Friday, January 4, 2013

A Boring Plan: A Few Lessons From 2012

A Boring Plan: A Few Lessons From 2012

 For the vast majority of investors, index funds or broad-based exchange-traded funds (ETFs) are the best way to invest.  On the whole, active money managers cannot beat a well-constructed index, such as the S&P 500.  The investment results for 2012 only add more evidence that a boring index fund is superior to active investing.  According to Morningstar, the average large cap mutual fund was up 14.95%, while the S&P 500 returned 16.0%.[1]  This is not an aberration.  The S&P 500 has beaten the average large cap manager for every time period over the last decade. 

According to the Wall Street Journal, investors are getting the message.  Through November, they pulled $119 billion out of active mutual funds.[2]  At the same time, they put $30 billion into Exchange Traded Funds and invested more money with firms such as Vanguard ($129 billion) that specialize in low-cost index funds.  As far as I am concerned, this shift is very good news.  I’m hoping that active money managers will finally respond to investors by lowering their fees, which would help those investors who remain with active managers.  Of course, I’ve been hoping this might happen for the past twenty years.

Unusual Portfolios (1999)

While the shift out of active money management is a step in the right direction, Morningstar and the Wall Street Journal are also reporting that investors poured a lot more money into bond funds.  With the yield on 10-year US Treasury bonds below 2% and investment grade corporate bonds at about 2.6%, these investments are unlikely to be attractive over the next decade.  Unfortunately, investors have the bad habit of investing by looking backwards.  While the equity markets have gyrated in the past decade, fixed income has plodded along in the wake of lower and lower interest rates.  Even high yield bonds and emerging market debt, which were buffeted in 2008-2009, have produced solid returns.  As a result, the historic data for fixed income investments look attractive.  However, those nice-looking charts and tables don’t tell us anything about returns in the future. As investors, we should be looking out the windshield instead of the rearview mirror.

What’s the long-term investor to do?  No one knows what 2013 will bring, let alone the next decade.  If you feel compelled to watch CNBC or read the predictions of market experts, do it for amusement, not advice.  The best advice is to stick to a steady long-term plan.  While stocks seem volatile and unpredictable, and bond yields are low, there’s no reason to abandon either.  While as I’ve noted above, there doesn’t appear to be much value in bonds, I know enough to know that I could be wrong.  Rather than pouring all your money into bond funds, and then abruptly shifting to stocks, steadiness is the better course.  To the extent fiscal incompetence in Washington or the Euro crisis keeps you up at night, hold a bit of extra cash (an extra 5% or 10%).  True, cash doesn’t earn anything right now, but it might help you sleep, and there’s some value in getting your rest.  And, if interest rates spike up, or the stock market tumbles, you might just be able to give your portfolio a tiny boost by buying a few bonds or stocks at bargain prices. 

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  1. I remember people whose holdings in bonds (as well as stocks paying high dividends) were severely impacted by rising interest rates in the late 1970s and early 1980s. I don't know that we're headed for 16% annualized rates on T-bills again, but anyone who buys long bonds at this point -- or mutual funds that hold long bonds -- had better understand the risk they're taking.

    1. You're absolutely correct. For nearly 20 years, investors lost money on bonds because they didn't price in enough inflation. Of course in the early 80s, bonds were an incredible value. One of my best investments was a tax exempt NYS MAC bond that had a coupon well north of 10% and was tax exempt. Unfortunately we didn't have much money back then, so it was a small investment.