“How a Second Grader Beats Wall Street: Golden Rules Any Investor Can Learn” by Allan S. Roth
Published 2011 by Wiley
Pages: 304
ISBN-10 : 1529063108
Date Finished: April 20, 2022
How strongly I recommend it: 7/10
Find it at Amazon or Bookshop.org
I heard about this book from a finance podcast. It’s a bit outdated and repetitive at times but overall was a solid read on investment fundamentals. What it reinforced for me was the importance of assets location and how it can effect your tax liability. Basically, I’m moving REITs and bonds out of my taxable brokerage account and into my tax-advantaged accounts like a Roth or 401(k), while leaving the low-cost index funds that are more tax efficient.
My Notes:
Of course, there is much more to this book than simply talking about three funds. There are alternative funds to use as building blocks that have lower costs and eve more diversification. These are some risky asset classes that may actually decrease the overall risk of our portfolio. If you are willing to do just a little work, you can even replace the bond fund and bump your return while lowering risk. Finally, there are some things you can do with this portfolio that will increase return no matter what the market does.
Successful use of this book means increasing your returns by 3 to 4 percent annually.
An important item to note is that Kevin's advantage isn't dependent on whether the market goes up or down; it's dependent only on the difference in expenses that he is paying versus the Wall Street average expense.
A fellow by the name of William Sharpe, the winner of the 1990 Nobel Prize in Economics, wrote a famous paper called "The Arithmetic of Active Management." In it Sharpe states, "Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs." He also notes that the proof is "embarrassingly simple."
It seems intuitive that paying a professional investor to pickc the right stocks and mutual funds should add value. The logic goes that someone who constantly studies the market should be able to outperform individuals who "play" the stock market. This might have been actually true at one time when there were but a handful of professional investors, and stocks were largely owned by individuals.
Today, however, 80 percent to 90 percent of the stock market is owned by professionals such as pension plans, mutual funds, and insurance companies. Information flows much more freely and instantaneously, thanks to the wonder of the Internet. Anyone can listen in on a company's earnings report, rather than just a few selected analysts as was the case in the past.
If we take a step back, we realize it all comes down to paying our professional more and more money in the hopes that he outsmarts someone else's professional. It's a flawed model...
They have no idea how much they are paying for their portfolio. When you look at the costs of your portfolio, such as the expense ratio of your mutual funds, and then throw in some hidden trading costs, you'll discover the painful reality that most people are needlessly paying thousands of dollars a year for their portfolio.
So, the investors who believe that they can pick stocks, or at least pick a professional who can pick stocks, better than the average Joe, fill an important need. Without these poeple trying to disprove arithmetic, markets wouldn't work, and the low-cost investor couldn't get a free ride off of their delusions and harness all that the market has to give.
Ultimately, the logic becomes more flawed with the belief that we can pick people who have access to managers who can beat the market.
There is one way, and only one way, to build a stock portfolio that is guaranteed to beat the average dollar invested. For the U.S. stock market, that one way is to buy the entire market in proportion to the value of each company.
There are a couple of ways to do this. You could go out and buy shares of thousands of different companies listed on the U.S. stock exchanges, making sure that you are buying far more GE and Exxon than you are a small, locally based company. This may work for Bill Gates and even all those overachievers on the Forbes 400 list, but if you don't have a few billion dollars to play with, there is a better way to go. ... the index fund.
Roughtly 70 percent of the value of U.S. companies is comprised of large cap, 20 percent mid-cap, and 10 percent small cap.
While there are many technical measures to classify a type of stock, value companies are those that are beaten up and trading at lower valuations. Warren Buffett is probably the best-known value investor. Growth companies, on the other hand, are the darlings of Wall Street and trade at very hefty premiums. Core companies are in between value and growth, Morningstar pretty much divides the three classifications by a third each.
A much better way to buy the U.S. stock market is to own a total U.S. stock index fund. It not only owns the S&P 500 stocks, it also owns the thousands of smaller corporations that make up the rest of the U.S. stock market. It's free from the Google effect in that it would have owned Google both before the announcement and its admission to the S&P 500, as well as afterward.
It not only comes with the lowest fees around, it provides yet another bonus: extreme tax efficiency. As it happens, the average mutual fund is constantly buying and selling the stocks in its portfolio, which causes it to realize any capital gains it may have earned on those stocks. The fund manager can ignore the tax implications of his frequent trading, but you can't—you have to pay taxes on gains from those sales.
A total U.S. stock fund is far less likely to generate a capital gain, because it doesn't actually buy and sell stocks.
