The Impact of Index Investing: A Follow-Up(philosophicaleconomics.com)
philosophicaleconomics.com
The Impact of Index Investing: A Follow-Up
http://www.philosophicaleconomics.com/2016/05/followup/
11 comments
This is basically a restating of William Sharpe's famous 1991 paper that basically started the whole discussion.
"Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."
When someone picks active management over passive, they are really betting that they can beat, and hence are not, average. It's difficult for people to swallow their hubris, even when simple arithmetic shows them that they are (collectively) wrong.
http://www.cfapubs.org/doi/pdf/10.2469/faj.v47.n1.7
"Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement."
When someone picks active management over passive, they are really betting that they can beat, and hence are not, average. It's difficult for people to swallow their hubris, even when simple arithmetic shows them that they are (collectively) wrong.
http://www.cfapubs.org/doi/pdf/10.2469/faj.v47.n1.7
when someone picks active management over passive, they're betting THEIR MANAGER can beat the average. people invested in buffett's stock picking skill; how are they doing?
What misses from the above analogy, is that if all of the "passive" half have a different random subset, then about half will by definition do "above average", and the other will do "below average". While in the "active group", less than half will do "above average" because they pay part of their gain to fund managers.
So if you want to beat the market, your chances are still better in the passive group...
Now, this doesn't take into account getting away with insider trading, of course. If you can get away with insider trading, then you can beat the market just fine.
So if you want to beat the market, your chances are still better in the passive group...
Now, this doesn't take into account getting away with insider trading, of course. If you can get away with insider trading, then you can beat the market just fine.
> Now, this doesn't take into account getting away with insider trading, of course.
More importantly, it also doesn't take into account that there are investment opportunities that are not as directly (i.e., without intermediary layers which extract some of the returns) available to passive investors, so that the passive/act groups aren't splitting the same universe of alternatives. (E.g., passively investing in any given index fund is on average better than actively investing restricted to stocks in that index, and you can probably even extend that to passively investing in index funds in generally being better than actively investing in investments that directly held by any combination of index funds, but not every investment vehicle in the market is directly held by index funds.)
More importantly, it also doesn't take into account that there are investment opportunities that are not as directly (i.e., without intermediary layers which extract some of the returns) available to passive investors, so that the passive/act groups aren't splitting the same universe of alternatives. (E.g., passively investing in any given index fund is on average better than actively investing restricted to stocks in that index, and you can probably even extend that to passively investing in index funds in generally being better than actively investing in investments that directly held by any combination of index funds, but not every investment vehicle in the market is directly held by index funds.)
> half will by definition do "above average", and the other will do "below average"
Is this really true? I think it's only true if you replace average with median (e.g. in [1,2,3,10] only 10 is above the average).
Is this really true? I think it's only true if you replace average with median (e.g. in [1,2,3,10] only 10 is above the average).
A very good point! I would say that it depends on what the distribution looks like, I wrote:
> [I]f all of the "passive" half have a different random subset, then about half will by definition do "above average", and the other will do "below average". While in the "active group", less than half will do "above average" because they pay part of their gain to fund managers.
So, if all the passive investors have pick a random "large enough" subset of stocks, one would expect the distribution to approach the normal distribution, with roughly half to either side of the arithmetic mean.
Similarly, as you point out, on the "active" side, one might see more outliers - and perhaps the selection isn't really uniformly random.
So, it would probably be a stretch to claim that half will be above average "by definition", even if one includes the expected distribution, while note perhaps entirely wrong.
> [I]f all of the "passive" half have a different random subset, then about half will by definition do "above average", and the other will do "below average". While in the "active group", less than half will do "above average" because they pay part of their gain to fund managers.
So, if all the passive investors have pick a random "large enough" subset of stocks, one would expect the distribution to approach the normal distribution, with roughly half to either side of the arithmetic mean.
Similarly, as you point out, on the "active" side, one might see more outliers - and perhaps the selection isn't really uniformly random.
So, it would probably be a stretch to claim that half will be above average "by definition", even if one includes the expected distribution, while note perhaps entirely wrong.
"Average" can refer to the median, or any of the various means. Its often informally used to mean the arithmetic mean (but also often the median), but it doesn't explicitly mean either of those.
Above average. Of course those people all made an above average choice in active management.
It's somewhat ironic that Buffett is using this analogy, as he made huge profits by being an active investor. You just need to be smarter than the average active investor, which in reality isn't very difficult. The best strategy seems to be to use value investing, which is how Buffett made his fortune. Buy undervalued stocks, then keep hold of them for the long-term (or at least, until they become overvalued, then sell some).
Isn't Buffett's case a bit different? He typically buys businesses outright, rather than making investments on the open market, so no passive investor (besides one in Berkshire Hathaway) could get those returns.
