A Strong Voice for Market Efficiency Diagnosed With Terminal Lung Cancer

Paul Winkler: Welcome. This is “The Investor Coaching Show.” I am Paul Winkler, the host of “The Investor Coaching Show.”

Investment Philosophy

So yes, oh boy, there is a lot to talk about this week. It’s been a very, very busy week. Some interesting things have come about regarding this tax bill. Ah man, just wonder what’s going to happen with all of that, but I guess we’ll find out.

But there are some things that were part of the tax bill that I thought I’d talk a little bit about. Some things that I think from an educational standpoint might be helpful for you as investors to understand, because sometimes people call me, and there are certain questions that come up about things that they invest in. They think, “Hey, this is really low cost, right?” And I’m like, “Uh-uh, not exactly.”

So specifically, I’ll get into some of that because I think that a lot of people believe things are inexpensive when they’re really not, and they don’t understand hidden expenses. And I’m not going to spend a whole lot of time, but I am going to get into it a little bit because something happened this week. I think it’s timely.

So that, and then there’s also Jonathan Clements. There was an old hero of mine, and apparently, what has happened is he has some form of terminal lung cancer, Jonathan Clements. And it’s very sad because I quoted him so many times over the years on this show.

He wants to leave a living legacy. And I’ve quoted him in workshops that we teach because so much of what this show is based on — it wasn’t something that he discovered by any stretch of the imagination, but it was something that he talked an awful lot about in The Wall Street Journal. And that is this idea.

When you invest for the future, if you were to say, “Hey, what do I think the job of an investment advisor is? What’s their job?” “Well, make me money.” Well, great, that’s really simple.

Sometimes I’ll ask people, “What’s your investment philosophy?” And they go, “To make money.”

And I’ll go, “Yeah, great. No, that’s your goal. Your philosophy will differ significantly.”

And most of what you hear about investing, I don’t care where it is, whether it’s here, whether it’s on TV, whether it’s in magazines, wherever.

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You will find that the philosophy that reigns is the idea that markets fail, that markets are inefficient.

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The Idea of Market Efficiency

Now, there was an old professor that said this one time. We were talking about this, and he’s thinking, Here’s the idea about market efficiency, how markets work. It’s the idea that markets price stuff properly.

Have you ever noticed that when the news comes out and a piece of information comes out, all of a sudden the market goes shooting up, or it comes shooting down? It comes crashing down because of that piece of news.

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That is because that news is being digested in the stock prices, bam, just like that.

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So let’s say that I have stocks that sell for 10 times earnings. So I get a dollar of earnings for each $10 that I pay. And all of a sudden, news comes out that says, “Ah, there’s going to be a 10% hit to earnings. It’s not going to be a dollar of earnings, it’s going to be 90 cents.”

The stock price, all else being equal — it never is, but all else being equal, goes down to $9 immediately based on what we think is going to happen. Now the earnings haven’t had time to change yet, let’s say. It’s something that’s going to come six months, a year down the line — the stock market will go down.

And when you’re going, “Oh, I heard this is happening right now. I think I got to get out.” You’re basically closing the door to the barn after the horse is long gone. Because that information has already been digested in the market prices.

Well, that’s the idea of market efficiency. Won the Nobel Prize in 2013.

And it’s the idea that I focused on, I started this show based on, in 2001. That was my goal when I started this show. I was going to teach this.

And the only thing that I thought was, Oh, you know what? If I become too public about this, the industry will change and I will be out of a job. Perish the thought.

Now it’s worse than it was then. It’s way worse now than it ever was back at that point in time.

Own Lots of Companies

The professor I was referring to made a comment, he said, “Hey, you know what? The idea that markets fail is predominant in the investing world. It’s also predominant in Cuba. It’s predominant in North Korea, and in China.”

Now China, not as much, but it’s getting worse, again. China is getting worse again.

And his point was that there is this idea. The idea is that I can put a really smart person at the helm, with maybe a group of people that are really well-informed, and we can properly set prices. We can come up with what the right price should be for a car. We could come up with what the right price should be for a telephone or whatever, a computer.

And the idea is we can set prices so we can grow the economy at a faster pace. Because instead of having a bunch of idiots out there determining what prices should be, AKA the general public, we can have a really smart person, or a smart group of people, determining that.

Well, there’s only one problem with that: It’s never worked anywhere it’s tried. And that is the same thing with the investing world.

This is why I always tell people, “When you’re reading about investments and you’re trying to figure out what to do with your money, go and look at the prospectus. I know you hate reading that kind of stuff, but read the prospectus. What does it say that the fund manager believes their job is? Finding undervalued companies.