The final chapter of my diversification lesson to Kevin was that, in addition to buying the companies, we could lend money to the companies. In fact, we could even lend money to the U.S. government. [Bonds] pg 30
"Why do people pay so much to invest when they get nothing for it?"
Investors have no idea that they are paying 2 percent or more.
Investors think they are getting something in return for the fee they pay. pg 21
The consumer can be paying the following fees without realizing it:
Fees to their advisor in the form of commissions, paid as a percentage of assets or even on an hourly basis.
Front-end or back-end loads to buy and sell a mutual fund or insurance investment.
Ongoing fees known as the expense ratio. The expense ratios of many funds often include expensive marketing fees, through Wall Street prefers to use the more obscure term 12b-1 fees for these expenses.
Ongoing hidden fees no one has to disclose, such as brokerage fees and buy/ask spreads incurred by mutual funds that churn the stocks in their portfolio.
Fees should be so transparent that paying them should be like writing a check out of a checkbook. When I write a check, I look at all the other items I am writing checks for and ask myself, is this a good expenditure of my money? Without such transparency, investors have no idea how to make good choices.
We investors have no clue as to what we are paying for our investments, and even worse, there is no easy way to find out. pg 44-45
Have you ever been told you beat the market? Look for some of these Wall Street tricks to create the illusion:
Have you seen any data supporting this, or are your advisors expecting you to take their word for it?
If there is data, is it accurate?
Are they comparing your returns to the right indexes?
Did they strip the index of its dividends?
Are they including new money invested during the year as part of your returns?
Have they adjusted your returns for taxes? pg 48
"The two types of people that come back from Las Vegas are losers and liars." pg 54
It's difficult to see the whole picture on fees, but going to Morningstar.com is a good place to start. There you can find the annual expense ratio and front- or back-end loads. If your fund has turnover of more than 50 percent annually, a safe assumption is that your soft-dollar and hidden turnover costs are also high. pg 62
... author George Santayana's famous warning: "Those who cannot remember the past are condemned to repeat it." pg 69
Males tend to suffer more from overconfidence than our counterparts. We men tend to think we can pick the winners and sell the losers. This causes us to trade more frequently, which results in earning nearly 1 percent annually less than women. There is no question that, on average, my female clients tend to get indexing and the arithmetic of investing faster than my male clients. pg 76
We don't mind paying someone 1 to 2 percent to manage our money because these are small numbers and we don't actually have to write out a check. pg 82
As Warren Buffett put it, "Be fearful when others are greedy and greedy when others are fearful." pg 86
Don't pay the 1.5 percent penalty that most investors pay by following the heard. pg 105
If two stocks move perfectly in tandem in the same direction, they are known as having a perfect positive correlation (or 1.00). pg 111
... [to] move in the opposite directions. That is known as being perfectly negatively correlated, or having a correlation of -1.00. Thus, all correlations fall between -1.00 and + 1.00. pg 111
In reality, I don't know of any perfectly negatively correlated assets to produce a risk-free stock market return. In fact, for the most part, we are doing pretty well to get asset classes with low positive correlations, but the concept is still true that the lower the correlations of the assets in our portfolio, the less risk we have. pg 111
The correlation between the U.S. stock market and the U.S. aggregate bond market has been -0.27. Because bonds or other types of fixed income have had negative correlations to the stock market, they act as stabilizers to our portfolio. There is also certainly no guarantee that bonds and U.S. stocks will remain negatively correlated, but there is reason to believe that the correlation will at least remain low. That is why even a second grader needs some bonds in his portfolio. pg 112
The correlation between U.S. stocks and international stocks is +0.79. Nothing to write home about, but it does slightly lower risk. pg 112
... alternative asset classes—those assets that are not generally owned by the public equity markets and have low correlations with the U.S. stock market.
I think there are two alternative asset classes that add to diversification. These are real estate and precious metals. pg 113
My recommendation is to add REITs only if you meet the following criteria:
The value of your stock holdings is substantially higher than the value of your real estate holdings, including your home.
