Medicare: Begins, Not Ends, Reform
The elderly consume a disproportionate share of total health expense. That soon forces Medicare, the "Third Rail of Politics", to get first attention in any lifetime health plan -- even Lifelong Health Savings Accounts, our central proposal.
Low-fee, low-turnover investing of diversified index funds is sweeping away old-fashioned investment management.
Burton G. Malkiel published A Random Walk Down Wall Street in 1973, and John Bogle founded Vanguard Group in 1974. Without getting into quarrels over originality, the timing makes it hard for an outsider to judge who thought of what, first. It could diplomatically be said there are two concepts mixed together to make a more general concept called passive investing. Professor Malkiel is associated with the idea that the stock market contains all the information publicly known about corporations, so, therefore, a random selection of stocks will result in the same yield as stock analysis will, and involves less trouble and expense.
Jack Bogle is in the stock brokerage business and offers a closer, more critical, view of his competitors in the business. In his view, whatever extra profit there might be in stock-picking by experts, is eaten up by the experts themselves in the form of fees and salary. So, why bother with any small differences, when the vast multitude of ordinary investors would be better off with passive investing. There is little practical difference between the messages of the two essayists, although John Bogle's Vanguard has already achieved deposits in the trillions, growing so fast they have largely closed their retail outlets. Both men advocate the advantages of wide buy-and-hold diversification, with low brokerage fees. And because of low turnover, fewer taxes. John Bogle is more censorious about retail brokerage practices.
Ultimate Goals of Passive Investing. These two offer somewhat different reasonings, but they come to the same conclusion: The average investor will do better for himself, using random stock selection, than by picking individual stocks, even with the help of experts. John Bogle offers the simply packaged randomization of the capital-weighted Index Fund, which allows the manager of the fund to maintain the same randomization if it wanders, and he has his reasons for thinking one particular method (capital-weighted) of indexing is best. You might add other factors, like cost saving through computers in the "back room" shuffling of orders and payments or narrowing of the buy-sell margins by greatly increased transaction speed and capacity of computers. Who cares, it's now cheaper.In any event, it was John Bogle's insight into how to take practical advantage of these stockbroker ideas, which produced index funds mirroring the whole stock market, and their close relative, ETF, or stock-traded units of index funds. Taken all together, these features make up the concept of "passive investing", which includes the advantages of buy-and-hold over more frequent trading; the considerable reduction of advisory fees; broad diversification; and taking advantage of the payments float. Substituting randomization for stock research introduces economies of scale, and shifts the profits from stock research to computer research. Unfortunately, many other methods of random selection have been offered which give the investor different returns, and they too call themselves Index funds. Someday, someone may well devise a formula for constructing an index which produces results superior to those weighted for company capitalization; keep an eye out, but be careful of fly-by-nights. Furthermore, index funds ordinarily start small, using a sampling technique; in time, they can get big enough to contain a proportionate share of all stocks listed in the index and be picked by "big data" methods. But which index? If you buy a small-stock index, some of the stocks will grow right out of that category and into the need to be replaced. A few of the components of a large-stock index will fail and be dropped. In a mid-cap index, there can be migration both up and down. The simplified method at present is to restrict the list to index funds which are 15 or more years old and pick the index which has performed best. Switching around among index funds defeats the transaction-cost saving, achieved by just buying one index and sticking to it.
That is, someday the system may improve still further, but at the moment an innovation seems just as likely to harm results, as improve on them. Nevertheless, the quest continues, because a variation of a trillion-dollar fund by a tenth of a percent, produces enormous overall savings (and bonus) for the fund manager. The manager is looking at totals, the individual investor looks at averages. Eventually, profitability may shift from computer research to tax research, or from tax research to marketing skill.
In what follows, we are suggesting trillion-dollar Index Funds, so big they might contain some of every listed stock in America, or in the whole world. As any tiny stock rises, it gets included; and as any listed stock fails, it is dropped. Even the largest stocks individually affect the average to only a slight degree. Right now, John Bogle's books and speeches emphasize the brokers' fees and commission as what the investor captures, while Burton Malkiel tends to emphasize the essential randomness of the entire stock market. Both men are surely correct to some degree, and the investor need not care why the system works. It's called "passive investing", with the central advantages of avoiding the selection of individual companies or industries, and at the extreme, emphasizing the economies of the whole world. In the case of American investors, there is the great good luck that American stocks are both the biggest and the best performing. If you think this will change in a lifetime, an argument can be made for the superiority of world-wide indexes. In the long run, all sovereign nations can change their rules and taxes. While the average investor is encouraged to buy the biggest and cheapest, it is possible to go too far. Every passive investor is urged to compare the results of his choice with a broad range of 15-year competitors, once a year, just in case. At least one fund, the Pitcairn Fund, restricts itself to family-owned businesses, and that has a certain logic to it.
