By Greg Retzloff
www.workingmansdollar.com

Fund companies continue to post their total return figures in ads, carefully pulling together lists of funds that together compose what looks like a winning team. Morningstar ratings are often paraded along with these return figures as though Morningstar ratings have any real predictive power. Rarely mentioned in these stellar lists are sales fees, fund expenses, trading costs and taxes.

Professional investment advisors and informed individual investors know of the cumulative long-term effect of these costs on the real performance of mutual funds. But often both professional investment advisors and individual investors gladly ignore these costs as though they are just inconvenient reminders of the otherwise exceptional performance of the fund that they either currently own or want to buy.
 
Costs are important – very important! Even the best index funds from companies such as Vanguard and Dimensional Fund Advisors (DFA) have them, and actively managed funds will have added costs because of the expenses associated with active management and more frequent trading. 
 
It is unfortunate that investors are not provided with the cost-adjusted returns of funds in a single figure. These figures make a critical difference in the final investor returns. Neither the mutual fund industry nor the SEC require an actual “investor return” figure demonstrating the return an that investor would have received after all costs are deducted from total-return figures. So-called total-return figures do factor in management fees, but do not generally include trading or tax costs.

For example, the Dodge & Cox Stock fund (DODGX) posted a 10-year total annualized return of 5.51% according to Morningstar. This number factors in the expense ratio, but does not include the tax costs associated with the fund’s trading. The fund’s tax-adjusted return was just 4.04% for that period.

John Haslem wrote an interesting paper in 2006, “Assessing Mutual Fund Expenses and Transaction Costs.” In the paper he proposes an all-inclusive expense ratio that would include the following: regulatory expense ratio (management fees, 12b-1 fees, and other expenses), brokerage commissions, and implicit trading costs (generated by portfolio turnover). Together these would constitute a total expense ratio. This number would help an investor determine the true historical returns of a mutual fund. 

In the Meantime

The single total expense ratio suggested by Mr. Haslem doesn’t yet exist, but there is a good way to get a handle on the historical return of a mutual fund with a figure that does exist.   

The tax-adjusted return figure as provided by Morningstar is close to the actual total return figure we are looking for because it provides us with something resembling actual investor return over time. This figure indicates the total return of a fund less taxes and sales charges. You can find this number on Morninstar.com for a given fund based on three-, five- and ten-year time periods.

A fund that has been a consistent performer and kept costs and taxes low in the past is likely to be a good performer into the future. But, as always, past performance is no guarantee of future results.

Despite the choppiness in the stock market over the past week, large cap stocks are still up more than 50% since the market bottom in March, and small stocks have gained north of 70%. That means a money manager who made some well-timed, risky bets earlier in the year could easily be sporting year-to-date investment performance approaching triple digits. Sales reps fairly fall all over themselves when they come across managers that have those kinds of gaudy gains, knowing they can attract droves of assets by just selling the numbers.

Recently, one of my clients forwarded me an email from a broker who was doing just that. He claimed to have found a new money manager who had generated huge returns this year by:

“…focusing on short-term returns from stocks in beaten down sectors by buying the top 8-10 stocks in the sector when a signal is given, then managing the risk by exiting the position in 4 days if not profitable but holding for as long as 5 days if profitable. The year-to-date return is 70%.” 

I love the part about holding for four days if not profitable and as long as five days if profitable. I guess the 24-hour interim is the manager’s idea of “The Long Term.”

I also couldn’t help but notice this “advisor” is a Certified Financial Planner. I wonder what his financial plans looks like for his clients if five days is the long side of his holding period? If you put that kind of trading activity into your financial planning software it would have about the same effect as putting a fork in a wall socket.

It’s been so long since we had a run of big gains in the market – second quarter ’09 was the first positive quarter in two years – that it’s easy to forget the tactics that the performance hawkers use when times are good. It’s always about the numbers, and it’s always a trap. Remember that these are the same folks who were shilling dot.com stocks a decade ago.

The bottom line is that it’s definitely caveat emptor time in the market again…

Anyway, the iPhone came with an app (FYI, this is what cool people say when they mean “application,” becoz we R busy and don’t have time for 4 syllables) that tracks the performance of the major stock indices. At the bottom of the screen are links to a variety of news stories related to the market and finance, and after a few weeks I began to notice a curious thing about the headlines I was seeing.

