Only Fools Rush In…and Out

In 1957, the news show Panorama on the BBC made and announcement that the mild winter and elimination of the dreaded spaghetti weevil, some Swiss farmers reaping the benefits of a fantastic spaghetti crop. Along with the announcement they had actual footage of people pulling noodles off of trees. Massive amounts of people bought it and they started calling the BBC. They actually wanted to know how they themselves could grow their very own spaghetti tree. Rather than burst the bubbles of these hoodwinked souls, the BBC simply said, “place a string of spaghetti in a tin of tomato sauce and hope for the best.”

This is considered one of the greatest April Fool’s Day hoaxes of all time. The question is how can so many people fall for something so ridiculous? The truth is the active managers jumping in and out of the market can be just as foolish as the people burying noodles in tomato sauce cans.

The stock market follows along a meandering path no one can discern. This is often referred to as the Random Walk Theory. This theory simply states the obvious: Nobody can consistently see what tomorrow will bring. Markets are moved by news. News, by its definition is unpredictable and unknowable. It’s why they call it news and not “olds.” So if the market is moved by news, it means the market is moved by unknowable and unpredictable factors. It begs the question, how can anyone expect to call it in advance?

From 1901 to 1990, the stock market return was approximately 9.5% per year. The SEI Corporation completed a study in 1992 that determined in order to just equal this average (just to equal it mind you…not beat it) a time picker needed to correctly select about 70% of the ups and downs of the market. Any idea how difficult that would be? Let’s take a look at some of the time picking all-stars.

The CXO Advisory Group tracks the forecasting records of market-timing gurus as seen in this table. The best of the gurus has a 63% accuracy rate, still well short of the required 70%. What is most interesting is that the average accuracy rate of all 51 forecasters is a little bit less than 50%. In other words, we could replace the whole group with coin-flippers or dart-throwing monkeys and we would have the same (or maybe even a little higher) level of accuracy. There are two lessons: 1) Don’t waste your time listening to the “experts” since nobody knows what the market will do in the short-term. 2) If the “gurus” cannot successfully forecast the direction of the market, there is zero reason to believe that you can do it, and you certainly should not pay anyone to do it on your behalf.

But there’s more at work against time pickers. Time pickers usually charge clients an annual fee of two to three percent of the value of their investment portfolios. Seems like a high price to pay for essentially nothing more than a paid gambler who bets with your money. The funds also generate short-term taxable capital gains due to the liquidation of fund stock positions to pay off departing shareholders. Enter index funds. Investors can avoid cost-generating, tax-creating moves made by managers and shareholders of active mutual funds by remaining fully invested in index funds at all times. Instead of being distributed and taxed, unrealized capital gains are profits that have not yet been realized for tax purposes. This means you are not taxed on these gains. Unrealized capital gains remain a growing part of the net asset value of a fund’s share rather than being distributed to the investor. The index fund manager minimizes portfolio turnover. This has the beneficial, little side-effect of maximizing unrealized capital gains.

With tax season in full swing, now is a great time to see just how much of your hard earned money you lost due to someone trying to time the market. Will your manager be making Uncle Sam happy? Index funds tend to make Uncle Sam a little down in the dumps.

There seems to be universal agreement among investment experts that time picking is like burying your money in a tomato sauce can. But, it’s not unusual for these same experts to actively tout its merits. Wall Street brokerage firms publish stock picking, time picking, money manager picking, and style picking studies to encourage existing and potential clients to change their investment strategies in midstream. This of course puts more sales commissions into the pockets of these firms and torpedoes more of your gains. Active management is one of the greatest April Fool’s jokes of all time, and most of Wall Street is in on it.

In Burton Malkiel's book, A Random Walk Down Wall Street, John C. Bogle is quoted as saying, "In 30 years in this business, I do not know anybody who has done it successfully and consistently, nor anybody who knows anybody who has done it successfully and consistently. Indeed, my impression is that trying to do market timing is likely not only not to add value to your investment program, but to be counterproductive." Don’t bury your assets in a tomato sauce can, ignoring the scientific evidence that it does not work. Invest in low-cost, no-load index funds…and watch your money grow.

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