Also, as I understand it, Berkshire gets to implement management changes (if it deems them necessary) as it wishes, since it owns whole companies, and so the improvements they see could also come from better management of a business rather than picking better businesses. So arguments about average or above average stock picking ability seem less relevant here. (It could well be that Buffett has average management-picking ability, but is one of a relatively small number of market participants who both can and do exercise it, thereby getting an outsize result.)
Also, as I understand it, Berkshire gets to implement management changes (if it deems them necessary) as it wishes, since it owns whole companies, and so the improvements they see could also come from better management of a business rather than picking better businesses. So arguments about average or above average stock picking ability seem less relevant here. (It could well be that Buffett has average management-picking ability, but is one of a relatively small number of market participants who both can and do exercise it, thereby getting an outsize result.)
Buffett also benefits from having Charlie Munger at his side. Buffet gets most of the credit but Munger is also a world class investor. It's like if Steve Jobs and Bill Gates had worked together.
He buys them outright now, but not when he was amassing his fortune.
Also, I believe he has bought a number of privately held business, which are almost always waaaaay cheaper (on a P/E basis for example) than publicly traded companies.
Right, you just buy low, and sell high. It's so simple, I don't know why everyone doesn't do it. In reality, there's nothing statistically inconsistent with a 5 sigma outlier like Buffett.
I'm not sure what your point is. Yes, it is as simple as buy low, and Buffett is saying the same thing. The main point is that most people aren't smart or confident enough to be able to [a] determine which stocks are undervalued and [b] buck the herd instinct.
[deleted]
That may be true that the "average" actively dollar will underperform but it should be easy (or at least possible) to identify the "above average" actively managed dollar.
It's actually quite difficult to identify above average.
ISTR a study a few years ago that said the only way you can know for certain that a fund manager is above average is on something like 30+ years of data. There's too much random variation.
I think it was the same article that said the baseball season would need to be several hundred games before you could definitively choose the best team in a given season.
ISTR a study a few years ago that said the only way you can know for certain that a fund manager is above average is on something like 30+ years of data. There's too much random variation.
I think it was the same article that said the baseball season would need to be several hundred games before you could definitively choose the best team in a given season.
Stepping back even further, a lot happens over 30 years. Wars, social change, major political movements, tectonic shifts in technology, etc.
Perfect example: Buffett has always touted value as a great investment strategy, but he completely missed the cocktail of global trade, speed, and scale that have driven Amazon, Google, Uber, Netflix, Apple, etc. to grow revenue and profits so rapidly.
Looking back, I think this shift into a world where it's possible for a company to go from zero to hundreds of millions/yr in net revenue over a span of 4-5 years (Uber) is really going to be seen as some kind of historical turning point in business, on par with the invention of the printing press, or electricity. Companies used to take a century to accomplish growth that's now possible in less than a decade.
Which is all to say, over a long enough timespan, you're talking about a pretty deep and complex philosophical question, what it means to be a "good investor" in the face of so much change, risk, etc. To be honest, I'm not sure it's something that's knowable at all.
Perfect example: Buffett has always touted value as a great investment strategy, but he completely missed the cocktail of global trade, speed, and scale that have driven Amazon, Google, Uber, Netflix, Apple, etc. to grow revenue and profits so rapidly.
Looking back, I think this shift into a world where it's possible for a company to go from zero to hundreds of millions/yr in net revenue over a span of 4-5 years (Uber) is really going to be seen as some kind of historical turning point in business, on par with the invention of the printing press, or electricity. Companies used to take a century to accomplish growth that's now possible in less than a decade.
Which is all to say, over a long enough timespan, you're talking about a pretty deep and complex philosophical question, what it means to be a "good investor" in the face of so much change, risk, etc. To be honest, I'm not sure it's something that's knowable at all.
I think it's actually supposed to be quite difficult to see who is above average. At least in "A Random Walk Down Wall Street", they cite some statistics about how only 20% (?) of managers beat the market over a period of time, but it isn't the same people who do it over different periods of time.
This is the danger of only considering averages. Everyone on the passive side gets whatever return the market dictates. In a bad/recession year, this could be largely negative. They are not hedged against business cycle downturns.
Different individuals on the active side have wildly differing returns. The guy who invests in the hedge fund with 200% returns doesn't care about the 20, 2 fee structure he has to pay on his investment because he's made so much more than the passive guys. There will be large losers and large winners, but you have to pay table stakes (fees) to play and have your shot at winning those big returns.
Buffet is talking his book - a hugely diversified portfolio that basically represents and relies on the strength and growth of the American economy, as well as US government-mandated oligopolies like insurance.
Different individuals on the active side have wildly differing returns. The guy who invests in the hedge fund with 200% returns doesn't care about the 20, 2 fee structure he has to pay on his investment because he's made so much more than the passive guys. There will be large losers and large winners, but you have to pay table stakes (fees) to play and have your shot at winning those big returns.
