Editor’s Note: James Cloonan founded the American Association of Individual Investors in 1978. As Jim now prepares to retire, AAII president John Bajkowski and I sat down with him to hear about the early history of AAII, including the story of what eventually became our Model Shadow Stock Portfolio.
—Charles Rotblut, CFA

Charles Rotblut (CR): Jim, could you tell us how you came to start AAII?

James Cloonan (JC): Well, it came from my experience when I was in a brokerage firm. My main academic area was marketing and quantitative methods, but my hobby and my side interest had always been the market, and particularly derivatives. I had been active myself in convertible bonds, stocks, and put and call options. When the CBOE [Chicago Board Options Exchange] decided to formalize option trading [in 1973] and have it controlled and regulated, I thought it was a tremendous opportunity.

From a book I’d published at that time and a service I had started, I made contact with a commodities firm that wanted to get in the stock options business. With them, I formed the brokerage firm Heinold, O’Connor & Cloonan. During my experience there, I realized there was nothing to back up the individual investor. We had published materials and I’d given seminars on the use of options, but that was only one small area and there didn’t seem to be anything formal going on except for finance classes at business schools.

At that time, the people who were targeting individual investors were promoting books like “How to Be a Millionaire in Three Months in Real Estate.” There was nothing in between to help the individual investor. When I left the brokerage firm, I went back to teaching, but I also concentrated on the possibility of opening an organization that would provide the things that were necessary for individual investors. At that time [in 1975], negotiated commissions had just come in, which was a very important part of being able to do anything for individual investors. So that got me pushing in the direction to do it, and so I just started to do it.

CR: My understanding is that there were also conversations with your wife about starting AAII.

JC: Some of the practicalities involved in starting the organization were certainly discussed. And my wife certainly helped me a lot in the administration from the very beginning. We started really early in 1978, thinking about it and developing it, and we started to discuss people who might be on an advisory board to give information and support. It took all of 1978 to get things going, but we were doing active things to attract members. Membership didn’t officially begin until January 1979, when we published the first AAII Journal, but we started to get members in the fall of 1978 from our public relations efforts.

I had already started to test various approaches to direct mail and print advertising in The Wall Street Journal and Barron’s. Cash flow was a problem because I didn’t want to get money from anyone who would be perceived as impacting our independence. We wanted to make it grow from a grassroots basis. That slowed us initially. My daughter Carrie, who also volunteered her time, even lent $5,000 from her college fund to speed things up.

John Bajkowski (JB): When it comes to the actual content, the kind of information that individuals were looking for, you mentioned that when AAII got started, the transition to discount brokers was just starting. What was the market like back then when the association started? How did the individual investor get information?

JC: I don’t think he could get unbiased information: His stockbroker would tell him what the research department was telling him to promote that month.

I think Value Line was doing something at that time; it was a pretty exclusive service, though. There really were limited resources. It certainly has changed, because now you can’t escape being bombarded with advice. Whether all the information is good or not is subject to question, but at that time it was very unusual. I think that’s why our initial PR had such an impact on getting new members, people had just been thinking that they really needed something like this and nothing was really available.

JB: How did the name come to you?

JC: I thought of a number of names, but I liked things beginning with A’s because they get put first on lists. And “Individual Investors” just seemed to be the most natural name I could think of.

JB: As a membership association, you were structured as a nonprofit. Were there any benefits to being a nonprofit?

JC: I think the main reason for being a nonprofit, in my mind anyway, was I thought it made it more believable that we were independent. If it wasn’t a nonprofit, I think there’s a danger that potential members might think, “Well, there’s some big brokerage firm behind this somewhere.” But as a nonprofit, I felt that people wouldn’t think that way.

JB: In looking back at some of the early AAII Journals, I know you did a lot of writing, but you were also able to get contributors, many of them professors. How did that come about? And why was that community so ripe for information and for education?