“Looking for overlooked areas of the market. Finding companies that maybe are poised to rally in the future, or maybe they’ve got good fundamentals. You’ll hear fundamental analysis, or technical analysis. Technical analysis is charting.”

And as I’ve said before, professors actually go, “You know, I’d like to compare chartists to astrologers, but I hate to give astrologers a bad name.”

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So that idea about investing is that your job is to own companies, and make sure that you own lots of them all over the place. 

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There are people out there who say, “Hey, if you have more than five or 10 stocks, you’re over-diversified.” Which is nonsense, because if I take a handful of companies, let’s say 500 of them, the S&P 500, and they’re big companies, and historically the return should be around 10%, let’s say. Well, all of those companies, the expected return is the same.

Now, some companies are not going to do it. They’re not going to make it. Some companies are going to overdo it, they’re going to end up outperforming.

But that’s the idea. It’s a cost of capital. There’s a cost to use your money, and the expected return does not go up when I reduce the number of companies.

In fact, all that happens is I increase risk. And that’s the problem with that philosophy of investing.

Focusing on U.S. Companies

Now the big problem with American investors, they tend to focus most of their money in U.S. companies. People will call me and say, “Paul, why don’t I just put all my money in S&P 500 index fund?” And I go, “Well, because you can go 20 years without a return.”

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It’s hard to get you to actually be disciplined for 20 months, let alone 20 years, if markets are not doing anything now, number one.

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Number two, your goal may be a lot shorter than 20 years. You may have a goal that you need this money back in five or 10 years. So what happens is that you’ll have different areas of the market.

If you go from 1966 to 1982, and the rate of return of the S&P 500 after inflation was zero, it’s a long time. That’s been a long time, not quite 20 years, but it’s almost. And then you have 2000 through 2012, no return. And 2000 probably to about 2013 after inflation, no return.

Well, you look at, let’s say, the United Kingdom stocks from 1966 to 1982. You had 17, 18% returns for small caps. I mean, that’s money doubling every about four years or so. So you see, there’s a big difference when we diversify in other areas.

But since we’re not familiar with UK small companies, we don’t even know who they are, we don’t do business with them. Maybe they operate regionally. We don’t even think about those companies.

So that is what happens with investors is they get most of the information about investing from people selling investment products and trying to tell them that they have these insights on what’s going to happen next and where things are going to go, what you ought to be doing right now. And then on the other hand, what they’ll do is they’ll say, “Well, let’s just put everything in S&P 500 fund, and it’ll be cheap.”

And that’s not necessarily the case either. If I’m only capturing that asset category, large U.S. stocks, it’s still not necessarily the category.

So how’s that work? Well, what happens is this, you’ll have companies, I don’t know, Jeff, if you have that audio where I can run audio through the system.

I don’t know if you’re ready for that. It’s that one mic input right there. Do you hear anything yet?

Jeff Malinoff: Surging.

PW: There you go. Look at that. All right, love it. All right, cool.

I’m going to come back to that in a second. I just want to make sure we’re ready because I never gave you a heads-up when we first started the show, man.

JM: Always be prepared. Right.

PW: I get Jeff Malinoff as my producer here.

JM: I’m prepared for anything.

PW: I mean, you know …

JM: I’ve handled Dan Maness and Matt Murphy. Whatever you can throw, I can handle.

PW: That is true. That is true. If you can handle those guys, I am cake.

JM: Yeah, they never warned me about them when I first started.

PW: Oh, they didn’t?

JM: No. No one gave me a warning. They should have.

PW: Oh, yeah. Clips are the bomb. They’re really good.

The Cost of Investing

Okay, so let’s just get this out of the way right here when we’re talking about the S&P 500 large U.S. stocks, and let’s talk about the cost of investing. Then I want to play this clip for you.

So we invest in markets and we say, “You know what, Paul, I am totally on board. You can’t pick stocks, you can’t time the market. I am totally on board. That makes complete sense to me.”

What you might do is you might buy an index fund, a fund that just tracks a certain area of the market. So you have an index like the S&P 500. It owns all 500 of the biggest companies in the United States.

It goes up, and you go look at from 1926 until today. The rate of return for the S&P 500 is about 10% per year. It means money doubles about every seven years.

So, young guys, listen up, check this out. If I had, let’s say, $100,000 — yeah, you’re not going to have $100,000. Let’s be more reasonable.

Let’s say I’ve got $1,000 and we’re going back, let’s say 56 years, because the math works out really well if I do this. So I go back 56 years, how many times do I have to double on that type of an investment? Well, eight, right?

So if I got a thousand bucks, it becomes 2,000. That’s the first double. Then 4,000, 8,000, 16,000, 32,000, 64,000, 128,000.

Now we’re starting to look at big money, you know. You look at that and go, “Wow, that’s not terrible.” We’re at 128,000, and then we get it to 256,000.