It makes some difference which factor most explains the improved performance of passive investing because they reach limits of penetration at different times. Index investing is increasing by trillions of dollars a year but must flatten out eventually when the market finally segments into those who wish to vote their shares, and those who are content not to meddle. John Bogle irritates his colleagues by repeating, the financial industry takes 85% of the total return for themselves, but even if that is accurate, it must come to an end when the financial industry threatens suicide if it isn't better paid.
Further Growth of Returns. It does appear that Bogle has so far won his argument, but eventually one-off things like this always flatten out. It would be my opinion that Roger Ibbotson's book of the century-long returns on various asset classes sets final limits to the running average to be achieved by this approach. To whatever degree the index funds fall short of Ibbotson's figure, the manager of an index fund has further work to do. To be blunt: The difference between the long-term results of index funds, and the price index for the asset class, probably results from the degree to which the index fund manager or his company is himself eating up the total returns. But some of it is the difference between doing it with pencil and paper, and actually doing it. For example, small-cap index funds should closely approach 12.7 % long-term total returns. (i.e. dividends plus realized and unrealized capital gains.) Strangely, big business corporations you have likely heard of, average only 10.4%, so the executives of firms of over a billion dollars in capitalization are extracting a 2.3% premium from stockholders for something unidentified, which needs to be clarified. Long-term U.S. Treasury bonds average 5.4%, and U.S. Treasury bills average even less at 3.7%. All of these various premiums for "safety" would seem to be the market's estimation of their true value, and that premium must surely disappear if they cannot justify it. Inflation averaged 3%. The far superior results by Warren Buffett and David Swensen, the endowment manager at Yale, represent the somewhat different advantages of being a large, immortal, tax-exempt investor buying things like Canadian lumber forests, totally beyond the reach of the average small investor. When someone devises a way to capture these advantages for the small investor, their new price advantages might possibly be considered achievable by average investors, but if so that advantage should be reflected in the index, to some extent.
Buy-and-hold Index Fund Investing. Index funds will vary in their returns, and the difference between 0.25% commission and 0.06% will only become noticeable in larger accounts. But the difference between $7 retail trades (passive) and $300 trades (active) is simply absurd. If an index fund is composed of the stocks of American companies in the same proportion as the stock market, investing in an American index fund becomes the same as investing in the American economy. Investing in a total world index is comprehensive in a different sense, but there is merit to the idea we owe this success to the American economic style, so Americans ought to climb aboard the American lifeboat. If they do, there is the reason to argue they should eventually reach a limit of an effort-free 12.7% return on their money; any higher return probably entails unrecognized risk. But remember, high corporate taxes have driven many American corporations to Ireland, the Cayman Islands and other tax havens. If this trend gets out of hand, it may be necessary to turn to world index funds. But when the broker gets fancy and makes up an index of his own recommended stocks, the maneuver gets too fancy to be called passive. That's a variant of active investing, and it's not what we are talking about, or recommending.
