Passive investing – the only way to plan for retirement

This entry includes highlights from a journal in CFA publications. My intention is to urge investors to invest in low cost index funds. The general rule of thumb is, the higher the cost, the lower your rate of return. Active managers who can outperform the market is incredibly hard to find. In fact, it’s quite improbably to find one who can outperform the market persistently, net of fees, over a long time.

There is extensive, undeniable data which show that identifying in advance any particular investment manager who will—after costs, taxes, and fees—achieve the holy grail of beating the market is highly improbable.

If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.

[Kinnel, Russel. 2010. Morningstar FundInvestor, vol. 18, no. 12 (August):1–3.]

Whether one is investing a lump-sum amount or a series of periodic amounts, the arithmetic of investment expenses is compelling. Although a long-term investor may be able to find one or more high-cost managers who can beat an appropriate benchmark by an amount sufficient to more than offset the added costs, the reality is that “compared with the readily available passive alternative, fees for active management are astonishingly high” (Ellis 2012, p. 4).

Managers with extraordinary skills may exist, but as I argued in this publication many years ago (Sharpe 1991), another exercise in arithmetic indicates that such managers are in the minority. And as Ellis has reminded us, they are very hard indeed to identify in advance.

References
Ellis, Charles D. (2012). “Investment Management Fees Are (Much) Higher Than You Think.” Financial Analysts Journal, Vol. 68, No. 3 (May/June): 4-6.

Kimmel, Russell (2010). Morningstar Fund Investor, Vol. 18, No. 12 (August): 1-3.

Sharpe, William F. (1991). “The Arithmetic of Active Management.” Financial Analysts Journal, Vol. 47, No. 1 (January/February): 7-9.

Vanguard Group (2012). “Vanguard Total Stock Market Index Fund Admiral Shares.”
https://personal.vanguard.com/us/funds/snapshot?FundId=0585&FundIntExt=INT#hist=tab%3A3 (accessed 5 July 2012)

Further evidences that active management does not impress

Evidence that active management does not work – from Active Management in Mostly Efficient Markets (Robert C. Jones, CFA, and Russ Wermers)

The study shows that neither the average mutual fund nor the average institutional separate account (ISA) earned a positive alpha, net of fees and expenses, after adjusting for market and style risks. It is even harder for actively managed funds to outperform passive alternatives on an after-tax basis.

The study found that the average active manager earns a positive alpha before fees but that this alpha does not quite cover the costs of active management.

Most important findings in that study:
Active returns (adjusted for risk) across managers and time probably average close to zero, net of fees and other expenses. This finding is what we should expect in a mostly efficient market.

In another study (Does Active Management Pay? New International Evidence)
Quote: “The authors examine the empirical evidence for the common academic guidance that even sophisticated investors should avoid active equity management because of the outperformance of passive strategies after costs. They confirm this advice’s validity for the US equity market, the world’s most efficient market, but identify exceptions elsewhere.”

Active management might work in inefficient markets. But in efficient markets, active management does not work net of fees.

Expense ratio is key determinant to returns

This entry includes highlights from a journal in CFA publications. My intention is to urge investors to invest in low cost index funds. The general rule of thumb is, the higher the cost, the lower your rate of return. Active managers who can outperform the market is incredibly hard to find. In fact, it’s quite improbably to find one who can outperform the market persistently, net of fees, over a long time.

There is extensive, undeniable data which show that identifying in advance any particular investment manager who will—after costs, taxes, and fees—achieve the holy grail of beating the market is highly improbable.

If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.

Whether one is investing a lump-sum amount or a series of periodic amounts, the arithmetic of investment expenses is compelling. Although a long-term investor may be able to find one or more high-cost managers who can beat an appropriate benchmark by an amount sufficient to more than offset the added costs, the reality is that “compared with the readily available passive alternative, fees for active management are astonishingly high” (Ellis 2012, p. 4).

Managers with extraordinary skills may exist, but as I argued in this publication many years ago (Sharpe 1991), another exercise in arithmetic indicates that such managers are in the minority. And as Ellis has reminded us, they are very hard indeed to identify in advance.

References

[Kinnel, Russel. 2010. Morningstar FundInvestor, vol. 18, no. 12 (August):1–3.]

Ellis, Charles D. (2012). “Investment Management Fees Are (Much) Higher Than YouThink.” Financial Analysts Journal, Vol. 68, No. 3 (May/June): 4-6.

