Wizards and Humbugs

Outsourced thinking runs rampant in the world of investing. Jon Stewart laid bare the dangers of letting others direct our investing attention during one of the most memorable Daily Show segments of 2009 in which he interviewed Jim Cramer. Cramer, the host of the popular prime-time financial advice program Mad Money, joined Stewart during a weeklong series of discussions about financial markets and the financial crisis.

During the half-hour interview, Stewart took Cramer—and the broader financial news industry—to task for misleading viewers seeking investment guidance. After some friendly banter, Stewart explained why Americans were frustrated with finance and, specifically, financial media. Stewart cited a “gap between what CNBC advertises itself as and what it is and the help that people need to discern this.”³

To crystallize the idea, Stewart played the promotional advertisement for Mad Money while pictures of Cramer wearing a tie with a serious expression flashed across the screen, a seemingly wisdom-filled voice bellowed, “The economy in free fall. Investments on the brink. When you don’t know what to do, don’t panic. Cramer’s got your back!” At which point the logo for the show appeared, reminiscent of a dollar bill: “IN CRAMER WE TRUST” was written across the bill. After the audience had a small chuckle, Stewart spoke directly to Cramer, saying, “We’re both snake oil salesmen to an extent, but we do label the show here as snake-oil. Isn’t there a problem selling snake oil as vitamin tonic?”

In Stewart’s eyes, Cramer had misdirected his viewers. He suggested Cramer was trying to entertain people, but in the process obfuscating the seriousness of investing. The normally comic Stewart then turned noticeably serious: “I can’t reconcile the brilliance and knowledge that you have of the intricacies of the market with the crazy bullshit you do every night.… I understand that you want to make finance entertaining, but it’s not a fucking game.”

I was recently reading The Wonderful Wizard of Oz to my children and I couldn’t help but notice the similarities between Cramer and the Great Humbug. (Perhaps this is because I had recently been reading how The Wonderful Wizard of Oz has been analyzed by some as a parable about the perils and dangers of currencies that were not backed by hard assets!⁴) But in the children’s version of the story, Dorothy discovers that the Wizard is not the magical force she and the Lion, Tin Man, and Scarecrow had been led to believe he was, and so bluntly asks: “Are you not a great Wizard?” to which he replies, “Not a bit, my dear; I’m just a common man.”⁵

The Wizard says that he can’t “help being a humbug … when all these people make me do things that everybody knows can’t be done.”⁶ Reading this line to my children made me think of Cramer as “The Wizard of CNBC,” the great humbug of the modern investo-tainment industry.

Stewart seemed to draw a similar analogy. After he highlighted Cramer’s obvious duplicity and misguided focus on getting eyeballs rather than helping investors, Cramer agreed that the “goal should always be to try to expose the fact that there is no easy money.” But Stewart didn’t stop, adding, “There are literally shows called Fast Money” on CNBC, to which Cramer sheepishly responded: “There’s a market for it and you give it to them.” Sound like the Wizard of Oz? Is Cramer the finance equivalent of a common man peddling bran and pins and needles as brains?

The problem is ultimately one of focus. In our never-ending search for magic bullets, we willingly listen to those offering the investment tonic that might cure our woes. By doing so, we’re misled and misdirected. We focus on the wrong things. Cramer, CNBC, and most of the financial media complex funnel our attention toward individual stocks and the daily vicissitudes of financial markets. Our focus as individual investors should lie in long-term investing, not whether Cramer’s reaction to the mere mention of a stock yields a screaming “Buy, buy, buy!” while he frantically throws a stuffed bull at the camera. Our focus should not be on the daily swings in stocks. Aside from professionals who spend their days and nights studying markets, it’s been best to just gain broad exposure at low costs. But that too may be changing, as I’ll address in the next section.

Jack Helped Me (and Millions of Others)

I’ve known Jack for a long time, and I attribute much of my success to his generosity. In 1987, as an eighth-grade student at Mt. Arlington Public School in northwestern New Jersey, I heard about a scholarship program being offered at a boarding school located due west of my family’s home in Landing, New Jersey. I had never even contemplated private school. Simply put, my family couldn’t afford the option.

