Count the cost: social justice

pepi-stojanovski-MJSFNZ8BAXw-unsplash

Costs are not fun. Instead of counting them we tend to ignore them, to our own detriment. Thomas Sowell, in his book The Quest for Cosmic Justice, presents the case for counting costs in the arena of social justice. American’s today are obsessed with justice, objectively a good thing, but it’s important to be clear about what we mean by ‘justice.’ Sowell notes that instead of the traditional concept, we’ve become more and more enamored with a cosmic, god-like, concept of justice. Traditional justice is the right to a fair trial, it’s a process, it follows a set of rules, and it’s divorced from outcomes. A prime example of traditional justice exists in sports: everyone is measured by the same set of rules while the outcome is up for grabs. It doesn’t matter where a player has come from, what advantages or disadvantages they’ve benefited from or had to overcome, justice in the game is only concerned with whether or not players are fairly and equally evaluated according to the rules. That’s traditional justice. Cosmic justice, on the other hand, is unsatisfied with disparate outcomes. The fact is that some people, through no merit of their own, benefit from growing up in healthy and/or wealthy families with great access to education and opportunities while others, through no fault of their own, are inhibited by growing up in dysfunctional and/or poor families with limited access to education and opportunities. The term ‘privilege’ has been popularized in reference to this. Instead of creating a fair set of rules universally applicable, cosmic justice is concerned with promoting equal outcomes. Most of us would agree that the fact that some people are born into bad situations is not ideal and seems unfair, so the pursuit of cosmic justice feels right. The important question is not about fairness though, the question which must be considered is, what’s the cost?

The costs of traditional justice are straightforward. We pay taxes to fund judges, courthouses, law enforcement, prisons, etc. Our taxes fund the system of law. We elect rulers and authorities who (ideally) structure fair laws to the benefit of the people. It’s scalable and achievable, albeit imperfectly. The costs of cosmic justice are much more nebulous and far-reaching. One example can be seen in the concept of reparations, forcing people today to pay for injustices done in the past, even generations in the past. It’s not fair that people were subject to slavery and served other people, for free, often for fear of their own lives. It’s not fair that families were separated from each other. It’s not fair that people were denigrated, stripped of their dignity and freedom, treated like livestock, even hunted like animals. The whole thing reeks of evil and we feel a desire to fix it. It seems like reparations could be helpful for righting past wrongs, or the least it’s better to do something than nothing. In order to execute this urge to right past wrongs, a whole other set of questions must be answered: Who gets paid? Who has to pay? How much? For how long? At what point or amount will the reparations be sufficient to remedy the incredible injustice of slavery? Who will decide all of this? Who has the insight and understanding to fairly distribute the reparations? Reparations, and social justice more broadly, is not merely a question of morality (an incredibly divisive question on its own), it’s a question of reality. The cost of social justice is beyond the scope of humanity to conjure, let alone pay. We can’t understand the depth of the injustices we seek to remedy, and if we could we would still never be able to apply an appropriate amount of money to achieve ultimate justice. Money has nothing to do with justice! The fact is that injustice exists in our world. The question is, as Sowell states, “What lies within our knowledge and control, given that we are only human, with all the severe limitations which that implies?” (P21) Social justice is not something humanity is equipped to adjudicate, we are not God.

Your 401k account is probably loaded up in the wrong asset class

 

timj-EJ4qfFp1g8Q-unsplash.jpg

401k accounts good and bad. They’re mostly good because they provide an avenue for people to save and invest money for their future, but there are some things to watch out for.

Good stuff:

  • The main benefit of a 401k is that it allows you to invest qualified money. You could just invest money on your own, but investing in your 401k accounts means that you get some significant tax advantages (no capital gains on the growth of your investments and an income tax break). The same advantages apply to IRA accounts, but 401ks include two other significant advantages.
  • Many employers offer a matching contribution. For example, if you contribute a certain small percentage of your income (say 5%), the employer may kick in an additional small percentage into your 401k account (say 4%). That’s free money, and you should definitely take it.
  • 401k contributions are capped at $19,000 per year by the employee, employer contributions can exceed that. IRA contributions are capped at $6,000 per year. Not all of us are maxing out our qualified retirement accounts, but the larger cap offered by 401k accounts is certainly an advantage.

Bad stuff:

  • 401k accounts offer a limited number of investing options, and they’re almost never great. 401k Plan sponsors (employers) are typically concerned with one thing when choosing a plan: cost. If the plan seems expensive it will be harder to explain to the board, regardless of the value or benefits of the portfolio and the advisor.
  • Your money is locked up for as long as you work at the company. You’re stuck with the options available and you can’t move the money elsewhere unless you leave or retire.
  • Investors have little to no help deciding which funds or options to use within the 401k so they end up in default options, which are usually target dated funds. You may have seen these funds that end with a future year, like 2045, which you’d be in if you were expected to retire sometime around 2045. A target dated fund is not the worst investment you could be in (which isn’t saying much) but it’s far from ideal. A target dated fund will load you up in U.S. large growth companies (essentially the S&P 500), sprinkle in some international large growth companies, and decide what percentage of your money should be in bonds based on the target year. Unfortunately, in the history of the market, large growth company asset classes are among the lowest-performing of any asset classes over time. A target dated fund is usually made up of index funds (along with their inherent problems) so at least it’s not active, but it will sacrifice large amounts of return over time because of its poor diversification.