Most of the stories were links to generic, market-related articles from well-regarded news sources such as Reuters, Associated Press, etc.  But sandwiched in between, I kept seeing headlines scroll by that were both dire and sensationalistic:

Are We On The Verge of Another Black Monday?

Welcome to History’s Biggest Sucker Rally

Why the Dow Won’t Close Over 10,000

(Ha-ha on that last one, BTW.)

These links always went to obscure web sites that I didn’t recognize. Initially I assumed they were just opinion pieces written by news sites I wasn’t familiar with, and I didn’t pay any attention to them. But one day curiosity got the better of me and I followed the link to the story about how the market was about to take a 90% swan dive. And as soon as I started reading I felt like “History’s Biggest Sucker” myself, because three paragraphs into this “article” about how Armageddon was upon us there was the pitch:

“At my XYZ Fund Timing Newsletter we correctly called the 2008 market crash. Subscribe for just $149 a year and learn how to protect yourself from the even bigger crash to come!”

It wasn’t an article at all – it was an infomercial for a market-timing newsletter. It never ceases to amaze me that people fork over good money for these things, because of the gaping hole in the logic: If the guy knows what the market is going to do and knows how to profit from it, he should be able to make a couple billion dollars just by flipping stocks, right? So why does he need your measly $149?

I assume these are paid-placement links in the stock-market app, but I really don’t know. Maybe the people who compile the links are just gullible enough to think these web sites are legitimate news sources instead of charlatans in journalists clothing. Whatever the case, it was sandwiched right in there with all the legitimate market news of the day from the mainline media.

That is the problem for investors today: In the cyberworld the lines between real media and faux media are fuzzier than a Congressman’s expense report. At traditional media outlets you have editors who double as gatekeepers, but there are no editors on the Internet – only compilers, aggregators and advertisers.

Investors have never had access to more information than they do today, and they have never been more on their own to sleuth out the real news from the faux news. And that is a very precarious situation, because one of the great ironies of successful investing is that too much information is often a bad thing, because investors become overwhelmed and can’t sort out fact from fiction. Real articles from fake advertorials. So they fall victim to the one guy who claims he absolutely knows what to do and where to be. Alas, that is the absolute last guy you want to listen to.

And that’s the way it is in today’s world of mixed media. We miss you, Walter Cronkite.

For residents of North Georgia, though, the most unsettling part of it all was watching our primary water source, Lake Lanier, dwindle day by day, literally going down the drain and evaporating into thin air simultaneously. During the worst of it, in December 2007, the lake’s level dropped 21 feet below full pool, and the Army Corps of Engineers estimated that Atlanta had a three-month supply of water remaining. People in other parts of the country began to tell me they were praying for me when they learned I was from Atlanta. I think when people you don’t know tell you they’re praying for you that’s a pretty good indicator your situation is dire.

Dire it was. The experts said that it would take years – perhaps a decade – to refill Lanier, and that was assuming we got a decent amount of rainfall. Some of the real doom-and-gloomers posited that the South was in a permanently drier climate now and doubted that Lanier would ever again reach full pool.

 “Lake” Lanier in late 2007

I mention this because, over the past week in Atlanta, we have received between 15 and 20 inches of rain, depending on where you live. It has been the kind of rain you would expect to run across in, say, the rainforests of Borneo, but not in Atlanta. The rains spawned an epic flood – perhaps greater than a 100-year flood – in a year that was already well above average in rainfall. Having already come up more than 12 feet this year, Lake Lanier has now come up another four feet in only a week. By the time all of the runoff from this week’s deluge makes its way into the basin, the lake will be almost full.

In less than a year.

Lake Lanier in September 2009

This is a great example of the fallacy of extrapolation; the tendency of layman and expert alike to take the recent past – the known – and project it into the unknown future as if events are already a foregone conclusion. We can see that we are in an epic drought, we can see the implications of that drought, and we project that into the future and see that it will be many years before the lake is back where it needs to be. What we can’t possibly see is that the weather patterns are going to change faster than anyone thought possible and fill the lake back up in months instead of years.