Short and Long-term Volatility. Every business has cash overhead, endowment funds have volatility; put those two ideas together and you find periods of time when there isn't enough cash to run the business or pay the dividends. According to Ibottson, the yearly volatility of the stock market is 11%, meaning 70% of the time the market is within 11% (one standard deviation) of the mean. It would thus seem prudent for a fund manager to hold 10-15% of the portfolio in cash, recognizing that when a fund is growing there will be considered cash inflows from new deposits. For this reason, an index fund should probably be only 90% in stocks, 10% in cash. There are also long-term cycles of 28-40 years (remember 1929 and 2008), with a volatility of 50% followed by a recession of 10 or so years. For a fund to continue to pay out 8% during those cycles requires long-term reserves of about 20% in long-term fixed income securities averaging 5.5%. This is what underlies the old adage of 60/40 portfolios, although most observers see the cycles are lengthening, suggesting smaller portions of fixed income are safe enough. In all likelihood, the appropriate asset mix is a gamble on which stage of the long term cycle you are in. If you start at the very depths of a new cycle, it is probably appropriate to have no long term reserves at all, but scarcely anyone has that degree of self-confidence. In the long run, the number of needed reserves will depend on the attitudes and ages of the investors.The Past is (usually) Prologue. All those historic events, plus several severe recessions and the invention of the computer, seemed like earth-movers at the time, but in retrospect scarcely affected the long-run relative values of various asset classes. Unfortunately, many of John Bogle's insights were not available during long stretches of this experience, so data is not available for precisely the mixtures we wish had been collected. It is also useful to keep in mind the man who drowned while crossing a river which averaged six inches deep. Nevertheless, it seems safe to conclude U.S. Treasury bills will closely follow U.S. inflation, and stocks will do better than bonds. Traditional Endowment Lore. The endowment community contains a great many serious investors whose livelihood and reputation depend on arriving at the right combination of safety and income return on their endowments. Among such persons, it is the wide-spread belief that a long-term return of 8% is about the limit of the safe return of an endowment. The reasoning focuses on the perpetual need to return a safe maximum, in spite of unpredictable hills and valleys of investment return. In those circles, the most devastating mistake they can make is to be forced to sell good stocks at the bottom of a decline in the market. Seeking to avoid that squeeze at all costs, the 8% maximum return is the conventional answer of these professionals. Their stocks return 10%, but they are diluted by holding enough bonds or cash to reduce the effective overall return down to 8%. The exact proportion of bonds will depend on how much cash flow they can expect from new contributions during a recession, and that is variable between endowments. For this reason, we tend to use 7% in our illustrations, because the formula of -- 7% doubles the principal every ten years -- makes it rather easy to do long calculations mentally. So that's the working goal: invest your Index stock portfolio so it returns between 10% and 12.7% annually, and dilute the stocks with cash or bonds until the total portfolio reaches 8% as return on investment. If that overall running average is not maintained, questions need to be asked. Individual accounts may vary from these benchmarks because people do get sick unexpectedly, but the aggregate account of all subscribers needs to achieve this goal to be considered healthy and its index fund to be considered well-run.
What if We Start Investing Just as a Long Depression Begins? John Bogle was recently on a television program, asserting long-term passive investing will probably average 5% total return for the next decade. Since the stock market is up 20% in the past year alone, one interpretation is this is a way of saying he expects a major decline in stocks of 25% fairly soon, from which there would be a recovery of 30%, leaving a 5% gain for the whole cycle. (He might well squirm at this interpretation of his remarks, which definitely were not that specific.) At his age, with his heart problem, he probably regards 10 years as long-term, while this book is looking at an 80-year horizon of 10%. In that sense, all of us could mean the same thing. I am urging the belief that if the market closely followed 10% for the past century, it will probably return to 10% for the next century. Of course, it might turn out that it follows 5% for half a century, then follows 15% for the last half of a century; that would have mathematical truth but would be essentially worthless information for everyone who dies in the next fifty years. Those people would be like the inhabitants of Asian Angkor Wat, or the Mexican Yucatan, dreaming of past glory for a while, but eventually just forgetting it all during a parade of ancient relics. But since I am willing to concede 5% for the next century is a possibility, it is necessary to wish for some enduring wisdom to emerge from the wars of civilizations, not just within national economies, or the transient achievements of a single stock market.
Rising Above Mere Investing. Running one of these funds is not child's play, even though individual stock-picking is superseded. The only reason for investing amateurs to play with such numbers is to get a feel for what size of total return should be expected, in the light of what others are doing. The reader is invited to study Ibbotson's yearbook, and see for himself whether he agrees that a 10% total return on stocks seems safe to bank on; or whether the whole permanent staff devoted to the management of some favorite fund needs to be replaced. Best of all might be to invest in several private funds and reward the ones that do best. To go just a little further, Congress might even consider whether management which consistently produces less than the long-run return of a related index is eligible to be replaced. But that's not reasonable. To be reliant on such approaches alone is unlikely to be successful. One only needs to watch how quickly an investment committee clusters around the consultant they have hired, glowingly eager to ask him for investment tips, while ignoring the business at hand.
