I Love The Smell Of The Mill In The Morning….
I am an early riser… I get up most days at 4am… usually without the help of an alarm and that was the case this morning. I woke up in my old home, Beta Theta Pi on the UMaine Campus. I walked downstairs and went on to the porch and was not surprised by the scene. The porch looked like someone who knew nothing about our fraternity would expect the porch to look. Although the house is usually very well appointed and clean, this was summer and many alumni had invaded and taken over for work weekend. There were crushed beer cans, discarded solo cups and what I hope was a pickle, that had been stepped on. The highlight had to be a man in his underpants, sleeping on a pull-out couch underneath a bug-zapper. It appeared that a marauding band of vagrants, without much of a plan, had seized control whilst I slept.
As I stood there a friend (and Brother) of mine came up to me and had some financial questions, most interestingly one about how to structure distributions of a patent held by a third party. As we bounced ideas off each other, he stopped me mid-sentence and said,
“Do you smell that?”
I responded, “Yes, it is the mill” and we both said in unison,
“It is going to rain”
After all these years we both associated that distinct smell with rain. It was hardwired into us. We took it as a fact, as it had been proven to us, time and time again. It was the way it had always been and it was our belief that history was going to repeat itself once again.
We returned to our conversation and we got on to the topic of investing. I expressed my views as an efficient market theorist and spoke out about the down falls of single stocks and the unnecessary fees of most mutual funds. The man I was talking to disagreed and stated that his investments had grown by a healthy rate and he had beaten the market.
A statement to that effect is one of the most common arguments that I encounter. People are quick to tell me that their portfolio is out performing the indices or even more common, “beating the market.” As I often do, I did not take this as a fact but instead had a few follow up questions including…
“How do you factor in the effects of the sales charge and maintenance fees?”
Meaning that if you invest $100 and there is an initial sales charge of 5% and an annual fee of 1% (pretty conservative charges as some top 8% and near 2%, respectively) and that mutual fund goes up by 10% you don’t end up with a $110, you end up with a little over $103. You made around $3 and the company that sold that fund to you made over $6. Or if the mutual fund goes in another direction and drops by 10%, you will not lose $10 of your $100 investment, you instead lose over $15 dollars and the company makes $5.85…
Now in both cases the number, in bold, on the statement is 10%. It says that you either gained 10% or lost 10% but it does not clearly show that you only gained $3 or lost $15. Oh it will show the old value and the new value but where are the total fees found?
That number in bold reminds me of the time that I read about a jail administrator who decreased the number of returnees to his jail by 18%. I happen to know the story from an inside source that the secret to his success was to change the definition of recidivism. It turns out that about same amount of people were still being incarcerated but they found a new way to add the numbers.
Now using those same numbers above, an index fund that has no sales charge and a 0.25% (some are as little as 0.04%) annual fee BUT only returns 8% results in a gain of $7.75 and even if that index fund lost 12%, it would represent a loss of only approximately $12.
So try to make sense of the fact that if you own the first fund you beat the market both times but you have less money than the person with the index fund… now what difference does $6 vs. $7.75 make… Well, when you are talking about $100, there is little difference BUT when you are talking about hundreds of thousands of dollars, the difference is huge. More importantly even with the example of $100, the next year that difference ($1.75) has the chance to grow too… the difference is not the $1.75 this year, the difference is that that small amount will also grow in “up years” or provide a cushion in “down years.”
Now please bear in mind that the example above is not typical because on average index funds BEAT mutual funds, even before you take out the fees! As a matter of fact, index funds, over a 20-year period, beat mutual fund 96% of the time.
Let’s just say that the mutual fund and the index fund had the same performance for a 20-year period. On a $100,000 portfolio, where 10% annual growth compounds monthly the difference would be huge.
The Mutual fund would be worth $570,869.
The Index fund would be worth $697,352.
But the year-end statement would show the same return every year… the exact same return and about $127,000 difference in the balances…
The question about how my friend calculated his return just kind of lingered there… he eventually told me that he was going to get back to me after he spoke to his advisor.
Just like the smell of the mill had historically meant rain, salespeople seem to always recommend the things they make the most money on. Just like the rain falls indiscriminately on the trees, grass and the porch, the salesman sold products that all have a slim chance of beating the least expensive method of investing for the future and in the end the salesman and the company he works for make money whether the price goes up or down.
Eventually it did rain and we had to postpone some of the outside work we had planned to do that day… the guy I found asleep on folding chair in the living room did not seem too broken up about that decision.
Eric Simonds, MsFP, is the owner of Saltwater Harbor Financial, LLC and a proud Brother of Beta Theta Pi. When he was an undergraduate, Eric held several fraternal offices including Scholarship Chair, Rush Chair and Pledge Educator. In all those roles he placed the needs and future of the fraternity ahead of trying to simply win a numbers game. That strategy paid off then and continues to pay off today. Eric will never win a sales contest but his choice to never trade your future for a commission is better than winning a Cadillac Eldorado or a set of steak knives.