Extrapolating is an innate human tendency, something that tugs on all of our emotions as we try to get out ahead of events, whether to prepare for them, avoid them or profit from them. We look at things as they have been, and as they are, and we convince ourselves that that is how they will be, too. And yet, more often than not, our foregone conclusions are really false assumptions.

The tendency is pervasive in nearly all human endeavors, none more so than investing. (As an aside, that was 558 words before I got the investment angle in – a new Tranquil Investor record!) I have had thousands of meetings with investors over the years, and in nearly all those meetings I have found folks have a powerful tendency to extrapolate the present into the future, and a keen desire to make investment decisions accordingly.

In the past two decades, I have heard that Japan is the only logical place to invest. I have heard that Blue Chips are going to rule the day forever. I have heard that we are in a New Era and earnings don’t matter. I have heard that bank stocks are “safe.” I have heard that the market is broken and we need to get out before we lose what money we have left. I have heard all these assertions and many more, and they all proved to be wrong.

Presently the extrapolation that I am hearing at every turn is that gold is the only logical place to be because the government is printing money left and right, and it is a foregone conclusion that hyper-inflation is not only likely, but actually inevitable.

I am here to tell you, folks, that there is no such thing as inevitable when it comes to investing. An event observed is an event altered. When millions of people begin making investment decisions based on an assumption such as, “We are going to have high inflation in the future,” their very actions begin to alter the event. If, say, a few hundred million people run to gold in anticipation of high inflation, wouldn’t you think that might impact the price, and thus the future expected return, of gold? And simultaneously create value in the very areas of the market that are being shunned?

You can provide me all the foregone conclusions you want, with all your supporting documentation, and you will not convince me that your scenario is inevitable. You may convince me that such a scenario is possible. Maybe even probable. But never inevitable.

And that is an important distinction, because “possible” and “probable” are hardly compelling enough words to bet one’s life savings on. If you need proof, just find someone who bet last year that $200 a barrel oil was “inevitable.”

They can testify for you…

This was the refrain I heard from one investor after another from September ’08 through March ’09. Some folks who said this to me had already bailed out of the market. Others were contemplating it. And in all cases, it was based on the following assertion:

It is clearly so different this time – so much worse, so much more dire – that any fool with eyeballs can see it. And it would be complete insanity to stick around in a stock market that is clearly just, well, broken, when I can save what money I’ve got left and hide out in my money-market fund until there is some evidence that the ship has been righted.

Truly, it all seemed so logical in the emotion of the moment, when the best thing about weekends was that the stock market wasn’t open.

So today, brothers and sisters, it is my great joy to bring you good news! Almost one year to the day after the collapse of Lehman Brothers…

THINGS HAVE OFFICIALLY CALMED DOWN!

I do not base this on mere opinion. In fact, the news today was a veritable cornucopia of items that make the case, to wit:

• The widely followed Empire State Manufacturing Survey’s business conditions index came in at 18.88 in September, the highest level since late 2007, from 12.08 in August. That’s up from a low of -38.23 in March.

• Fed Chairman Ben Bernanke essentially declared the recession over in a Washington Speech.

• The Libor-OIS Spread, a gauge most experts think is the best indicator of credit-market health, returned today to 0.11, its five-year average from the period before Lehman collapsed. (For comparison’s sake, it peaked last October at 3.52)

• The CBOE VIX index of market volatility fell to 23, a level last seen before the failure of Lehman. (For comparison, it peaked at 82 last October, a level best described as “widespread panic.”)

So I think we can all agree that things look a lot better today than the dire straits that drove millions of investors from the market from September through March.

Now, though, for those who bailed out of the market, I am afraid I must also be the bearer of some bad news:

While you were waiting for things to calm down, the Dow Jones Industrial Average gained, from its March 9 low through September 14, let’s see, um…

Fifty percent.

Hold on, it gets worse: The Russell 2000 Index of small U.S. stocks gained…

Seventy-six percent.