But that's not what this book is about, nor what is ordinarily expected of bean counters in a bureaucracy. Someone must devote himself to such issues, but there's investing and there is finance. About the best, we can hope for is to include in our planning some national agency to monitor the economic environment. That agency should feel obliged to warn Congress and the nation that we must apparently reduce our goals for the program. We might need to develop some other plan for paying off foreign debt for Medicare, for example. Or the Health Savings Accounts might only be able to pay 50% of our bills, saving the rest for unexpected contingencies. Or we might need to require a 50% larger annual deposit in the HSA accounts. Or we might need to float some bonds for the duration of some sudden national emergency. All because it becomes apparent in the future that some national or international upheaval has changed the basic terms of trade. It's important to be a good investor, but when a program gets as large as this one ought to become, its finances are pretty much the same as the national economy, and each will influence the other.
The takeaway points are that the better funds can and should produce total returns which are superior to what an ordinary citizen can produce for himself, and some way to measure it is mandatory. And also, that there is no point to getting into this unless Congress establishes -- and monitors -- policies which deliver on the promise. If you think Fannie Mae and Freddy Mac affected the economy, just consider what this one could do.
This program will fail unless we maintain a narrow margin between what the stock market is earning, and what its owners are earning.
Your money earns 11%, but that isn't necessarily what you will earn.
Proposal 14: Congress should remove all upper (and lower) age limits to opening Health Savings Accounts.(2584)There needs to be an added layer of investment in government securities, to provide liquidity to all HSAs, in the general range of 10% of the total investment. There must be some available cash in any business; there are bills to be paid. For example, in the case of Obamacare insurance, the first purchase in the deductible fund might well be $1250 in indexed Treasury Bills, reverting to total stock market index purchases, thereafter. Other liquidity needs are an individual matter, remembering cash reserves will lower the overall return of the fund and slow its growth. At the moment, interest rates are artificially low; leaving the reserve in cash is nearly as good. At this writing, we have experienced several years of essentially zero short-term interest rates, so long-term bonds are not for an amateur to buy.
Proposal 15: Congress should impose transparency rules on fees and net returns for Health Savings Accounts, including mention of the fees available from the least expensive local competitor.(2584)
The investment alternative of purchasing in-house stock-picking funds, or funds with a concealed kick-back to your broker, is probably the riskiest of all alternatives available, and to be avoided. The goal here is to get a 10% long-term return as cheaply as possible, or else as soon as possible. With an index, 50% of customers do better than the average, and 50% do worse. For health costs, just be sure to avoid the bottom 50%, and the rest becomes fairly easy. There is one other common hazard: the tendency of all investors, small and large, to buy high and sell low. Dollar-cost averaging is the simplest way to avoid it.
In recent years, health insurance has tended to avoid co-pay and therefore to raise deductibles. For people living from paycheck to paycheck, any hospitalization encounters a cash shortage, soon translated into a hospital bad debt. It is not entirely clear what plans have been made to meet this shortfall. There needs at least to be an added layer of investment in government securities, to provide liquidity to all HSAs, in the general range of 10% of the total investment. On the other hand, it is possible to be too cautious, maintaining a duplicate cash balance for an investment fund which is itself maintaining a 10% fixed-income portfolio. In the case of Obamacare insurance, the first purchase in some deductible fund might well be $1250 in indexed Treasury Bills, reverting to total stock market index purchases, thereafter. Indeed, because of the universality of high deductibles, it looks as though an HSA ought to be the first step in any health insurance with a high deductible. Always remembering not to duplicate the safeguards put in place by the fund manager. Specific investor cash needs should also be kept in mind: regardless of fund composition, just how available is your fund's cash to the customer? Excessive cash reserves will lower the overall return of the fund and slow its growth. At the moment, interest rates are so artificially low, leaving the reserve in cash is nearly as good. At this writing, we have experienced seven years of essentially zero interest rates on Treasury bills, so long-term bonds are not for an amateur to buy.
The investment alternative of purchasing volatile stock-picking funds, or low-return funds with a concealed kick-back to your broker, is probably the riskiest of all alternatives available, and to be avoided. The goal here for HSA owners is to approach a 10% long-term return as cheaply as possible, or else as soon as possible. With an index, 50% of the customers do better than average, and 50% do worse. For health costs, just be sure you aren't in the bottom 50%, and the rest becomes fairly easy; passive investing assures it. There is one other common hazard: the tendency of all investors, small and large, to buy high and sell low. Just avoid selling stock; if you plan not to keep it there for long, just put some cash in the bank.
Originally published: Wednesday, September 17, 2014; most-recently modified: Sunday, July 21, 2019