Kimmel, Russell (2010). Morningstar Fund Investor, Vol. 18, No. 12 (August): 1-3.

Sharpe, William F. (1991). “The Arithmetic of Active Management.” Financial Analysts Journal, Vol. 47, No. 1 (January/February): 7-9.

Vanguard Group (2012). “Vanguard Total Stock Market Index Fund Admiral Shares.”

Sure way to lose money- crowdfunding a firm

Crowdfunding is often perceived as a way to democratize finance. Everyone can commit a small amount of money to fund small companies. Crowdfunding is also known as P2P lending.

Unlike VC funding or debt, crowdfunding requires potentially less paperwork. You can do it on Kickstarter, you can borrow from friend and friends. But crowdfunding can be dangerous. Better startups would have received attention from formal sources such as angel investors, venture capital firms, banks and laboratories. Crowdfunding firms bypassed these sources to ask the public for money. Is there a potential for adverse selection?

Can we conclude that there are more “thrashy” projects on crowdfunding platforms? People who invest little amount of money invest when they feel inspired by ideas. They probably do less due diligence than VCs. This is why crowdfunding can be dangerous for the investor.

There are intermediaries like Lending Club who tries to include some credit risk analysis into startups. But anyone will be able to attest that business stability leading to proper cash flow evaluation is always almost impossible. When the investor losses their investments in the case of crowdfunding, there is little recourse. Pursuing legal actions is costly and difficult. Here are some examples of start-ups which, even though they raised money, didn’t manage to complete their project successfully:

Pirate3D Inc raised nearly $1.5M on Kickstarter in 2013, planning to make a 3D printer available for use by anybody. A total of 3,520 backers invested money to the project including 3,389 who gave more than $300 to eventually get a printer.

Another example is that of Neil Singh’s lawsuit against Seth Quest. The latter launched a Kickstarter campaign in March 2011 for Hanfree, a standing iPad mount he’d devised. The crowdfunding campaign was initially a success, and he raised $35,000. However the production was a disaster and Quest couldn’t fulfill his backers’ pre-orders, one of whom was Neil Singh.

The fact is crowdfunding companies probably need more than capital. They need professional advice. Money is one of the many things they will need.

Summarily, if you are an individual, do not invest in startups in your retirement plans. Instead, keep them in an index fund, ensure low cost investments. There are plenty of evidences of how active management does not outperform passive management. Here are some links:

https://www.ft.com/content/2e975946-fdbf-11e5-b5f5-070dca6d0a0d

https://www.ft.com/content/c9aea9f0-74c2-11e6-b60a-de4532d5ea35

https://www.ft.com/content/e555d83a-ed28-11e5-888e-2eadd5fbc4a4#axzz43RnnhB3V

[UPDATE] A very recent and vivid example of crowdfunding risk, is that of FND Film, a filmmakers’ start up, which raised about $78,000 in 2014 through Indiegogo crowdfunding platform, regardless of the fact that they didn’t provide any other detail about their project, but the name of the film “It’s All Good”.

After raising all that money the filmmakers disappered and started posting photos in social media showing that they were enjoying themselves with champagne and limos in Italy. As it was expected, the people who funded the project got furious, for what eventually turned out to be a troll, as the filmmakers made the movie two years after. It came as a very pleasant surprise to their supporters that the project they funded, was actually a metamovie of not making a movie, illustrating vividly the risks that crowdfunding entails.

Passive funds are a better choice than active funds

At the end of 2015, more than 84% of U.S. active funds underperformed the S&P 500 over the year. From a long-term view, over the past ten years, more than 98% of active funds failed to beat their benchmarks. Diving through the data, active funds failed to outperform the market over almost all time frames, the report of S&P Dow Jones Indices shows.

Savita Subramanian, strategist of the Bank of America Merrill Lynch, stated briefly that the active fund managers continued to be on the wrong side of the trade this year. Telecom, utilities and energy benefited from the rebound of oil prices, to which many funds did not attach enough importance. On the contrary, healthcare and consumer discretionary, two of the three worst-performing sectors, were overweight in active funds.

The fees are eating into the gains of funds. If the investor was lucky and chose a follow-the-benchmark active equity fund, the fees would take 1/3 of the income, not to mention that most active funds usually underperformed the benchmarks. Although the fees keep lowering these years, there are quite amazing when the gains of the market and funds are modest.