It’s not like this took years to unfold. It took, in fact, a mere six months. Six measly months to recover what would ordinarily be a half-decade’s worth of returns. Six skinny months from what conventional wisdom told us was the brink of financial Armageddon to, “Eh, not so bad…”

Thus, while things are calmer, they sure aren’t any clearer for those who bailed out of the market and are wringing their hands trying to figure out when to get back in. In fact, for those on the sidelines, things today are a lot less clear than they were back in March.

So…what to do? If you are one of those folks who is stuck in the mud trying to decide when to get back in the market, my advice is to quit focusing on the market and start focusing on yourself. Don’t worry about where the market is today compared to where it was when you got out and where you are afraid it might be in another six months. That is the mindset that got you into this mess in the first place, and your paralysis will only increase with each passing day no matter what the market does.

Focus, instead, on what your goals are – your long-term investment objectives – and where you stand today in relation to those goals. Perhaps you find that you really don’t need as much growth to sustain you in your golden years as you once thought, in which case you needn’t plunge all of your money into the stock market anyway.

On the other hand, if you still need a healthy dose of stock exposure to achieve your goals, then…plunge away. You may be wrong in your timing – you may well get back in just in time for another downturn – but in the long run you will have removed the single biggest impediment you have to successful investing (your own emotions) and will be back in the market knowing that, sooner or later, you’ll be glad you got back in.

(And you will stay in this time…right?)

“But sir,” said my phone rep, “Greg,” in his lilting Indian accent, “you have been with us for 10 years!” He sounded like I was breaking up with him.

“I know, ‘Greg’, but whattayagonnado?” I said, doing my best Tony Soprano impression. “Something better has come along.” 

“Well what can we do to keep you?” he asked, moving to step #2 in his “What To Do If A Customer Tries To Cancel” procedure checklist.

“Increase my download speed to 18mb a second like I’m going to get from the fiber optic line,” I told him, knowing he had about as much ability to do that as my dog does to meow.

“Well, we can’t do that, but we can increase it from 1.5mb to 3mb a second!” he said, as though coming in at 1/6 the connection speed of fiber optic was going to be a lot more compelling than 1/12.

“Sorry, ‘Greg’,” I said. “I’m cancelling.”

“But sir, you’ve been with us for 10 years!” he said again. “We value our relationship with you and want you to stay!”

I thought back on my deep relationship with my DSL carrier over the years. I couldn’t seem to recall any golf outings, or steakhouse lunches, or gambling trips to Vegas. Heck, I couldn’t even see the thing I was paying them for. The only thing I had ever gotten from them was a monthly bill and an invisible portal to the World Wide Web.

After “Greg” tried the remaining nine steps on his checklist to no avail he finally gave up and put me through to the cancellation department. When I got off the phone I couldn’t help but think of the experience as a lesson in “Creative Destruction” – the notion that companies are at their most vulnerable right when they seem to be at the pinnacle of success. Once a company becomes a world dominator, goes the theory, they lose their edge and appetite for risk – the very things that made them successful in the first place. Inertia sets in, and then new technologies come along that suddenly render them obsolete or irrelevant.

That is certainly the case with my old DSL carrier. When I first signed up with them a decade ago DSL was the hottest thing around – a blazing gateway that blew my old dial-up connection out of the water. The company was one of the darling stocks of the New Economy, poised, it seemed, to dominate the new virtual landscape forever. Now, a scant decade later, their stock price has been sliced by eighty percent and they stand helpless as a new technology is steamrolling over them, unable to offer anything even remotely competitive. They are learning that, when what you offer is a commoditized service, there is no such thing as customer loyalty – only customer inertia.

What’s happening to my DSL carrier is a story as old as capitalism, and it is happening with blinding speed in today’s technology-driven world. That’s why investors today can’t afford to bet their money on the fate of just a few individual stocks, as investors thirty years ago routinely did. No matter what the analysts want us to believe, there is simply no telling who the winners and losers are going to be in any industry in the long term, as investors in such formerly venerable companies as Enron, AIG and Wachovia have found out firsthand. In fact, if you buy into the notion of Creative Destruction, then piling into what conventional wisdom tells us are today’s hottest stocks may well lead us right to tomorrow’s losers.