But a scholarship was a compelling proposition, and you can imagine my joy when I was awarded a scholarship and supplemental financial aid to attend. I enrolled as a freshman at Blair Academy in the fall of 1988 and began a four-year high school experience that inspired me and gave me much-needed confidence. My time at Blair would not have been possible with the generosity of a single donor—John C. Bogle (Jack)—the father of the passive index fund and the founder of Vanguard. I had the distinct honor of getting to know Jack before I understood what a mutual fund was. He changed my life by opening a world of opportunity.

The best part of Jack’s story is that I’m just one of the millions of lives that he’s changed. By shifting the focus of America’s investing mantra, Jack helped secure the retirement and futures of many people. Here’s an abbreviated story of his career and the stunning focus-shift he’s enabled.

Jack became interested in mutual funds as an undergraduate at Princeton in late 1949, when he came across an article in Fortune. An economics major, he decided to write his senior thesis on the industry.⁷ After graduation, Jack secured a job at the Wellington Fund, rising through the ranks and eventually becoming chairman. After being forced out in 1974 following an unwise merger that he oversaw, Jack set out to found a new company. He named it Vanguard after the British admiral Horatio Nelson’s seventy-four-gun ship, the HMS Vanguard.⁸

Jack made sure that the shareholders in the mutual funds of Vanguard also controlled the company itself, so that the interests of shareholders in the funds and the company were aligned, allowing it to focus on reducing fees. Under this new entity, Jack started the first real index fund, which tracked the S&P 500—inspired by a 1974 article Paul Samuelson wrote calling for the creation of such a fund. Further, Jack’s own research showed that most active funds lost out to the S&P 500.

Toward this end, Jack exhibited a mission-oriented mindset. His goal was to offer well-diversified funds at minimal costs, focused on the long term. Rather than getting sidetracked by a task focus, when his initial offering was 93 percent below the anticipated size and underwriters wanted to cancel the deal, Jack responded, “Oh no we won’t! Don’t you realize that we now have the world’s first index fund?” At the time, Jack recalled, the fund was referred to as “Bogle’s Folly.”⁹

But it ultimately took off, in part thanks to support from Samuelson and others. Today, Vanguard controls some of the biggest equity funds in the world and manages trillions of dollars of Americans’ assets. Jack contributed at least three major developments to investing. First, he introduced index funds. Second, he lowered the costs of these funds. And third, he showed the importance of removing the perverse incentive of for-profit mutual fund companies. In doing all this, Jack meaningfully shifted the objective for many investors from beating market returns, eloquently called “a loser’s game” by Charley Ellis, to earning market returns.¹⁰ By helping individuals not lose, he helped them win.

Jack’s logic was sound: turning off CNBC, focusing on asset allocation, and investing in Vanguard’s low-cost passive index funds would allow you to avoid many investment pitfalls. (I’m not sponsored by Vanguard, I promise!)

But I need to insert one (major) caveat. The logic behind passive investing relies on two things: (1) accurate prices and (2) owning everything. But these don’t always hold true. Prior to his unfortunate passing in January 2019, Jack was getting nervous about another product available to investors hoping to go passive: exchange-traded funds, or ETFs. First created in 1993, “ETFs have become a marketing and promotional game,” he said in an interview with Think Advisor.¹¹ The July 2, 2017 issue of Things That Make You Go Hmmm, a newletter published by my friend Grant Williams, who’s been active in the finance world for thirty years, was titled “Passive Regression.” In it, Grant quotes Jack:

Through September 2015, shares of the 100 largest ETFs, valued at $1.5 trillion, were turning over at an annualized volume of $14 trillion, a turnover rate of 864%. By way of comparison, the annualized turnover volume of the 100 largest stocks, valued at $12 trillion, is running at $15 trillion for the same period, a turnover rate of 117%. Trading in the 100 largest ETFs thus represents about 89% of such stock trading, up from a mere 7% 15 years ago. Given these powerful data, it is hardly unfair to describe today’s ETFs—as a group—as the modern way to speculate in the stock market.¹²

Passive investing is good generalist logic. You can’t know everything, so why not own everything? But with the explosion of indices, each one narrower than the last, the logic breaks down. Are you really getting the benefit of passive investing when you invest in an index that tracks small cap biotech companies listed on emerging market exchanges but excluding state-owned enterprises or companies that begin with the letter w? It’s now possible to invest in the Obesity ETF, SLIM, which tracks the performance of companies positioned to profit from servicing the obese, more than 40 percent of which is invested in two companies; narrow ETFs such as these (and others) may prove useful for speculation, but let’s not think they’re good passive index investments.