As a result, investors gradually shifted from active funds to passive funds, for reducing the cost and stopping the loss. According to data from Morningstar, active funds have lost $149.8bn in assets in the first half of 2016, while passive funds took in $286.1bn.

How should you invest your retirement money?

Most agents want your money invested in funds that they can earn a commission from
Based on my experience, most agents are not highly skilled in assessing investment instruments. They pass a couple of mandatory exams. But they cannot explain simple quantitative risk measures.

Typically, they will show you a snapshot of how a fund performs over time. This is tricky. A study by Cass university shows how fund performances lack persistency. i.e. If you buy a loser, the chance of outdoing a winner next year is higher. Simply put, there is a return to average. It is a simple, yet stubborn principle.

Most fund returns are not persistent
In this study – Why Does Mutual Fund Performance Not Persist? The Impact and Interaction of Fund Flows and Manager Changes, it was concluded that the performance of the worst performing funds experiencing both the replacement of the fund manager (internal governance) and high outflows (external governance) enjoys a subsequent increase of 2.40 percentage points in the following year, relative to loser funds not experiencing these effects.

If statistically fund performance are not persistent, it makes more sense to just buy the cheapest index funds. “The persistence of performance among past winners is no more predictable than the flip of a coin,” said Peter Westaway, Vanguard’s chief economist in Europe.

The next step

• You should go direct. Skip agents and save cost
• You should have a longer time horizon. If you don’t have at least 10-year horizon, go for simple banking deposits.
• You should go for index funds that are cheap and broadly diversified, preferably cash based index funds and not diversified.

Read more here:
https://www.ft.com/content/996d4afa-1f5b-11e2-b2ad-00144feabdc0

Top performers definitely do not remain at the top.

Investing in actively managed funds is a bad idea

Investing in actively managed funds is a bad idea: they only eat up your hard-earned money, while financial mediators make a fortune. Make more of your money by investing in an index fund.

Actively managed funds are expensive and consequently often underperform the market.

Few funds perform well, and there’s no guarantee even those few will continue to do so.

Investors often underestimate the true cost of actively managed funds. Put the majority of your assets in safe, low-cost index funds.

Each index fund comprises an expense ratio that represents management fees and operating expenses. These expenses, though typically totalling less than one percent, can add up in a long-term investment.

Actionable advice: Invest the majority of your assets in an index fund, and if you want to gamble with some of your hard-earned money, then place a small amount in actively managed funds. If, despite what you’ve read you still want to partake in the thrill of risking some money and making fast profits in actively managed funds, bet on no more than 5 percent. You can afford to risk this small amount but absolutely keep the majority of your assets in a safe long-term investment.

The costs of investing in such a fund are very high. As an investor, you’d pay the brokerage commissions, the fund manager’s fees and so forth. All those fees add up to a hefty chunk of your expected profits.

If the funds perform extremely well, you might not mind those costs, but in the long run, actively managed funds are likely to yield you less profit than the overall stock market.

An actively managed fund will generate significantly less profit for you than a passive, low-cost index fund that merely mimics the performance of the overall market. In fact, if you had invested $10,000 in 1980, by 2005 you would walk away with 70 percent less if you invested in an active fund rather than an index fund, due to fees alone!

Investors pay huge fees to funds, deferring to financial experts who have a solid understanding of the stock market. However, despite industry knowledge or expertise, only 24 of the 355 mutual funds that existed in 1970 have outperformed the market consistently and remain in business.

Actively managed funds automatically come with high costs. However, fund managers rarely disclose the dollar amount. Instead, they boast about the high returns but forget to divulge what the investor will really earn after deducting all the performance and portfolio fees.

Surprisingly, that omission occurs often: 198 of the 200 most successful funds in the latter years of the 1990s reported higher returns than the investors actually earned!

Don’t let what you now know about actively managed funds persuade you to keep all your money under your bed. The index fund is your best alternative.

In contrast to actively managed funds, index funds are much more cost-efficient.

By definition, an index fund holds a diversified portfolio that reflects the financial market or a specific market sector. However, instead of betting on the market, index funds hold their portfolios indefinitely, eliminating the risks of making short-term, volatile bets while simultaneously minimizing operating costs.

Because index funds track the performance of all stocks included in the index without betting on individual stocks, they’re also called passive funds.