Well, you look at that, $1000, $256,000, that’s a huge deal. Time value of money. The power of compounding, right?

Well, the problem that you run into is, will that actually happen in a shorter time period? Because your time period may be shorter than that.

But if we look at small companies, it doubles even faster; about every six years, money doubles. Value stocks, small value, every five years, somewhere in that neighborhood. So you look at that and go, “Wow, there is a big deal to be had here.”

What we’re trying to do when we actively manage, we’re trying to get a higher return than that. What a daunting task. What a daunting task to do better than that.

So what we’ll often do is say, “Well, I’ll put it in the S&P 500 index fund and be done with it.” Well, what happens with the index is those companies change. If we look at the Dow companies, the Dow Jones Industrial Average, it’s only 30 stocks.

You go all the way back to the 1930s, that list of companies is completely different, 100% different than what it is right now. So you look at these companies, they come and go, so somebody’s got to manage this.

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They’ve got to make sure that the portfolio is changing to reflect what companies are out there.

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Same thing with the S&P 500. So those companies change, and when they change, if you run an index fund and you are using the words S&P, Standard and Poor’s 500, to market your fund, you must mirror that index. Well, if you have to mirror that index, then when that index changes, you’ve got to sell companies that are going to be leaving the index, and you’ve got to buy companies that are going to be entering it.

Investing in Cryptocurrencies and Gold

Right now, what’s going on is everybody’s talking about cryptocurrencies, right? We’re talking about cryptocurrencies and investing in Bitcoin. And I tell people it’s not an investment.

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It goes up and down based on supply and demand. It’s not an investment. 

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There’s nobody paying to use your money. They’re not paying you rent. They’re not paying you earnings. They’re not paying you interest.

They’re not paying you anything. So what’s it worth? Well, it’s worth whatever somebody will pay for it.

Well, that’s precarious. It could just fluctuate all over the place.

For example, you had a couple of months here where gold has been going up in value. Why? Because China has been buying more of it, and some of these third-world countries have been buying more of it.

Why have they been buying it? Because they’ve been nervous about what Trump is doing. They’ve been nervous about the dollar.

Matter of fact, the news right now is that the federal debt, the government bonds, the last pristine government bond that was triple-A rated, had a ratings drop. Well, you have a ratings drop, and then you have tariffs, and you don’t know what’s going to happen.

You don’t know whether somebody’s going to manipulate something to where your economy is going to be hurt. You might buy gold.

Well, if that goes away and all of a sudden that fear goes away, what happens to the price of gold? It drops like crazy. If all of a sudden the things that they’re fearing don’t happen, it drops like crazy.

Did you know, you may have heard me say this before, but 50% of all the gold ever mined in the history of Earth was mined from 1971 till now? Yeah, 50%, two-thirds of it, two-thirds of the gold ever mined in the history of Earth has been mined since 1950.

Well, if you have, let’s say, something that you’re buying because you think it’s valuable, but the amount of it actually increases, what can that do to the value? It can hurt it.

Market Impact and the Reconstitution Effect

Get back to the S&P 500. Now we’re going to change that index. People are talking about cryptocurrencies. What happens when you add a company like Coinbase to the S&P 500?

Coinbase was added to the S&P 500. What happens? Everybody that runs an index fund now must add Coinbase to their portfolio and what happens to it?

Clip: We’re also looking at shares of Coinbase. They’re surging. The crypto exchange will replace Discover Financial in the S&P before trading begins next Monday. You can see shares are up almost 9% right now.

PW: Okay, there you go. So you have this added to the S&P 500, and every fund that has to actually add this to their portfolio has to buy it. What happened to the price? It went up 9%.

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Who paid that? The funds added to it. Where does it come out of? Your pocket. 

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And this is what’s called market impact and reconstitution effect. This is actually well known in the academic world, this idea.

And investment managers will take advantage of this. They’ll take advantage of “You’ve got to add this,” and now you end up with a fund with a hidden expense that you were not aware of.

So there’s more to the story than really meets the eye. You can’t invest directly in the index.

So when you hear about the S&P 500, you’ve got expenses. You have to have a fund that puts together that index fund.

Now, Jonathan Clements, he was a guy that got this. Back to him. He was a guy that got the idea that markets worked.

He’s a guy that got the idea that markets were efficient, and he would just wear this out in his columns in The Wall Street Journal. And this is just a thanks to him because I used so much of his material over the years.

And now what he’s doing, he’s got this grim prognosis, as they say, that his health is failing. He’s doubling down, bravo to him.

I think it’s great when somebody looks at their life and goes, “You know what? I wanted to show something for my life.” Really, really good stuff.

Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.