There is an easy way around this. When you create a broadly diversified portfolio, you are buying, in effect, the global capital markets. You are buying the whole shooting match, and you can sit back and let the phone company and the cable company and the DSL provider slug it out over the years without having to worry about who the winner is going to be, because you own them all, and thousands of other companies in hundreds of other industries to boot. You can let Creative Destruction run its course and not have to worry that, one day, you’ll end up with all your money riding on a company that is stuck with a technology that is heading the way of the VCR.

 Sorry, “Greg.”

“Land values in this area are increasing 20% annually!” said the sign, which then provided a phone number to call for information on how get in on this golden opportunity.

About two miles later I passed another farm with another sign – this one larger, fresher and professionally lettered.

“Farm for sale: 57 acres,” said the sign. “Reduced 50% from original asking price.”

I couldn’t help but laugh at the irony. The story of an epic asset bubble, told in a couple of farm signs two miles apart.

Bubbles are like that, aren’t they? Always so obvious, but only in retrospect.

Every third piece of mail I received in 2006 was a pre-approved credit card or checks for a home equity line I never asked for. I applied for a mortgage in 2007 and when I tried to provide income verification the mortgage broker told me he didn’t need it because it would just “gum up” the underwriting process.

I look back on those days and shake my head, amazed and appalled at the way so many different entities and institutions conspired to create a massive real estate bubble that took the whole economy – and very nearly the whole financial system – with it when it popped. But I only see it now. I didn’t see it then, in real time.

We think we know, but we don’t. In fact, what we think we know is often dead wrong. A year ago oil prices were sitting at almost $150 a barrel, and commodities from wheat to copper to grain were soaring in price. A commodities fund seemed like a no-brainer. And then, out of nowhere, commodities prices suddenly plunged, a harbinger of things to come in the economy.

We think we know, but we don’t.

It is an innate part of human nature that we are massively influenced by the current environment we are in, and by the mass media that reports it to us all day, every day. This is why a disciplined investment strategy is a must – one that is based on long-term fundamentals, and is never, ever altered based on short-term market conditions. That is the one, sure way to navigate through the manic/panic dynamic that is inherent to all bubble events.

It’s how we avoid getting caught up in the group think that plagues investors in every day and age.

It’s how we avoid having to hold a half-off sale for our farm that was increasing in value at a 20% yearly clip when we bought it.

– E.S. Browning, Earnings Uptick Lifts Confidence, Wall Street Journal,
July 20, 2009

Ruh roh. Once again the stock market threw a surprise party and forgot to send out invitations. It can be such a pain that way.

The four weeks after the market’s spring rally peaked on June 12 were a long, slow downward slog. All the optimism seemed to have seeped out of the news reports. The experts told us that sentiment on Wall Street had (cue the kettle drums) turned negative. Economic indicators had stopped surprising us with good news. For every step the market took forward it seemed to take two back the next day. In early July the AAII Index, which measures the investment sentiment of individual investors, hit its highest bearish level since the market bottom in mid-March (let that one sink in for a minute, by the way). The rally was over, we were told. Once corporations began reporting their inevitably dismal earnings in mid-July, the only thing left to debate would be how low the market would go.

As Gilda Radner’s old SNL character “Emily Litella” would have said… “Never mind!”

As the earnings reports began streaming in, one company after another topped expectations. Simultaneously, economic indicators about the credit market and manufacturing activity began showing significantly positive signs. None of it was anticipated, but the stock market could care less. It gained back nearly all of the prior four week’s losses in just five trading sessions. If you blinked, you missed it.

This is the part about investing that escapes so, so many people. Stock market gains come quickly, massively, and unexpectedly. In fact, they often come when you expect the opposite. It is a story as old as the markets themselves. And it is why only the slimmest handful of investors ever obtain the returns that the stock market is trying so desperately to give them.

A few days ago I was in a store looking at smokers (as in meat, not cigarettes) trying to decide on a new model. I developed an interest in the Big Green Egg ceramic cookers about five years ago and it has since blossomed into either a passionate hobby or expensive obsession, depending on whether you are talking to me or my wife.

Anyway, the Muzak in the store was playing “country classics,” I suppose you would say, none of which I was paying attention to until an old familiar song my college roommate used to wear out on our cassette deck came on:

The preacher man says it’s the end of time
And the Mississippi River she’s a goin’ dry
The interest is up and the stock market’s down
And you only get mugged if you go downtown

It was Hank Williams, Jr. singing “A Country Boy Can Survive,” which (the miracle that is Google tells me in 0.37 seconds) was released in 1981.

