Firm Grasp of the Obvious Week at WSJ

Yesterday Wall Street Journal columnist Brett Arends reported that from 1995 you would have been better off in a money market fund than the stock market. Apparently the meaning of the Dow hitting a twelve year low took a while to sink in. Arends also tells us that “Thanks to inflation, investors have lost ground simply if they haven’t gained it.”

Today Jason Zweig picks up the theme with a column entitled “After the Crash, Stocks May Face Long Road Back; History Suggests There’s No Guarantee of Quick Rebound; Buy and Hold — for Decades?” Zweig reveals the not at all shocking truth that just because the stock market went down a lot in the last year or two that does not mean it will necessarily go back up a lot in the next year or two.

He cites a soon to be released report from a professor of finance saying that the expected time that it will take the Dow to regain its 2007 high is nine years. That is, it has an equal likelihood of getting back to its peak after 2018 as before. Zweig says that this “shocked” him. Really? In round numbers the stock market is down 50% from the peak, so getting back up requires a gain of 100%. If you are a little pessimistic and assume an 8% average return from stocks, that will take 9 years. If you think 10% sounds right, then it will take about 7 1/2 years.

There is a powerful psychology of denial that affects many people, personal finance columnists at national newspapers included. The numbers on the 401(k) statement in early 2007 just seemed so real and substantial that it is hard to acknowledge that today’s much lower numbers are just as real. People tend to expect a V pattern in stock prices, that a few really bad years are inevitably followed by a few really good years.

The stock market doesn’t work that way. It can’t. It’s like a law of nature. The market cannot let itself be so easily predicted. Knowing what happened one year tells you (almost) nothing about what will happen the next. Since 1871 the stock market (as measured by the S&P 500) has had 38 down years. Excluding this year, the average return the year after losing money is +11.63%. The S&P has also gained more than 20% in a year 38 times. The average return in years following big gains is +12.27%.

There is obvious incredulity in the question “buy and hold — for decades?” But the straightforward answer is “Yes, of course.” Did you think that you could guarantee fat stock market returns if you were willing to stick it out for five or ten years? You can’t, and that’s something that all stock market investors, and all Wall Street Journal columnists, need to know.

Amex Paying Customers $300 to Go Away

There’s much buzz in the blogosphere (e.g. here, here, and here) about the latest from American Express. They have offered certain of their customers $300 if they will close and pay off their credit card accounts by April 30. (Are there other businesses that will pay me not to do business with them? I could use the money.)

What is going on here? Amex is letting the accounting tail wag the business dog. They feel pressure to reduce their book of consumer debt. Investors are very worried about financial companies that are overly leveraged with too many (possibly bad) loans to consumers. Bribing some customers to beat it addresses this problem because it will reduce both the total that Amex is owed and the total that its customers could borrow. Amex may also be targeting customers with low credit scores or other characteristics of which investors are particularly leery.

Does this make good business sense? Not even close. Imagine separating credit card customers into two categories. Group A is made up of those willing and able to pay off their balance in 60 days in exchange for $300. Those in Group B are either uninterested or unable. Everything else being equal, with which group would you rather continue to do business? Amex has concocted a scheme that efficiently and expensively drops the customers it need not worry about and keeps the ones that might have trouble paying what they owe. Brilliant.

Does this mean that the people who run Amex are idiots? Not necessarily. They are probably acting rationally and making what are, from their point of view, sound economic decisions. Wall Street wants them to improve their balance sheet and will pay them to do this, in the form of a higher stock price and lower borrowing costs. From this, the managers of Amex can do the math and work out that paying some customers, even relatively good ones, to get lost is profitable. The fact that this ought not to be the case, that the markets should not be rewarding Amex for doing something that actually harms itself, does not enter into the calculation.

This scheme may not be the ideal implementation of the lose customers to improve balance sheet strategy, e.g. I have trouble believing that offering everybody the same $300 is optimal, but it’s not a sign that the folks at Amex have lost their marbles. It is, however, a sign of the times. We currently live in a world where the appearance of improving a balance sheet outweighs the substance of shrinking a business.