Don’t be afraid to use your 401k account, especially if your employer offers a matching contribution (again, free money). But if you’ve obtained the maximum matching contribution, think about investing additional money into a better portfolio through an IRA. Unfortunately, your 401k is probably loaded up in the wrong asset class.

Are you stock picking?

Stock picking is the art of choosing stocks that you believe will outperform (in which case you’d buy) or underperform (in which case you’d sell) the rest of the market, at least for a period of time. Whether you decide based on some special analytics or just follow your gut, it doesn’t really matter, you buy stocks you think will do well or dump stocks you think won’t. To put it another way, you’re looking for inefficiencies in the stock market. You believe that the stocks you plan to buy are underpriced; if everyone else knew or believed what you do the stock price would already be higher. Or you plan to sell stocks you believe are overpriced; again, if everyone knew or believed what you do, the stock price would already be lower. Naturally, once you’ve made your move, you expect the rest market to catch up and the stock prices to move accordingly.

Stock picking is a normal practice throughout the investing industry, even the prevailing practice. Professionals have been engaging with it since the inception of the stock market, and, with the advances in technology, more non-professionals than ever also have access through convenient investing apps and websites. Stocking picking is everywhere. In fact, most people think stock picking is investing, that they’re one and the same. The above definition of stock picking sounds like investing, doesn’t it? Here are a few reasons why that’s a problem:

1) Stock picking is built on the premise that the market is not efficient, that smart people can find deals and make money buying and selling the right stocks at the right time. The problem is that’s a false premise, the stock market is actually efficient. An efficient market means that stocks are never overpriced or underpriced, there are no deals, there is no right or wrong time to buy. Stock prices move based on future news and information (no one knows the future) and they react to the new news and information very quickly. If you purchase a stock based on an intuition about the future, that’s just guessing. If you purchase a stock because you believe it’s poised for growth based on a new report you read, the stock price has already adjusted to the report’s information, the price has already moved. With improving technology and additional regulation the market is more efficient now than ever before. News is disseminated immediately and trades can be placed instantaneously. There are differing beliefs as to the level or scale to which the market is efficient, but research continually supports the Efficient Market Hypothesis. Since the market is efficient, stock picking doesn’t work by definition.

2) Research into the results of stock picking has been impressively depressing. Study after study shows that no one, not even professionals, has consistent success picking stocks over time. People will outperform the broader market occasionally, maybe even for a few years in a row, but because of the number of people trying that’s a statistical probability, it’s not based on any skill. Professor Russ Wermers stated in a 2008 mutual fund study, False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas, that “the number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives.” He’s basically saying that there are so few active stock pickers who have outperformed the market that they were more likely a product of luck than skill. And that’s the professionals. Stock picking doesn’t work because it’s built on a false premise and the research agrees.

3) Research into the costs associated with stock picking is also grim. William Harding, an analyst with Morningstar, said that the average turnover ratio for managed domestic stock funds is 130% (Apr 23, 2018). That’s a terrifying number. It means that through the course of a year the fund will replace all of the stocks it owns, and then re-replace another 30%. It means that the average stock is held for only 281 days. There is a lot of trading going on here. One of the reasons stock picking fails is because of the additional expenses it incurs for all of these trades. Active funds charge an expense ratio, which is normal (although active funds typically charge higher expense ratios than passive funds because of the additional work it takes to actively trade), but they also incur significant trading costs, which is unique to active funds. The expense ratios are published but the trading costs often aren’t. A 2013 study, Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance, discovered that the average trading costs of mutual funds amounts to 1.44%, that’s in addition to the already higher expense ratio. Even worse, funds owning higher performing long term asset classes (see Three Factor Model) have even higher trading costs, 3.17% on average for small cap funds. These additional trading fees are debilitating to fund returns.

So stock picking is built on a false premise, it doesn’t work by definition, and it charges a premium for its lackluster results. On top of all of that, there’s a massive cost of lost opportunity when your portfolio is stuck stock picking. While your funds are engaged in the losing strategy the rest of the market is consistently earning great returns over time, returns that can be captured simply with diversification, rebalancing, and discipline. Unfortunately, large swaths of the investing industry still promote the active stock picking strategy, in fact, you’ve more than likely got stock picking funds in your 401k portfolio. There’s a better way to invest.