My first concern was that ol’ Hank couldn’t find a way to make “Interest rates are up” work in the third line. “The interest is up”? What does that mean? I mean – c’mon – mine was right there!

But I quibble.

The thing that really stood out to me about that song was how appropriate Hank’s lyrics could have been today (except, of course, for the high interest rates). In fact, as I dug deeper into the history of the song, I learned it has actually had three different iterations in the past three decades.

Here’s the opening verse from the version that was released in anticipation of the CERTAIN DOOM THAT WAS OTHERWISE KNOWN AS Y2K:

Computer man says it’s the end of time
December 31st 1999
People buyin’ up all the surplus things
Afraid of what the New Year will bring

Seems kind of quaint now, doesn’t it?

And then there was the version that was released after 9/11, which is decidedly more rousing:

People think it’s nearly the end of time
Cause we’re together and we’ve drawn the line
Our flag is up, the stock market’s down
But we’re all united from the country to the town

So what can we discern from the fact that Hank Williams Jr. was able to parlay an apocalyptic song written in 1981 into three different iterations spread over 20 years? (I mean, besides the fact that it must be a seriously catchy tune.)

Three things, I think:

1. Doom-and-gloom is a recession-proof business. If we aren’t worried about today, we’re worried about tomorrow, and there are always plenty of people around to help make sure we’re worried.

2. It always seems worse today, in real time, because we worry about all the unknowns as well as the knowns. In retrospect we can see that Y2K was no big deal and 9/11 was a very big deal. But in real time every potential crisis seems like a big deal.

3. From despair comes defiance, and sooner or later that quality galvanizes us and pulls out of the quagmire. Until, inevitably, we let our guard down, forget our lessons and have to learn them all over again. It is a cycle as inherent to humans as the seasons are to nature.

It occurs to me that Hank hasn’t gotten to the 2008/09 version of “A Country Boy Can Survive,” so I want to go ahead and get my own version down ASAP before he comes around for Version 4.0. So here goes:

Talking heads say it’s the end of time
Cause the budget deficit’s gone sky-high!
TARP & TALF are the words today
And we’re printing tons of money in the U-S-A!!!

Here’s hoping that seems as quaint in ten years as the Y2K version does today…

Anyway, the reason I am so intrigued with this feature is that you can search covers by hundreds of different categories and themes that Time has assigned to their thousands of covers. You may be interested to know, for instance, that Darth Vader has been on more covers (4) than Mother Theresa (2).  It is also interesting to note that “Family Values” has garnered only one cover in Time’s history, but “Sex” has garnered 22 covers.  (I guess this explains why Hugh Heffner lives in a mansion.)

While you can certainly idle away some time fooling around this site, it does offer a practical application for my work as an investment advisor, because it provides some great perspective about how the media makes us believe that every point of time we are in is uniquely dire, yet in the big picture we somehow seem to keep muddling along.

For instance, this cover in 1979 would have had us believe that we were on the verge of a new Ice Age:

So to look at this cover from 2001 you would wonder how we went from Ice Box to Frying Pan so quickly:

And whatever happened to the hole in the Ozone layer (see 1992 cover below)? Did that fix itself, or did the media just get bored with it? Or did our sunscreen get better?

While some stories change, though, many of the media’s obsessions seem to repeat themselves in familiar patterns. Consider these covers from 2008 (left) and 1992 (right):

You’d never have guessed the stock market more than tripled during that span of time (even after the ’08 crash), would you?

And if you think that’s Déjà vu all over again, consider these four covers from (left to right) 1984, 1974, 1972 and 1970:

The point to all this is not to assert that we don’t have real problems to contend with. It’s that contending with problems is a never-ending process in life. But the media can’t sell that premise; they need you to buy magazines and watch TV shows, so every single thing has to be presented as uniquely dire.

So don’t let the mass media fear machine guide your investment decisions, because, after sifting through nearly a century of Time covers, I can assure you that you will never find a comfortable time to be in the market.