JC: Well, during my time in the brokerage industry I had made a number of contacts, and I had my academic contacts as well. So I had some old friends who specialized in certain areas to write articles.

As I think back, DePaul University has been a rather significant influence: All our chief executives have been from DePaul University, many of our financial analysts past and present are DePaul graduates, and we continue to have interns from DePaul. Initially, I used my contacts and their contacts. Plus, very early on, I wrote to the exchanges, asking if they would have someone serve on our advisory board. They were very cooperative and, surprisingly, early on I got support from all the exchanges.

CR: Even near the beginning, you were getting media attention. What was the message you were getting out there? And what were you telling investors they would get when they signed up for membership?

JC: Well, basically, just education and data—information that they could use—and then different forms of support.

CR: Were there any challenges as the membership grew from a small number to the membership that we have now? Did you find any challenges in serving individual investors?

JC: Well, things happened that I didn’t expect. When I originally formed the organization, I had in my mind to help a wide range of investors. As it turned out, I wasn’t able to attract many of those whose income and wealth would rank at the lower level of the middle class; over half our members have graduate degrees.

The level of income and wealth was way above average, and I kind of felt bad, because of the proverbial problem that the people who really need help the most are the ones who don’t seek it. No matter what we did, we were never able to get many members from that group.

We also have never been able to get the younger adults. We do have a number of young people, but not the number we should have. Anyone who studies our philosophy on investing is familiar with the effect of compounding. If you start putting away a few bucks when you’re 30, as opposed to when you’re 55, there’s a significant difference. If you invest it wisely at a younger age, the difference is even greater.

JB: One of the early things you started developing as being involved with the association and your education mission was a lifetime strategies guide. How did the thought behind the Lifetime Strategy guide come to mind? And has the guide changed much over the years?

JC: Well, it was a two-part series published in our second year. I wrote it as AAII Journal articles. It just seemed a natural thing, to put all of this into a kind of overview that people could use as a guide to integrating our programs.

It has changed through the years; in fact, I don’t even agree with some of the things that I said just two or three years ago.

CR: How has your thinking changed for individual investors recently, versus how you thought when you first got started?

JC: Well, I had a lot of faith in the traditional measures of risk—standard deviation and then more complex measures that had longer tails and were more realistic. I have come to believe, now, that risk is immaterial for the long-term investor, at least risk as we think of it. The real risk is not whether the stock market’s going up or down; it’s whether you’ll have money when you need it, for retirement or education or whatever other purpose you’re going to use it for.

When you take that view, you have to look at longer waves of investment fluctuations.

JB: This reminds me of some of the teachings you have in your recent book, “Investing at Level3,” where you talk about phantom risk versus real risk. You define phantom risk as volatility risk and real risk as not being able to meet your financial goals. Would you care to elaborate?

JC: Well, if you think about it, you can get zero risk from a portfolio that goes down 10% every year with no volatility at all. It goes down 10% a year, so it was a “risk-free” investment from the standpoint of no fluctuations around its average return. If you’re talking about the money you’d like to have when you are getting ready to retire, it’s very risky to be in that kind of investment. I think you do have to worry about volatility risk when you start to need the money.

JB: The focus at AAII, and your focus, has been the individual investor. Do you find that the individual investor has any special needs, interests, abilities or even opportunities that don’t exist with institutional investors?

JC: One of the first articles of the AAII Journal was about the advantages of the individual investor. And I think those advantages have grown with the reduction and almost evaporation of commissions. When I was putting together some of the material for this month’s issue, I realized how bad it was before 1970. It’s easy to forget, but if you bought a mutual fund, you paid almost 8% upfront.

Not only did you pay the “load” fee at the initial purchase, but you also paid the 8% for every distribution if you took it as additional shares in the mutual fund. So that meant that every penny of profit and every penny of the initial investment had an 8% hit to it. In addition, there were operating costs, up to 1.5%. On top of that, the funds were paying full brokerage costs, or some soft-dollar version of it, which was probably running another 1%. So, it’s incredible that any investor could come anywhere near the 10% that the market has averaged over the last hundred years. If individual investors got 5% out of a mutual fund, they were probably lucky.

