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Scott Burns' Articles -- Recent and Archived

The End Is (Not) Near

The downbeat is quickening. First Motley Fool intones that index funds are unlikely to do well in the future (July 20). Then Morningstar says future stock market returns are likely to be disappointing (August 11). This column hasn't offered much cheer either, questioning whether investing in anything was worthwhile early this month (August 1).

So take heart. When pessimism prevails, bargains are more likely than rip-offs. Pessimism isn't a sign we should stop investing in stocks.   Or that we should abandon index funds.

Index funds are the only way the average investor can avoid the recommendations of the investment/retirement complex and their debilitating expenses. While low tax rates on dividends and capital gains make the tax efficiency of index funds less meaningful, actively managed (and actively sold) funds still have higher portfolio turnover averaging over 100 percent while the largest index funds average 2 percent. That extra 98 percent is an invisible layer of expense.

Yes, managed funds did better than index funds in the bear market. The sales force, ignoring more than 30 years of results and research, declares this to be the end of indexing. Hogwash. Managed funds have a portion of their assets in cash. Index funds are fully invested. Result: index funds rise more in bull markets and fall more in bear markets.

At the end of July, the average large cap blend managed fund had returned 9.17 percent over the preceding 12 months. The Vanguard 500 Index fund returned 11.02 percent. Vanguard Total Stock Market Index fund returned 10.66 percent. The 500 Index fund bested the average managed fund over the last 5, 10, and 15 years--- but trailed by 0.33 percent over the last 3 years.

The Total Market Index fund beat the average managed fund over all time periods. Over the last 10 years it returned 13.71 percent annually. The average managed fund returned 11.50 percent, a massive 2.21 percent difference.

That, of course, only measures comparable large cap blend funds. But the major index funds also did better than managed funds in other fund categories: large cap, mid-cap, and small cap growth. They trailed against large, mid, and small cap value funds and the mid and small cap blend funds.

Does this mean index funds are doomed?

Not likely. Large cap stocks represent about 80 percent of all market capitalization. Mid cap and small cap stocks represent about 20 percent. Take the averages, make the investments proportional to capital value and a combined 80/20 large/mid cap managed portfolio returns 12.69 percent. That's still behind the 13.00 percent of the Vanguard 500 index or the 13.71 percent of the Vanguard Total Stock Market fund.

Bottom line: There is a chance that we can improve performance by seeking professional help. But the chance is much reduced by a dismal reality. The number of true investment professionals is seriously diluted by massive numbers of ill equipped salespeople. Who do you think John Q. Public is most likely to meet?

Indexing core assets remains our best defense.

Will investing in stocks produce disappointing returns in the future?

Morningstar's analyst observes that the historical 10 percent return was boosted by an average dividend yield of 4.1 percent. The current yield is only 1.9 percent. All other things equal (P/E ratio, capital gains return), we should expect a future return that is 2.2 percent lower.

That would take the future return on common stocks down to about 8 percent. Worse, P/E ratios are high and could "regress toward the mean." That would reduce future returns still further.

But Vanguard founder John Bogle made the same argument--- in 1991. He forecast the 90's would probably bring lower returns than the 80's. His idea was sound--- but high valuations can persist for long periods of time. This is 2004.

The important question isn't whether future stock returns will be disappointing. It is how will they compare to other investments?

A likely return of 8 percent looks very good compared to earning 1 percent on cash. It also looks good compared to earning 4 or 5 percent on high quality bonds.

Bottom line: This is a good time to keep on keeping on. We need to have faith that we, collectively, create more value than we destroy.   We need to remember that the stock market is only a shabby sideshow to the engine of human creativity.

On the web:

July 20, 2004: Motley Fool--- The Case Against Index Funds   (Registration required)

August 1, 2004: Scott Burns: Thinking Financial Blasphemy

August 11, 2004: Morningstar: Stock Market Returns Are Likely to Disappoint  

Sunday, July 7, 1991: Forecasting Total Returns for the Nineties: TBA   (910707SD)

Tuesday: Searching For Winners that Don't Lose

Comments

 

ABModerator03 said:

I read your article on MSN Money, the titel was "Is investing in stocks woth the risk? The article was posted on 8/7/2004.

You last paragraph gave this as a Conclusion. "It's time for us to reset our investing habits. Except for savings dollars going into 401(k) plans where the employer matches our contributions, we need to look for other uses of the money we save."

What about the Roth IRA as an investment? Thanks for any advise you may have. I am at least 5 years from retirement and I am told that I need to begin planning to reduce a number of taxable events that are coming at me.

Thanks for any advise you may be able to give. I enjoy your articles in the Dallas paper.
February 10, 2007 11:05 AM

About scottb

Scott Burns has covered the changing world of personal finance and investments for nearly 40 years. Today, he ranks as one of the five most widely read personal finance writers in the country. Scott began his career as a newspaper columnist at the Boston Herald in 1977 where he was also the financial editor. Nationally syndicated in 1981 and now distributed by Universal Press, the column appears in newspapers from Boston to Seattle. In 1985 he joined the staff of the Dallas Morning News where his column quickly became one of the most widely read features in the paper. He left the Dallas Morning News in 2006 to become one of the founders of AssetBuilder and its Chief Investment Strategist. Burns is a graduate of Massachusetts Institute of Technology (1962). He has written four books, including "The Coming Generational Storm" (MIT Press, 2004) coauthored with economist Laurence J. Kotlikoff. His fourth book, also coauthored with Kotlikoff, will be published this spring by Simon & Schuster. "Spend Til' the End" uses consumption smoothing to demonstrate the errors of conventional financial planning. His business experience includes working as a staffer for a major consulting company and service as a director and audit chairman of a NASDAQ listed manufacturing company. He and his wife divide their time between Dallas and Santa Fe, New Mexico.
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