You are investing in this asset class for the long run and won't move in and out based on how you feel or what the Wall Street gurus are saying. pg 115
The long-run reality is that precious metals prices tend to keep up with inflation and produce little real return. pg 116
A bond is essentially when an investor loans money to an entity (corporate or governmental) for a defined period at a certain interest rate. pg 125
Municipalities can also issue bonds. They aren't as secure as those issued by the U.S. government because municipalities can't print money. pg 128
Next come corporations issuing bonds. Those large companies with strong cash flows and balance sheets can borrow money at low rates, but not as low as the U.S. government. They have to pay the money back the old-fashioned way—by earning the cash rather than just printing the money. Smaller companies with weaker cash flows and balance sheets issue bonds with higher interest rates because of the higher risk. These are also known as junk bonds. pg 128
The case for stock indexing rests on simple second-grader mathematics, and the exact same mathematics is true for bonds. If the average bond fund is paying 6 percent and the average expense is 1 percent, then the average investor will get 5 percent. What is different here is that the inverse relationship between costs and returns is even more dramatic in bond mutual funds than it is in stock mutual funds. pg 136
Buy bond funds rather than the individual bonds themselves. They provide diversification and dramatically decrease the costs of selling, should you, need to sell. pg 138
Always buy a low-cost bond fund, because what you don't pay in costs you receive in higher returns, without taking on more risk. pg 138
There is a term known as alpha that refers to the abnormal rate of return investors get on their investment, on a risk-adjusted basis. An investment that beats the market by 2.00 percent is said to have an alpha of +2.00. As mentioned, most dyed-in-the-wool indexers correctly believe that alpha must be a zero-sum game. For every portfolio with a 2.00 alpha, there must be one with a -2.00 alpha. pg 144
All banks and crredit unions use risk-management techniques. One of these techniques is matching the maturities of their portfolios (assets) to those of their deposits (liabilities). Sometimes they become exposed to certain maturities and need to close the gap by issuing CDs of a certain maturity. That's why you might see specials running such as a 7-month or 48-month CD. pg 146-147
Historically, the stock market has yielded a long-run annual return of about 10 percent, while fixed income has yielded a bit over 5 percent. Many people, including myself, don't think returns will be so handsome going forward. In my view, I've shaved 2 percent off the stock market to yield a long-term 8 percent return. pg 159
Even a common 60 percent equity and 40 percent bond portfolio has lost over 21 percent in a given year. Studies show that a large proportion of investors who lose this amount will react by selling stocks to reduce future exposure to losses. People who do that will be selling low and probably never should have allocated that much to stocks in the first place. pg 164
As a general rule of thumb, however, I think the mathematical answer is to put any funds you won't need for more than 10 years into the stock market. pg 166
As previously discussed, the more we move into and out of the market, the lower our returns end up being. pg 166
As a rule of thumb, money you need in the next 5 or 10 years generally should be invested in fixed income. The stock market is far too risky for money needed in the short-term—and yes, even 10 years can be considered short-term. Take this risk only if you have no other way of meeting your goal. pg 174
The Wall Street wizards will always be optimistic in an up market and pessimistic during a down market. My advice is to ignore them. The more you move in and out, the lower your returns are likely to be. Sticking with the allocation you select is every bit as important as selecting it in the first place. As they say, "If you can't be right, at least be consistent." pg 175
Exhibit 9.5 Second-Grader Portfolio
Total Bond Index or CD: High Risk 10%, Med 40%, Low 70%
Total U.S. Stock Index: High Risk 60%, Med 40%, Low 20%
Total International Stock Index: High Risk 30%, Med 20%, Low 10% pg 175
When you have to sell to rebalance, always look to your tax-advantaged accounts first. When you need to adjust your overall allocation, it's best to do it in a tax-efficient way. A good place to start is your tax-deferred accounts. You can buy and sell anything in your 401(k)s, IRAs, and the like without paying the tax collector. pg 176
See, you don't have to sell a fund to be taxed on it. If the fund you own sells its stock for a gain, the government wants its share. pg 183
In my research, I've found that the typical mutual fund holds a stock on average for about one year and four months... Broad index funds, however, have virtually no turnover... The broad stock index funds... have virtually no turnover. No turnover means no capital gains to pass on until you sell them. pg 184
There is a bank out there that is willing to lend us money. And it's at an interest rate that looks too good to be true—0 percent annually. It is true, and we can take advantage of this interest-free loan by using such tax-deferred vehicles as 401(k)s and IRAs. With these vehicles, the government is basically saying that it will let us hang onto the money we owe it and, in the process, let us reap the financial rewards. pg 185
If you think you will be paying at higher tax rates when you withdraw the money, consider Roth IRAs or Roth 401(k)s. They don't give you the tax deduction immediately, but do allow all of your earning to be withdrawn completely tax free. pg 186
My position is that this is exactly opposite of what we should be doing. That is to say, we should be overweighting stocks in our taxable accounts and putting bonds in our tax-deferred accounts. ... That's because stock index funds are very tax efficient, while fixed income and CDs are taxes immediately and at the highest ordinary income rates. pg 187
Under nearly any scenario, we are better off to place tax-efficient investments in our taxable account, and tax-inefficient investments in our tax-deferred accounts.
