Almost a perfect counterpoint to The Little Book That Beats The Market (review), this book could easily be titled The Big Book That Shows You Can’t Beat The Market. It weighs nearly 5 pounds, and is almost 400 pages long. This thing is a beast!

Instead, the title is Index Funds: The 12-Step Program for Active Investors. This is actually a pretty good title as well. Instead of starting at the pure beginner level, it assumes that you know a little bit about the market. Maybe you’ve dabbled in stocks, or have some hot mutual fund picks on your 401(k). The basic layout of the book is this:

1) Present an active-trading idea, and then
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There’s been a lot of buzz about The Little Book That Beats the Market, so I was excited when it finally came in from the library. Of course, at the time I was midway through Index Funds: The 12-Step Program for Active Investors, which I’ll also be posting a review about shortly. Alternating between the two books was like a roller coaster – the Little Book fanning the (little) stock-picking flame inside me, and Index Fund book trying just as hard to stamp it out forever.

The Little Book is well, really little. It’s about the size of a 5″x7″ photograph and barely over 100 pages long. It could be easily finished in one afternoon. The writing style is simple and easy to read, although many of the jokes felt a bit forced to me.

It starts with a nice little story which explains what you are actually buying when you purchase a stock. In short, you’re not buying a physical object, but a stream of future earnings. This is why stock prices fluctuate so much – you’re trying to predict the often-hazy future.

Accordingly, Greenblatt argues that the Market is simply crazy over the short term. But due to this craziness, there is the opportunity to snap up a company at a bargain price. Enter the Magic Formula: Buy good companies at bargain prices. Doing some number-crunching, using the formula gives you historical annual returns of about 30%, beating the market by 20% every year. All with lower risk than the market. Yowza! Sounds good right?

The tricky thing about this book is how ‘good’ and ‘bargain’ are defined. Greenblatt uses a vague definition in the main part of the book, and then a more complicated definition in the appendix. Thanks to JLP at AllFinancialMatters, I discovered this Barron’s article which confirms that even other quantitative people can’t understand the exact definition of the Magic Formula or replicate his awesome returns. They used a different stock database, leading to the returns going down significantly. That’s a bit fishy.

But… even if you use his dumbed-down (my name, not his) definitions of:

Good = High Return On Assets (ROA), and
Bargain = Low P/E ratio,

both of which are part of most stock screeners, you still get market-beating results.

Criticisms
Any time a book claims to beat the market, people line up to crap all over it. I mean, isn’t this just good ole’ Value investing? Traditionally this is done with other ratios like Book-to-Market ratios. Again, the data seems to support that the Little Book method does better than other ratios.

Another criticism, which is noted in the book, is if everyone knows this secret, won’t the prices adjust and remove this market inefficiency? Greenblatt counters this with the fact that his method only works for the long-run, and will underperform the market for sometimes years at a time. This volatility will scare away enough investors and/or fund managers over the long haul such that the premium will endure. Okay, maybe.

My personal nitpick is that the returns also don’t take into account trading commissions and bid-ask spreads. Greenblatt glosses over this point by implying “This method kicks so much ass (remember, 30%!) that you could pay full-service broker commissions and you’d still come out ahead!”

But let’s take a closer look. He suggests holding 30 stocks, each for only a year. Unless you’re investing huge sums, that’s a big drag. If you buy in $500 chunks ($15,000 total portfolio size) with $10 trades, that’s a 4% dent in profits every year (buy and sell). Even at $5 trades, that’s 2%. Finally, if you’re not holding these in an 401k/IRA, you’ll have to deal with taxes.

Added:
1) His returns were based on data from 1988 to 2004, which may be the best he could get will full data, but still is less than 20 years. Will it persist?
2) The book has a website, MagicFormulaInvesting.com, which you can generate the current picks per the Little Book method.

Conclusion
So, if you add in the database inconsistencies, smaller future market inefficiencies, the existing value-premium, the trading costs, and taxes, will you still end up with a risk-adjusted market-beating return for the next 20 years? I have no clue. I can only say that I’m not changing any of my current investments, but if I do eventually set up a small stock-picking portion of my portfolio, I’ll keep the results of this book in mind.

Although I don’t really recommend it as an investing guidebook like The Four Pillars of Investing, I did find it a fun book to read. I think it presents a new-ish view on picking stocks and was a refreshing change of pace for me.

Overall Rating: (ratings explained)

The Big Money by Frederick R. Kobrick, was also sent to me for review. It was good timing because I was looking for books on stockpicking to expand my reading horizons. One can only read so many books on the wonders of index funds before monotony sets in.

I’d never heard of Kobrick before this book either, but apparently he is a long-time mutual fund manager with accolades such as:

– Manager of the State Street Research Capital Fund, which was ranked as one of the top five mutual funds in the country for the entire 15-year bull market in 1997
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Recently, I have been avoiding reading more investing books that were basically ‘invest in index funds, invest in index funds, invest in index funds’. Great message, but I get it already. I wanted a more detailed analysis of the different asset classes, and more advice as to what to actually buy. And so I found All About Asset Allocation by Richard Ferri, which does exactly that.