Since they simply hold shares across particular market sectors, you will not have to bear operating fees for buying and selling shares, financial consultants, or fund management. You will, however, reap the benefits of commercial net returns.

Another advantage to index funds is that they’re likely to outperform actively managed funds in the long-term.

For instance, many Vanguard index funds fees are less than 0.06% per annum. Both funds have expenses below 1 percent, but over longer investment periods like a decade, those tenths of a penny add up.

Since index funds fluctuations follow the overall market, go ahead and choose the fund with the lowest cost structure, knowing that a company’s expense ratio doesn’t equate with its level of performance.

The truth about preparing for retirement

I’m amazed by the proliferation of articles and content on methods to make big money online. On forums, ordinary men try to give advice on which broker to use, which product to buy.

The truth is simpler. People simply want to earn commissions on your investment. The more you trade, the more they earn. The more you buy into mutual funds, the more fees you pay to agents. Investments should be boring. Put your money in a globally diversified fund and leave it there. Do not move money. Companies layer fees when you try to move money.

Start young, have a long investment horizon. Go for globally diversified passive funds. I like ETFs in Singapore because we cannot buy Vanguard funds direct yet.

Avoid actively management funds. I wrote a few articles consolidating evidences on why active managed funds don’t work.

Also read vanguard’s studies. See the truth about active funds here. Don’t trade actively. Don’t invest in active funds. You are simply funding the high salaries of managers. More than 80% don’t even beat the benchmark market returns.

There are only 3 simple steps to investing:

1. Save monthly, 20 to 30% is a good figure.
2. Invest the money in index passive funds.
3. Leave it. Don’t touch the pot of gold.

Run away from people who are trying to sell you active investments. Don’t even talk to people who want you to believe trading leisurely will make you rich. Let your money work for you. Leave your money in a passive fund.

Investing like an idiot, but earning like a Pro

Investing in low fees index funds is the only way to retire in peace. Morningstar found after years of research: low fees are “the most proven predictor of future fund returns.” In other words, the cheaper the costs, the better the fund is likely to perform and the more money you’re likely to make.

Passive funds are the cheapest because there is no active management. No fund manager is trying to outperform the market. In a recent article on FT, it is said that 86% of funds do not outperform the market. The average fee charged by active funds hovers around 2.5% comprising all the load charges and management fees. For index funds, it can go as low as 0.5%. I have a list of evidences here.

What kind of index funds should you choose? You can buy index funds from investment intermediaries. I suggest choosing a simple monthly plan where you can simply put money into an index fund and save with consistency.

There are a few types of products out there with local banks in Singapore. Choose those with minimal fees. I would avoid going through other platforms with higher fees.

If you are savvy, you can also buy ETFs (traded index funds) through brokers. But the list of ETFs on the Singapore market is not too exhaustive. So you can buy through U.S brokers only. I prefer Lightspeed and TD Ameritrade simply because of their low fees.

The principle behind investing is:

1.Low fees or no fees

2.Avoid intermediaries

3.Avoid trading too much, just rebalance yearly. A 60% global equity index fund (I really like the plain old vanilla Vanguard fund) and a 40% bond fund will be sufficient.

Non discretionary investing- the future of retirement planning

Investing in actively managed funds is a bad idea: they only eat up your hard-earned money, while financial mediators make a fortune. Make more of your money by investing in an index fund.

Actively managed funds are expensive and consequently often underperform the market.

The costs of investing in such a fund are very high. As an investor, you’d pay the brokerage commissions, the fund manager’s fees and so forth. All those fees add up to a hefty chunk of your expected profits.

If the funds perform extremely well, you might not mind those costs, but in the long run, actively managed funds are likely to yield you less profit than the overall stock market.

An actively managed fund will generate significantly less profit for you than a passive, low-cost index fund that merely mimics the performance of the overall market. In fact, if you had invested $10,000 in 1980, by 2005 you would walk away with 70 percent less if you invested in an active fund rather than an index fund, due to fees alone!

Few funds perform well, and there’s no guarantee even those few will continue to do so.
Investors pay huge fees to funds, deferring to financial experts who have a solid understanding of the stock market. However, despite industry knowledge or expertise, only 24 of the 355 mutual funds that existed in 1970 have outperformed the market consistently and remain in business.