The irony is that the logic that makes passive investing a good idea falls apart when too many people start to do it. Think about it. Imagine a world in which everyone is investing passively. All stocks would rise or fall depending on inflows or outflows. Both good and bad companies would rise with inflows and fall with outflows. The premise that prices are accurate, the foundation upon which the argument in favor of passive investing lies, breaks down. Systems thinkers will not find this shocking.

Prices lose their grounding if everyone invests passively. The blunt reality is that passive investment involves buying and selling stocks without considering their price. Stop and think about my last sentence. Does that make sense? Would you really want to buy and sell securities without considering their prices? We’re now seeing a drop in active investing overall, which I think is a worrying trend. We want people paying attention to prices! And in fact, it’s the active investment community that helps push prices toward their fair values. Without active investors, price discovery processes break down.

Grant describes this phenomenon with respect to fixed income ETFs, which have ballooned in recent years: “Assets which used to be subject to scrupulous credit checks … now sit in one-click wonders and, as volatility has steadily fallen, so has the quality control around the bonds which make it into ETFs.”¹³ Back in 2010, only 20 percent of companies in the S&P 500 had Vanguard index funds with a significant ownership stake (5 percent or more); since then, the number of companies in which Vanguard (and its peers BlackRock and State Street) own meaningful stakes has risen.¹⁴ As fewer people actively choose which companies to invest in, I’m afraid that we’ll see the market become more volatile. As the report showed, stocks with the highest passive ownership were more vulnerable to price swings because fewer shares were available for trading.

In many ways, investing successfully over the long term is about thinking for yourself and ignoring the noise. It’s about being a contrarian and understanding that most people do not think for themselves, allowing financial media houses to manage their attention. Push back on the allure of hot stocks and the Mad Money–inspired investo-tainment industry … and think for yourself about what makes sense for your risk tolerance and personal objectives.

“What Do We Do, Boss?”

When it comes to making decisions and thinking for yourself, in no domain are the stakes as high as they are when it comes to fighting terrorism. Jose Rodriguez, the director of the US Counterterrorism Center from 2002 until 2004, faced perhaps the highest stakes decision of his life when he was later traveling in Pakistan.¹⁵ But before I tell you about the call he received, it helps to have some background.

In the tense post-9/11 period, US intelligence authorities were monitoring what seemed like a never-ending stream of plots to attack US interests. Many American allies, including the United Kingdom, shared intelligence and coordinated gathering efforts. By 2006, one specific plot was gaining momentum at an alarming rate.

Here are the facts as they unfolded.

British intelligence services had been tracking a person by the name of Rashid Rauf, who supposedly had been in touch with Al Qaeda leadership in Pakistan. He was a British man from Birmingham and was emerging as the ringleader of a major terrorist plot.

By chance, investigators had the opportunity to covertly open the luggage of Ahmed Ali, one of Rauf’s numerous accomplices, when he returned from a trip to Pakistan. His luggage contained a large number of batteries and some Tang, the orange drink powder. These items raised sufficient suspicion that British authorities began what was then the country’s largest surveillance operation, employing hundreds of people and dozens of targets. It unveiled a disturbing set of facts, including a person of interest disposing of numerous empty hydrogen peroxide bottles. When the surveillance team followed him, they noticed him meeting with another individual, whose apartment (upon later covert inspection) was a de facto bomb factory. MI5, the British intelligence service, installed recording and transmitting devices in the apartment and later watched individuals constructing explosive devices out of various drink bottles. One of the men was later seen at an internet café, where he spent two hours studying airline timetables.¹⁶

The widebody plot, as it has since been called, seemed to point to the simultaneous downing of numerous planes that were heading to North America, all being masterminded by Rashid Rauf’s Al Qaeda cell. Both the US and British intelligence services were getting increasingly alarmed at the specificity of the rising threat. According to some reports, the British MI5 had infiltrated the group with an undercover agent. The evidence of an imminent attack was mounting.