The beginning of the book starts like most other index fund books: great investment skill is very rare, asset allocation determines much of your investment return, expenses matter, and you should invest for the long term. The book also explains (better than I can here) how asset allocation works by reducing your overall portfolio risk by introducing asset classes that have a low correlation to each other.
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The Intelligent Asset Allocator (IAA) by William Bernstein does exactly what it says on the cover, it teaches you ‘how to build your portfolio to maximize returns and minimize risk’. However, I would recommend that 95% of readers not buy it. Come again? Instead, I would recommend the later book by the same author, The Four Pillars of Investing (review). Even though Bernstein himself refers to it as for the ‘liberal arts’ audience, I have an engineering background and I still like Four Pillars much, much more. It just feels more refined and easier to follow.

Both books seem to cover the same general topics, with IAA giving you a clearer mathematical basis for his conclusions. To me, here are the main ideas within the book:

1) There is very little evidence that, on the whole, actively managed funds outperform the market. In fact, if you just buy what’s been hot the last 5 years, history has shown that you would consistently underperform the S&P 500 afterwards. In other words, don’t chase past performance.

2) As risk increases, so does the return. But that doesn’t mean you should just go out and buy the one riskiest thing you can stomach. Your goal is to get the maximum return out of your acceptable amount of risk.

3) To achieve the goal in #2, you must construct your diversified portfolio out of multiple asset classes which will work in combination to reduce risk. The vast majority of your returns come from your asset allocation mix.

4) You can’t guarantee your future returns, or expect them to follow historical returns exactly. What you can do, is to optimize your portfolio using that data to give you the best chance at achieving the highest returns.

5) Minimize expenses and taxes by choosing no-load index funds with low expense ratios, and by carefully placing each asset where it will be most tax-efficient (taxable vs. tax-deferred accounts).

Finally, in the end, the book gives you some advice on how to choose your specific asset allocation and then implement it using Vanguard or DFA funds. Again, I found the same section in Four Pillars to be easier to follow, and I’ve found myself referring back to it instead of IAA to plan my portfolio.

Summary
Read Four Pillars of Investing first. If you like things like standard deviations and statistics, then pick up The Intelligent Asset Allocator. They are both excellent books, with different approaches to teaching the same material.

Overall Rating: (ratings explained)

Ponzi scheme. You’ve most likely heard of the term, although you may not know exactly how it works. A Ponzi scheme is a scam where investors are promised amazingly high returns on their money based on some ‘secret super-investment’, but in reality the money to pay older investors is simply taken from the money of new investors. Of course, this can’t go on forever, and the investors involved at the end are usually left with nothing.

Let’s take the most recent ‘investment program’ which reeks of being a Ponzi scheme, 12DailyPro, which is now being investigated by the FBI. The story of this interested me so much I started reading ‘Ponzi: The Incredible True Story of the King of Financial Cons‘. The similarities between his story and 12DailyPro are astonishing.

Let’s start with Charles Ponzi, an Italian immigrant in the 1920s who promised a 50% return in only 45 days, compared to the 3-4% that banks were giving out at the time. He stated that the crazy returns he got were from some sort of international transactions involving postal stamps and currency exchanges. The first people involved were skeptical, but when he delivered on the promise in 45 days, people started rushing in with their money. At his peak, he had about $10 million (in 1920s money!!) of other people’s cash. Of course, there was a spectacular collapse when the government finally stepped in and shut it down. Even at the end, Ponzi still had many devoted followers who refused to believe it was a scam.

Ok, now fast forward to the present:

12DailyPro.com debuts, and promises a 44% return on your money in only 12 days, as compared to the ~4% APY banks are giving out now. The investment program states that the money comes from users surfing websites with advertisements for about 5 minutes a day, amongst other vague things. The first people involved were skeptical, but as the site consistently delivered the said returns, people started rushing in with their money. Millions of dollars are reported to have went through the company. Due to recent investigations by various state and federal authorities, the site has shut down, with many people losing tens of thousands of dollars. Even during this collapse, 12DailyPro still has many devoted followers who refuse to believe it was a scam.

Eery, isn’t it? I believe some people invested in 12DailyPro knowing full well it was a Ponzi, but also aware that the early adopters could come out well ahead. I think the rest truly thought they had found a gold mine that would erase all their debts and give them passive income forever. Anyways, the book was really good and almost made you root for Ponzi and want him to come out on top. I couldn’t put it down, the story really shows how greed can blind people.

For more on 12DP, check out this Wall Street Journal piece. A quote from the article:

Asked if he thought the gains were too good to be true, Mr. White said, “I suppose there was a possibility it was a Ponzi scheme. You always had that at the back of your mind.” He added: “144% in 12 days? You don’t get that from your bank.”

How do you know when there’s too many personal finance books out there? When comedian Dave Barry does one. In his new book Money Secrets: Why Is There A Giant Eyeball on the Dollar?, he pokes fun at corporations, Suze Orman, and everyone else.

He shares such gems as the solution to soaring college costs: Don’t let your kid study too much, so they can’t get into private school. State schools are much cheaper. Just like the gurus, he’s got a financial assessment quiz for you, with questions like:
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Smart and Simple Financial Strategies for Busy People. Whew, what a long title. I was putting off reading this book because it seems like ‘just another personal finance book’ by another so-called Money Guru. (I’d never heard of Ms. Quinn before getting this book from the publisher.) And in many ways it was. But I also learned a couple of new things.

I found it amusing that she makes fun of David Bach’s “latte factor”, while the rest of her book is so similar to his Automatic Millionaire book. Save a certain percentage of your money automatically every month. Invest it into diversified index funds. Let it compound happily. Sound familiar?
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