Index Fund Advisors from the United States are continually developing a website which fills this gap. For those who prefer to learn visually they have developed a range of videos and podcasts that are freely available on their website - http://www.ifa.com/ .
One aspect of these presentations is the series 12 Steps for Active Investors which provides 12 clear messages about the problems of an active investment approach.Here is a list of the 12 steps:
Step 1. Active Investors: Recognize an active investor. Step 2. Nobel laureates: Recognise that Nobel Prize winners researched the market. Step 3. Stock Pickers: Accept that stock pickers do not beat the market. Step 4. Time Pickers: Understand that no one can pick the right time to be in or out of the market. Step 5. Manager Pickers: Realize that the winning managers were just lucky. Step 6. Style Drifters: Comprehend active management style drift. Step 7. Silent Partners: Recognize the partners in your returns. Step 8. Riskese: Understand how risk, return and time are related. Step 9. History: Understand the historical risks and returns of indexes. Step 10. Risk Capacity: Analyze your five dimensions of risk capacity. Step 11. Risk Exposure: Analyze your five dimensions of risk exposure. Step 12. Invest and Relax: Invest, relax and stay balanced.
A word of caution, the materials are coming from a US perspective however the general principles are applicable to the Australian context with a few slight adjustments to take into account specific issues here.I am also not a big fan of the drawings used but if you can get over those two aspects the IFA website and supporting videos and podcasts are well worth a look.