Investors often underestimate the true cost of actively managed funds.
Actively managed funds automatically come with high costs. However, fund managers rarely disclose the dollar amount. Instead, they boast about the high returns but forget to divulge what the investor will really earn after deducting all the performance and portfolio fees.

Surprisingly, that omission occurs often: 198 of the 200 most successful funds in the latter years of the 1990s reported higher returns than the investors actually earned!

Put the majority of your assets in safe, low-cost index funds.
Don’t let what you now know about actively managed funds persuade you to keep all your money under your bed. The index fund is your best alternative.

In contrast to actively managed funds, index funds are much more cost-efficient.

By definition, an index fund holds a diversified portfolio that reflects the financial market or a specific market sector. However, instead of betting on the market, index funds hold their portfolios indefinitely, eliminating the risks of making short-term, volatile bets while simultaneously minimizing operating costs.

Because index funds track the performance of all stocks included in the index without betting on individual stocks, they’re also called passive funds.

Since they simply hold shares across particular market sectors, you will not have to bear operating fees for buying and selling shares, financial consultants, or fund management. You will, however, reap the benefits of commercial net returns.

Another advantage to index funds is that they’re likely to outperform actively managed funds in the long-term.

Each index fund comprises an expense ratio that represents management fees and operating expenses. These expenses, though typically totaling less than one percent, can add up in a long-term investment.

For instance, the Vanguard 500 ETF fund has an annual expense ratio of 0.05%, while the Aberdeen Asia-Pacific Income has an expense ratio of 1.14%. The cost differences add up over time.

Since index funds fluctuations follow the overall market, go ahead and choose the fund with the lowest cost structure.

Actionable advice: Invest the majority of your assets in an index fund, and if you want to gamble with some of your hard-earned money, then place a small amount in actively managed funds. If, despite what you’ve read you still want to partake in the thrill of risking some money and making fast profits in actively managed funds, bet on no more than 5%. You can afford to risk this small amount but absolutely keep the majority of your assets in a safe long-term investment.

Credit rating agencies may not always add sufficient value when assessing debt

Everyone accepts credit rating agencies’ accept of a debt issue as a professional opinion on

1. Likelihood of receiving the coupon and the principle
2. Likelihood of receiving them on the stipulated time
3. … in accordance to the debt conditions

These agencies also help sort out rating categories, giving you a relative understanding of debt against another debt issue.

However, you will only see a rating – A, AA, AAA. You will never see headlines reporting quantitative risk measures. So it is hard to understand the difference between AAA and B. An economist will use broader categories to differentiate between the investment grade bond and the rest. So ratings don’t add a lot of value.

There are quite few instances when credit agencies failed to evaluate correctly. For example, in March 2008, Moody’s Investors Services and Standard & Poor’s announced the downgrading of the ratings of the renowned investment bank Bear Sterns. Two days later, the U.S Department of the Treasure and the Federal Reserve Board started negotiating the sale of the bank to JP Morgan Chase. Bear Stern, which was one of the largest banks, only two years before that used to own assets of 350.5 billion dollars and total capital of 66.7 billion. The bank was sold for only 1.2 billion dollars by the end of March.

Although the blame was put on several sides, the U.S. credit rating agencies continue to be the number one aim, since they didn’t predict the collapse that was about to happen.

Another example is the Enron Scandal, which refers to the collapse of Enron Corporation, an American energy, commodities, and services company based in Houston, Texas, in December 2001. The company filed for bankruptcy few days after the downgrading of its credit rating.

I think it is more important for us to think about using ratios. People use ratios for equities. They say overgeneralize that a low PE is better than a higher PE ratio. I have doubts on these statements. There are too many assumptions in earnings estimation and growth assumptions. But it is better than comparing ratings.

Can we use interest coverage ratios? To pay down debt, we have to first consider the amount of money sitting in the firm’s bank account that can be drawn down to pay interest. So that’s the first level of assurance.

Can we use yield spreads? I think so. Yield spreads tell me the incremental rate over the risk free equivalent treasury bond. It tells me 2 things

1. My expected loss in a default
2. The premium I’m paying for credit and liquid risks

Please note that a firm would have been considered to have defaulted on payments when they fail to make payments on time. Being late for one day is default. So when you read on the news that shipping companies and banks fail to honor their debt obligations on time and in specific ways, they have defaulted. It happens frequently.

