Monday, July 30, 2012

Bogle: "The Tyranny of Compounding Costs" - Part II

A follow up to this post

Bogle: "Tyranny of Compounding Costs"

In the 1983 Berkshire Hathaway Annual (BRKaShareholder LetterWarren Buffett wrote the following about frictional costs and their impact on returns:

"...consider a typical company earning, say, 12% on equity. Assume a very high turnover rate in its shares of 100% per year. If a purchase and sale of the stock each extract commissions of 1% (the rate may be much higher on low-priced stocks) and if the stock trades at book value, the owners of our hypothetical company will pay, in aggregate, 2% of the company's net worth annually for the privilege of transferring ownership. This activity does nothing for the earnings of the business, and means that 1/6 of them are lost to the owners through the 'frictional' cost of transfer. (And this calculation does not count option trading, which would increase frictional costs still further.)

All that makes for a rather expensive game of musical chairs."

The costs of this expensive game ends up in the pocket of the croupier as participants trade stocks back and forth frenetically. Buffett also later added:

"These expensive activities may decide who eats the pie, but they don't enlarge it."

The source of the "frictional costs" in the specific example provided in that letter. Yet no matter what the source happens to be, Buffett's broader point is no less relevant. These days commissions are far lower so the possibility of reduced frictional costs for participants is theoretically easier than ever*.

The problem is the many new potential sources of frictional cost in the system. A bunch of comes from just the general trend toward trading hyperactivity or "short-termism" by market participants.
(A substantially reduced average holding period compared to historic norms whether the trading is done directly via stocks or indirectly via ETFs.)

In the same letter, Buffett parenthetically also added:

"...hyperactive equity markets subvert rational capital allocation and act as pie shrinkers. Adam Smith felt that all noncollusive acts in a free market were guided by an invisible hand that led an economy to maximum progress; our view is that casino-type markets and hair-trigger investment management act as an invisible foot that trips up and slows down a forward-moving economy."

All this additional trading hyperactivity has more than picked up the slack and kept frictional costs for the system as a whole very high. So the current way of doing business remains very costly for the average market participant, but those that avoid all this hyperactivity don't bear these costs.

In the prior post, I mentioned what John Bogle calls "the tyranny of compounding costs". Well, during a SmartMoney interview back in 2005, Bogle noted that in a ~13 percent market the average mutual fund earns something like 10 percent, while the average mutual fund investor earns just 6.5 percent.**

"People understand the magic of compounding returns. But few investors know about what I call the tyranny of compounding costs.... You put up 100% of the capital and take on all the risk, but you get only 20-something percent of the return. That's a system that is destined to fail. People will not be that dumb forever." - John Bogle in SmartMoney back in 2005

"The magic of compounding returns, it turns out, is simply overwhelmed by the tyranny of compounding costs at today's exorbitant levels." - John Bogle in The Wall Street Journal (unedited version of remarks)

Oh, and taxes only make it worse. In the above example, it seems like the average mutual fund investor will earn half as much as the overall market (13 percent versus 6.5 percent) but it's actually worse than that. When you take into account compounding effects, the average mutual fund investor actually ends up with more like a bit more than one fifth as much money over 25 years (and it, of course, just gets worse as the "tyranny" compounds in reverse). This huge gap is the result of all these frictional costs plus the tendency of investors to buy during the good times and sell during the not-so-good times.**

Pretty much the opposite of what successful investors need to do.

Also, consider that both Buffett, Bogle, and Grantham (in the prior post) are referring to frictional costs in their examples that are generally much less than what many hedge funds are known to charge.

Knowing all this, does it make sense to have a system where participants work feverishly to outsmart the other participants (to be on the "right side" of trades) with the net result being nothing of value in the aggregate being created?

Why wouldn't one instead designed to encourage the minimization of frictional costs at every level (and a longer holding period by the average participant) be the better way to go?

The productive assets themselves would still compound in value at the same rate with more of the gains remaining in the pockets of those who actually put capital at risk.

I know this won't happen anytime soon (and we all have to invest in the world as it is) but to me it seems a more than fair question. The good news is (and I mentioned this in the prior post) the individual investor can still choose to not participate in the folly even if the system remains the way it is, give or take, for a very long time.
(Yet, unfortunately, society still bears the cost of this mostly unproductive activity. Jeremy Grantham once made the point that frictional costs like this actually "raid the balance sheet" of investors.)

Those that work to minimize frictional costs, stay within their limits, buy with discipline (a plain discount to value), and generally own assets long-term that compound intrinsically at a high rate increase the probability of ending up well ahead of most investors. Other than that, it's often one's own temperament and various cognitive biases that get in the way of above average long-term returns.


* Even if someone is not buying stocks directly, quite a few low cost ETFs and traditional mutual funds exist now that could be bought and held long-term to keep expenses low. The problem is that the evidence suggests ETFs are traded rather excessively.
** The difference between the fund returns and what the investors get for returns comes down to investors attempting to buy and sell in order to increase returns and reduce risk. The intent is, of course, to improve results but the opposite is achieved. (i.e. Buying when stocks are expensive during what seems like clear economic skies; selling when stocks are cheap as dark economic clouds emerge.) Bogle provided another example that suggests the gap is even worse back in 2003. The problem stems more from how price compares to per share intrinsic value -- whether or not there is a sufficient margin of safety -- and less from timing. (Even if, at specific times, stock prices can be generally expensive or cheap. In 2000 many stocks sold at big premiums to value; in 2009 many were at big discounts to value. It's just that a focus on timing distracts from what really matters: price vs value.) 
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