So, conditions changed dramatically when the commissions changed and when the mutual funds started reducing their loads. The mutual funds first offered funds with low loads, then no loads; now we’re even fighting to get the operating expenses down as tight as possible. So, the advantage for individual investors is rather strong now.

I think another advantage that we’ve always promoted is that individual investors can be in small stocks and stocks that are not traded actively. Institutions cannot be active in these stocks. Our history has been that these stocks have done better than the big companies and the more actively traded companies.

Even one of the great mutual funds of all time, Fidelity, was investing in low-priced stocks. It used low price, but actually this turned out to be pretty similar to small capitalization. It makes sense if you think about it, because small companies can grow big. Some big companies can grow—as we see with Apple—almost infinitely, but very, very few are capable of doing so.

CR: In the first couple of years of AAII, you started talking about investing in small stocks. First there was the Beginner’s Portfolio, which eventually morphed into the Model Shadow Stock Portfolio. Can you give us some background about how that portfolio started, and what your thoughts were at the time?

JC: Well, it started with what I termed “shadow stocks.” They were stocks that were small and didn’t have much publicity. There was a whole series of criteria we looked at. We published the complete list of shadow stocks in the AAII Journal, and then we’d look at them in terms of characteristics. We continued that even after I started the more formal Model Shadow Stock Portfolio; we kept looking at a tighter range of smaller shadow stocks. Then we decided we should try it in the real world, and I started an actual portfolio that followed some of the more popular rules and the ones that had the strongest research evidence.

It must be one of the longest-running real portfolios I’m aware of that you can get information on. Twenty-plus years is a long history. The portfolio has done very well, with a compound return of 16%.

There are some outside influences on it, both positive and negative, because the nature of a real portfolio is so different than an academic portfolio. With an academic portfolio, you include all the investments that meet a set of criteria, then you sell them and buy the next ones every month, three months, every year or however you want to do it. With a real portfolio, you can’t buy until you sell because you have a limited amount of money. So that makes a lot of what is done variable based on when you did it. Did you have something to sell, or that you should have sold, when those opportunities came along? You missed buying opportunities if you didn’t have cash at the time.

There are some random influences affecting the returns. When you’re telling people in advance what our philosophy is, they can invest in front of the model portfolio and push the stock up. This can be a disadvantage if they are going ahead of your actual purchase. If they’re doing it after, then they’re pushing the stock price up after the portfolio bought it.

CR: What was the logic behind making the portfolio an actual portfolio run through an actual brokerage account? A lot of newsletters just have model portfolios where they announce the stocks, but there’s no actual trading occurring.

JC: Mark Hulbert has shown how advisory letters actually perform. When you follow recommendations they give you, the returns are very different than what the publishers claim. We wanted something we could look back on and say, “This followed the rules, and here were the actual results.”

We have a real portfolio that is traded and has the expenses that an actual portfolio would have in terms of commissions.

CR: How did you decide on the rules as to what exactly would qualify as a buy and what would qualify for a sell?

JC: Well, the buy rules were pretty much based on research that I thought was strong. Small capitalization was the strongest. Low price to sales was strong and still continues to be very strong. It sometimes limits the type of stocks you can buy if you use it. Then, the famous one, the Fama-French research, concentrated on determining value. Eugene Fama and Kenneth French looked at all the ways that value had been examined in the past, and they decided that low price to book—they used book to price because it makes the math easier, but price to book is the way most of us think about it—turned out to be extremely strong. Even in the larger stocks, the price-to-book ratio gave dramatic results. Now, their results were probably a little influenced by when they did it—it turned out to be a time when value stocks and small-cap stocks were doing especially well—but it has held up over time. In fact, the Model Shadow Stock Portfolio stays very close to the 16% annualized returns that it has averaged for quite a while, even though we’ve had our little swings every three or four years.