Credit risk is the risk that your borrower’s credit quality may change. If you gave someone $1000 for 2 years and in return, you get $100 per year and $1000 at the end of the 2 year period, you pray that this person doesn’t get into financial trouble. If he loses his job, his credit quality will change. But he may or may not decide to return you the money. This is credit risk. If he does not lose his job, but decides not to return you the money, this is default risk.

I often find that people are confused by credit, default and liquidity risk. Liquidity risk has nothing to do with borrower not returning money. If you bought a debt issuance and want to sell it on capital markets, you will face liquidity risks. You don’t know if you can liquidate this instrument quickly and in the right value. If you sell a $100 worth of stock for $50 and you have difficulty finding a buyer, the liquidity risk you are exposed to is tremendous.

Measuring bond value risk

How do we measure bond risk? Can we measure bond price like we measure stock price? Yes we can. But it is not as intuitive as volatility of yield spreads. I explained earlier that yield spreads contains information on bond risk factors. In addition, rates are inversely related to bond price. So it is better to measure bond risk by yield spread volatility.

For small changes in yields, bond price is directly negatively correlated. For bond portfolios, it’s not so clear cut. Bond convexity comes in to play – a term to describe the impact of different bonds with different payouts at different times. Every bond has a different modified duration.

So how is bond risks related to firm wide credit risk? Firms issue long term debt, these form the largest part of liabilities.

Layman understanding of credit safety

As a summary, a non-financial expert should only look at 2 things

1. Cash flow. The higher the cash flow the higher the interest coverage. I prefer to look into its operating cashflow. Are they making money from core operations? Some moneys sell assets to generate pseudo signs of positive cashflow.
2. EBITDA. You can also use earnings – add back non-cash charges.

Forget about ratings. They give you some information, but it’s clearly no adequate. Recall before the 2008 recession, rating agencies gave some of those banks that collapsed investment grade ratings.

Traditional Japanese lean concepts will revolutionize your business and personal productivity

Kaizen- The practice of constant improvement

Kaizen increases productivity by involving employees to help eliminate nonessential steps.

Kaizen leads you to greater productivity through elimination. When you analyze working processes, we often find several elements that consume time and energy without contributing anything to the end product.

Muda waste precious time, resources and ultimately money

These wasteful elements are called muda. By eliminating muda, we can free up resources, which in turn can be put to more effective use. For instance, muda could be overproduction, or the waiting time created by inefficient transportation. Work in progress, logistics and wait time is muda.

When team members come together to reduce muda, the firm will save a lot of costs. Kaizen is mostly used in manufacturing. Kaizen is applicable to a wide range of disciplines and fields. You can apply is to any industry.

Steps on how to apply Kaizen

1. Find ways to reduce muda
2. Solidify the solution and embed this new solution in the standard operating procedure

Gemba- Where the real action takes place

At this moment, I will introduce the “Gemba”. This term refers to the “workplace” or “production line”. You often need to be on the production line to see the problem for yourself. There are 5 terms related to Gemba

1. Seiri – sort out the mess
2. Seiton – straighten things out
3. Seiso – keep everything clean and tidy, literally.
4. Seiketsu– keep 1 to 3 a standard you do everyday
5. Shitsuke – sustain these new standards

I use the Kanban method to solidify gains under the 5S. Kanban is visual – allowing tasks to move from WIP to completion on a board. Visual management is an invaluable tool in an increasingly complex work environment. It’s cheap, commonsensical and allows us to save our time for the real work that needs doing.

Implement the three concepts together in your workplace to achieve improvement

Stringing the concepts together, Kaizen is a lean and efficient concept that must be implemented collaboratively among the team. Gemba is where things must start – at the workplace. We can use the 5S to find muda (waste), leading to Kaizen outcomes.

The place for improvements and innovations is the Gemba, so this is where managers should be. Only in the Gemba can one see where elements of Muda exist, and where there is room for improvement.

Soichiro Honda, the founder of Honda, never had a real office because he was always walking through the Gemba. If the workers see that their managers are in the Gemba, demonstrate Kaizen and are self-disciplined, their own motivation will increase. Both maintenance and improvement occur within the Gemba. Therefore, the manager needs to be there to do his or her job right. Of course, if the managers are active at all levels of the Gemba, they know their workers much better and both sides have more faith in each other. This is integral to the effective practice of Kaizen.