Carnival of Everything Money

My post on house prices appears in this weeks’ Carnival of Everything Money hosted by The Penny Daily. Obviously, loyal readers of this blog have already read the house prices post and likely printed it out to stick on the door of their refrigerator. But the carnvial contains many other interesting items from other bloggers that even my most devoted fans might enjoy. Go on, give it a try.

More on ETF Fees

I’ve been meaning to do a follow up on the costs of ETFs vs. open-end index mutual funds. My post from February 5 on why ETFs should probably not be the mainstay of your investment diet has inspired interest (much to my surprise it continues to be one the most popular posts here) and a little bit of controversy.

To summarize what I said three weeks ago, the pecking order of low cost for investors is: open-end index mutual funds (best), ETFs, and then open-end active mutual funds (worst.) You will often see ETFs touted as being low cost, and relative to active funds this is certainly true, but the typical investor will do even better in an old-style index mutual fund.

For a change of pace, I thought I would gather some actual data to make my point. Yahoo Finance has a useful list of the largest ETFs. Let’s look at the five biggest, which together account for about a third of all the money in ETFs.

One of the five, at number 3, is a special case, the streetTracks Gold Trust, which strictly speaking is not really an ETF at all. It represents simply the ownership of gold bullion, and Yahoo informs us that it is not registered as an investment company under the 1940 act, which means that it is not a mutual fund. Apparently as a side effect of this, Yahoo does not list an expense ratio for it, so it’s not clear what the fees are. I am going to set this one aside, but I cannot resist remarking what a sign of the times it is that gold is in the top 5.

Numbers 1 and 5 are virtually identical S&P 500 ETFs, the giant SPDR Trust (SPY) and the Pepsi to its Coke, the iShares S&P 500 Index (IVV). Yahoo tells us that the expense ratio, i.e. annual fee charged by the manager, for these two is 0.08% and 0.09% respectively. Fidelity has a pretty big S&P 500 fund, the Spartan 500 (FSMKX) which charges 0.10% and, for investments over $100,000, the Spartan Advantage 500 (FSMAX) which charges 0.07%. Even a precision freak like me will concede that all these tiny numbers are practically the same.

Number 2 is the iShares MSCI EAFE Index (EFA) which charges 0.34% in fees. You can get the same thing from the Vanguard Developed Market Index (VDMIX) which charges only 0.22%.

And at number 4 we have the iShares Emerging Markets Index (EEM) which charges an impressive-in-a-bad-way 0.72%. Vanguard will charge you 0.37% for it’s Emerging Stock Index Fund (VEIEX) or only 0.25% if you have more than $100,000 in the Admiral version (VEMAX). Note that both Vanguard funds have a 0.25% transaction fee to invest or sell.

So from this sample, based only on management fees, you might conclude that ETFs are mostly the same, or sometimes just a little worse than open-end index mutual funds. But with ETFs, you still have more costs to consider. ETFs trade like stocks, which means that you need to pay money to buy them and sell them. You will pay your broker a commission, you will pay the bid-ask spread, and you will pay both of these things twice, on your way in and your way out. These additional costs (shouldn’t be) huge, but they do count and are more than enough to tip the balance in favor of old-school index mutual funds.

As I wrote in the previous post, ETFs do have their role. There are things you can do with them because they are stocks that you cannot do with an open-end fund, such as buy on margin and sell short. And there are some peculiar things that actually are cheaper as, or even available only as, ETFs. Gold might be an example, if only I could work out what that ETF charges. The Nasdaq Composite ETF (QQQQ) is another because there are so few open-end funds that bother tracking it. You might also just enjoy trading your ETFs more than investing in open-end funds. But if you want to know which will, in the long run, make you more money, the answer is open-end mutual funds, not ETFs.

Carnival of Personal Finance

My recent post on IRAs is in this week’s Carnival of Personal Finance, hosted at Broke Grad Student. The host has included YouTube videos for much needed comic relief. Click and enjoy!