JB: Regarding the Fama-French research study, what I find interesting is that when that study was published many people talked about how it proved that beta (a measure of stock’s volatility relative to a benchmark) was dead. So many people focused on beta calculations as a measure of risk, yet you took it in a whole different direction. You looked at the different types of characteristics of stocks that performed well, whether it was market size, as measured by market cap, or the various forms of valuation. Then, you found that at the intersection of both size and valuation there were unique factors that worked well together. You helped keep members informed through your teachings in the AAII Journal, actually talking about how individuals could build their own mutual fund. What have you learned by going through that process?

JC: Even though I, and a lot of other people, felt that study killed beta, Fama and French didn’t give up on beta; they just started to use it in a different way. They still use the beta influence for their three-, four- and now five-factor models of stock behavior.

I think the best approach is to understand that sometimes the simplest things are the best. I think one thing I’ve discovered, and I hold to it now, is that when you start to get too many criteria, you lose efficiency. You wouldn’t think that would be true, but all criteria are not equally important. If you add a bunch of criteria, they may be pulling you out of the strategies and models that have the criteria that is most important.

The value concept is, I think, very interesting in itself. There are only value stocks and stocks with no value, but we can’t talk about stocks with no value, so we call them “growth stocks.” The reason we call them growth stocks is that if they have no value they must be growing, otherwise, nobody would buy them. It’s kind of a silly thing. When looking at value, if you cut all stocks right in half along some value measure, then one-half are going to be the growth stocks and one-half are going to be the value stocks. Every stock will belong to one group or the other, but I don’t think a value stock is necessarily a stock that is at the 50th percentile of some value criteria.

CR: With the Model Shadow Stock Portfolio, you really focused on making transactions only four times a year. Was that because you felt that, especially with micro-cap stocks, the transactions are very costly in terms of getting in and out?

JC: Well, certainly costs played a role, but I think one of my original ideas was that people shouldn’t have to spend a lot of time with their portfolios. They often didn’t have the time, and it was better to trade less frequently. You could have a portfolio that performed well, even when only checking it out quarterly for the different characteristics.

I thought that it was important to have a portfolio that could be managed without a lot of time because I think people, young professionals particularly, don’t want to spend a lot of time managing their portfolios. Older people who have some free time enjoy it. Investing kind of becomes like playing chess for them, but if a doctor has to give up performing a surgery to take care of his portfolio, it may not make sense. However, after he has a couple million dollars put away, giving up a couple hours of surgery to spend time managing his portfolio might prove to be worthwhile.

JB: The model portfolio rules are pretty straightforward and pretty simple. Have you found that people like the fact that it’s so simple? Or have you observed some psychological barriers to individuals following something that’s just so straightforward?

JC: I think the rules don’t present too much of a problem. I think the main problem that people have with the portfolio is that if they weren’t investing in it from the beginning, how do they get into it? We replace maybe four, six, eight stocks a year out of about 30. For someone just coming in—and I recommend that you should have no more than one-tenth of your money in any one position—it’s going to take two years to find 10 stocks that are recommended and add them to their portfolio.

What do you do with your money in the meantime? You don’t put it all into one stock because you still don’t want to have more than 10% in any one holding in this model portfolio.

People do get impatient, and we had to come up with alternatives to help them a bit. So, we say stocks that we recommended before and are close to where we would recommend them again in terms of valuation can be used. Alternatively, a small-cap ETF or opportunities that aren’t in the model portfolio can be used.

JB: In general, is there anything you’ve done personally as an investor that you think has helped you invest better, that somebody else might be able to learn from?

Jim: Well, I wish I had followed my own advice more completely. I deviated from my own advice; it’s very hard not to do. That would be what I would tell other people: When you set up a process, have faith in it and follow it; don’t look for exceptions.