As former CIA director Michael Hayden recounts in Spymasters, a documentary about the American intelligence agency, the US and British analysis of the threat differed a bit with respect to process: “The British wanted to build up as much physical evidence as possible … so we’re saying ‘They’ve got the hydrogen peroxide’ … and they’re saying ‘we need more evidence.…’ ” Hayden continues: “They had gathered up an awful lot of hydrogen peroxide and a homemade recipe to turn it into an explosive and then put it into sports bottles … so we had great concern on our side of the Atlantic.”

Rodriguez, who reported to Hayden, noted that the stakes were rising every day: “the plotters had already selected the ten flights that they were going to blow up … and I said to myself, ‘This is imminent!’ ” In early August 2006, Hayden was in Pakistan with Rodriguez, who at the time was the head of the National Clandestine Service. Rauf happened to be in the country as well. Rodriguez was summoned to a meeting with the chief of Pakistani intelligence and informed that they may have an opportunity to capture Rauf that very evening at a police checkpoint.

Earlier that day, CIA headquarters personnel had explicitly promised the British authorities that the American agency would not capture Rauf. Further, Rodriguez noted at the time, “I was told that Prime Minister [Tony] Blair had spoken with President [George] Bush that day and they had agreed that they needed more time.”

Later that very evening, Rodriguez was traveling with the CIA’s chief of station for Pakistan, who received a call from the Pakistani authorities informing him that the bus with Rauf was approaching the police checkpoint. The Pakistanis wanted authorization to capture Rauf. The chief of station turned to Rodriguez and asked, “What do we do, boss?”

What would you do? Remember the stakes. Lots of lives. But also that the president of the United States assured the prime minister of the United Kingdom that they would not capture Rauf. In boiling down the situation to its very essence, General Hayden commented, “So Jose, in a very short period of time, has to make a really big decision.” Had Rodriguez taken time to phone up General Hayden or to seek permission from Langley, it would have been, as he later noted, “the equivalent of saying ‘no’ to the operation.”

At great personal risk to his career, his reputation, and to the trust that had been built between the British and US intelligence communities, Rodriguez authorized the capture. Despite the protocol of following a chain of command, Rodriguez thought for himself. As Hayden later said, “The decision he made was ‘I can’t pass up the opportunity to grab Rashid Rauf,’ so he does.” The plot was foiled, saving hundreds of lives and preventing a global panic.

Weeks later, the New York Times revealed that seven martyrdom tapes had been discovered during British raids.¹⁷ Further, digital forensics found files pointing to the specific flights operated by United Airlines, American Airlines, and Air Canada that had been targeted, all of which were departing from London’s Heathrow Airport and were headed, as suspected, to North American cities including San Francisco, Toronto, Montreal, Chicago, Washington, DC, and New York City.¹⁸

As a result of the British raids and breakup of the cell, information was later revealed during the trials of several plotters that confirmed earlier suspicions. The plotters had planned to use hydrogen peroxide mixtures to create explosives once onboard and to use batteries to detonate the homemade bombs. And so now you know why passengers flying on commercial aircraft in the United States are restricted from bringing more than 3.4 fluid ounces (100 ml) onboard the plane in their carry-on luggage.

The stakes of thinking can be very high, as Rodriguez learned. But had he not thought for himself, or if he had decided to take a permission-driven approach, it’s unclear what might have happened. The panic and economic impact of a successful terrorist attack would have been as severe, if not more so, than 9/11. Fortunately, it didn’t transpire … but it was a really close call, prevented in large part by an official who thought for himself.

The Swensen Effect

As a thirty-something financier with zero experience managing money, David Swensen was convinced by his dissertation advisor, Nobel laureate James Tobin, to return to mother Yale from Wall Street and run the university’s endowment. Rather than begin from the approach taken by others, David began with a blank sheet. He went back to first principles, realizing that Yale had a long time horizon, was tax-exempt, and could handle illiquidity. The result was a portfolio that included heavier weights to alternative assets like private equity, venture capital, and hedge funds than his peer institutions. He developed his own guiding light, didn’t rely on the thinking of others, and put together an investment approach that made sense to him. David didn’t seek external validation. No focus groups, no conventional logic, just independent thinking.