For your taxable accounts, I suggest stock index funds. For your tax-deferred accounts, consider CDs, taxable bonds, REITs, and other investments taxed at the highest rates.
Taxable Accounts: Broad stock index funds, lower-turnover stock funds, Tax-managed funds
Tax-Deferred Accounts: Taxable bonds, REITs, CDs, High-turnover stock funds, fun gambling stock accounts.
As one financial planner put it, "Insurance preserves wealth, investments create wealth and confusing the two is a sure way to financial disappointments or outright disaster."
If you need life insurance, buy low-cost term insurance. If you take the savings from what you would pay with "permanent insurnace" and invest the rest directly, you are likely to be far better off.
"Mortgage interest is your friend, not your foe." I have heard two arguments to support this absurd advice. The first goes as follows: If you get a 6 percent mortgage and are in the 28 percent tax bracket, you are paying only 4.32 percent on it after taxes. Even a bond pays more than that, so at even 5 percent you are better off. The problem here is that the argument conveniently leaves out the fact that the 5 percent earnings on the fixed income are also taxable. At the 28 percent tax rate, that leaves you with only 3.60 percent. So in actuality, you are borrowing at 4.32 percent and earning only 3.6 percent.
Now, the typical response to this reality check is to say you shouldn't invest it in conservative bonds. You should get stock market returns of 8.5 percent or more. While I believe this is possible, I just don't believe it can be done without dramatically increasing risk. The stock market is far from being an actuarial certainty.
Albert Einstein once said, "If you can't explain it simply, you don't understand it well enough."
This may work in the short-term but, for right or wrong, changing credit cards regularly will pound your FICO score. The FICO score is a credit score that lenders and insurance companies look at when they decide how much to charge you. So I don't recommend this strategy.
Next comes the location of those assets in taxable versus tax-advantaged accounts, which pretty much run the opposite of your instincts. Stock index funds and stocks are very tax efficient and better in your taxable accounts. Your tax-deferred IRA accounts are better suited for your bonds, bond index funds, REITs, and anything taxed at the highest rates.
Another source for seniors is to reapply for social security benefits. Larry Kotlikoff, economics professor at Boston University, has written about one of my favorites. A little-known law allows beneficiaries to pay back all benefits without interest and then reset social security payments shortly afterwards. So if you took it at age 62 and, in a few years, you are still in good health, you can repay it and then take the higher benefit. And if you are nearing the early social security age and thinking about waiting for the highest benefit—don't! Take the money and put it in a safe investment, like a money market account or TIPs. Later, you can pay it back without interest and then opt for the higher payments. Be sure to monitor whether Social Security is looking at closing that loophole.
Is your cash working as hard as it can for you, or is it making your financial institution rich?
Can you get rid of your most expensive debt, either with cash or with less expensive debt?
Are you in an expensive index fund that is guaranteed to underperform the least expensive equivalent index fund?
Do you have your highest-taxed assets located in your tax-deferred accounts? It may feel good to have cash in taxable accounts, but it will cost you more.
Are you paying an expensive bill on a regular basis without checking to see whether there are alternative options at a much lower price?
Are there some tax savings that you are missing, such as the example of paying the college via the state 529 plan?
"Truth is ever to be found in simplicity, and not in the multiplicity and confusion of things." Sir Isaac Newton
"If you can't explain it simply, you don't understand it well enough." Albert Einsten
Each 1% in additional performance get's you to your financial goals roughly four years earlier.
Finally, remember that taxes are costs, too. Where we locate these assets is critical and, in my experience, we usually get it backwards. Broad stock index funds are beautifully tax efficient on their own and appropriate for the taxable portfolio. Bonds, CDs, REITs, and precious metals and mining stocks throw off gains at ordinary income and are better off in your IRA and 401(k)s.
The irony is that, if everyone invested in index funds, there would be no trading on stock exchanges. Markets would collapse and liquidity would disappear. It was obvious to me that he was 100 percent correct and we owe thanks to all of those professionals who try to add value in the zero-sum game of investing.
In his final (and 1,009th) column in The Wall Street Journal, Jonathan Clements reminded us all of the three purposes of money.
Having money makes us worry less about money. That alone improves our lives.
Money can give you freedom to pursue your passions (I actually once had a real job in corporate America.)
Money can buy you time with your friends and family. Studies show that regularly seeing friends and family can provide a huge boost to happiness.
For more… find it at Amazon or Bookshop.org