David articulated a boring, sound approach to investing—and I mean that as a compliment! It began with an understanding that there are three sources of investment return in any portfolio: market timing, security selection, and asset allocation. Market timing is choosing when to buy and sell; security selection is deciding which individual investments to make; and asset allocation is the act of spreading your investments across different buckets like stocks, bonds, and cash.¹⁹

Asset allocation—at what proportions you allocate your money across investment classes—accounts for between 90 percent and over 100 percent of investor returns, compared with security selection and market timing. That number could be over 100 percent because active timing and selection can actually lose you money—when you buy high, sell low, and incur all kinds of fees and taxes.²⁰ As David explained to my students when he visited my class, “Asset allocation is far and away the most important tool that we have available to us as investors.”

The results of David’s thinking for himself speak for themselves: the Yale Investment Office has produced one of the best long-term track records in the world of endowment management. But in addition to being a great manager of assets, David is a good teacher both in the classroom and at his office. Former colleagues of his from the Yale Investments Office are running the endowments of MIT, Bowdoin, the University of Pennsylvania, Stanford University, Princeton University, Wesleyan University, and many other endowments and foundations. While some have given David a run for his money in the short run by outperforming Yale, no one has been able to match the Yale Investment Office’s long-term track record. The performance has resulted in literally billions of dollars of support for Yale, enabling it to improve facilities, conduct ground-breaking research, and recruit the most promising students from all over the world, regardless of their ability to pay. Simply put, Yale would not be the university it is today had David not thought for himself.

This blunt fact seems lost on those who fail to appreciate independent thinking and fresh perspectives. Sandra Urie, the former chief executive officer of Cambridge Associates, the world’s leading investment consultancy to large endowments and foundations, recounted a story to me over coffee that illustrates the point well. She recalled how one of her larger clients asked for her help in recruiting a new chief investment officer and explicitly asked for “someone like David Swensen.” Urie responded with “OK, so you want someone in their thirties with no money management experience?” I suspect you can finish the rest of the story yourself.

Recall the earlier story of Trisha Torrey. When facing a dynamic as complicated as the one she faced, the only person who had a holistic view of the problem was Trisha. Had she not actively engaged, she likely would have been treated for a disease she didn’t have. But there are a host of other disappointments. Why did the surgeon simply assume the lab results were conclusive? Was he too busy to think about them or truly evaluate them? And why not check the ultimate test of malignancy, cell multiplication? Maybe because he didn’t need to live with the diagnosis but could simply pass her along to an oncologist? Let’s recall that Trisha began with her family doctor, who sent her to a surgeon, who then sent her to an oncologist. Each step is associated with narrowing perspective, deepening focus, and a greater likelihood of being blinded. You can imagine this chain continuing. Rather than crossing siloes and using multiple perspectives, the process got more and more focused.

Trisha’s story, unfortunately, may not be a rare anomaly. Medical misdiagnosis is not as unusual as we would hope. Arthur Elstein has estimated that doctors incorrectly diagnose a patient’s ailment somewhere between 10 and 15 percent of the time,²¹ a suggestion that should petrify all of us. We simply must take control of our own health and think for ourselves.

Trisha overcame a common trap that many of us fall into when we believe we’re being thorough. Rather than having a second first opinion, she went out and found a true, unadulterated, independent second opinion. That was a key event in her story, and it wouldn’t have been possible without her thinking for herself.

One thing that’s obvious from these and many other stories is that great breakthroughs rarely come from adopting other people’s thoughts. If David Swensen had adopted (and maybe even tweaked) endowment strategies of the world’s best managers at the time he took over the Yale endowment, rather than going back to first principles, he might not have come up with as innovative and successful a model. Rather than reading Harvard Business School case studies of successful endowment managers, he became the subject of one. As hard as it is to do, we all can and should take the time to think for ourselves.

Questions to Ask Yourself

• How would you approach a situation if you were a beginner and didn’t have prior knowledge?  Rather than relying blindly on convention and/or existing best practice, try approaching the problem from scratch. Revisit first principles and “blank sheet” the ideal strategy given your objective.
• Are experts helping or hindering your thinking?  As exemplified by the case of Jim Cramer and his info-tainment show Mad Money, some supposed experts are more akin to snake oil salesmen than those with deep expertise. Always ask yourself if they’re helpful with your specific situation.
• Have you adopted new thinking or just confirmed existing logic?  Think about Trisha’s experience and seek out truly independent second opinions (vs. second first opinions); using existing conclusions to begin your analysis is (by definition) not thinking for yourself.