Buffet is talking his book - a hugely diversified portfolio that basically represents and relies on the strength and growth of the American economy, as well as US government-mandated oligopolies like insurance.
I hear this mentioned "hedge funds are for downturns" but why is it that hedges were getting demolished going into 2016? If they really do better in downturns then I would have expected better performance from hedge funds as a whole.
The term "hedge fund" doesn't really mean anything anymore. It's just an actively managed portfolio with a lower AUM on average than a mutual fund, the legal option to take on more risk, and a certain fee structure. There are a few main investing "disciplines" or "strategies" [1] that each fund manager tends to subscribe to, but it's impossible to talk about them intelligently as a group as they all make wildly diverse bets on different assets across the globe.
[1] See figure 3: https://wealth.barclays.com/wealth-management/en_us/home/tho...
[1] See figure 3: https://wealth.barclays.com/wealth-management/en_us/home/tho...
> In a bad/recession year, this could be largely negative. They are not hedged against business cycle downturns.
This was the argument made by Protege Partners, when betting against Buffett in the great "index funds vs hedge funds" long bet [0]. It turns out that the index funds fared better — and they're mainly used for long-term investment, where the short-term macroeconomic ebbs don't have an impact on the overall return.
Of course the variance on the active side will be higher, but there are as many losers as they are winners, and much of it is due to simple randomness. Unless you're confident that you know more than other investors (for many people, including myself, we probably don't [1]), index funds, or "hugely diversified portfolios" are the way to go. Basically, no hedge fund is making those 200% returns you're speaking of, and even if some fund were, empirically it's more likely to be just noise. Look at the result so far of Buffett's bet on hedge funds. It speaks volumes.
[0] http://longbets.org/362/
[1] https://en.m.wikipedia.org/wiki/Dunning%E2%80%93Kruger_effec...
This was the argument made by Protege Partners, when betting against Buffett in the great "index funds vs hedge funds" long bet [0]. It turns out that the index funds fared better — and they're mainly used for long-term investment, where the short-term macroeconomic ebbs don't have an impact on the overall return.
Of course the variance on the active side will be higher, but there are as many losers as they are winners, and much of it is due to simple randomness. Unless you're confident that you know more than other investors (for many people, including myself, we probably don't [1]), index funds, or "hugely diversified portfolios" are the way to go. Basically, no hedge fund is making those 200% returns you're speaking of, and even if some fund were, empirically it's more likely to be just noise. Look at the result so far of Buffett's bet on hedge funds. It speaks volumes.
[0] http://longbets.org/362/
[1] https://en.m.wikipedia.org/wiki/Dunning%E2%80%93Kruger_effec...
Keep in mind that both have the same disadvantage. It is certainly possible (and getting much easier in the last decade) to pick times when passive investing was essentially a worthless proposition (e.g. Sep 2000 up to now yielded <2% per year. Doing better would have been easy, even if you got bitten by the crash. Buying and holding almost any asset would have beaten it (a house, gold, ...). By contrast, starting in March 2003 would have yielded 7.5% per year, which would be pretty hard to beat over that time period).
Truth is that the starting time of an investment determines your results far more than whether you pick active or passive investing.
Word of warning: on a long term graph, today does not look like a good time to start investing, in fact looks like a really good time to sell and stay on the sidelines. This is not affected by passive vs active investing.
Truth is that the starting time of an investment determines your results far more than whether you pick active or passive investing.
Word of warning: on a long term graph, today does not look like a good time to start investing, in fact looks like a really good time to sell and stay on the sidelines. This is not affected by passive vs active investing.
> Word of warning: on a long term graph, today does not look like a good time to start investing, in fact looks like a really good time to sell and stay on the sidelines. This is not affected by passive vs active investing.
Could you expand on what you mean here? Do you mean, that for every day, "today does not look like a good time to start", or do you mean that on this May 4th, 2016, you expect that investments made today, will seem like a bad investment on May 4th 2066? (Or whatever is considered a "long term graph")?
Could you expand on what you mean here? Do you mean, that for every day, "today does not look like a good time to start", or do you mean that on this May 4th, 2016, you expect that investments made today, will seem like a bad investment on May 4th 2066? (Or whatever is considered a "long term graph")?
I mean nothing more than that if you were to put the S&P 500 graph over the last 15 years and extremely naively look at it, you'd conclude it was very high at the moment. Naively it would seem that it will see 1600 before it sees, say 2500.
Also if you look at long term history you'd conclude something similar : the US has had a very long (if somewhat disappointing) economic recovery since 2008. We're due a bust.
And finally, the playbook from earlier recessions does appear to be unfolding : manufacturing production has dropped by a lot, and services has flatlined. This is very much like the start of previous recessions. Next up is bad loans to commodity producers (ie. miners) and manufacturers actually going bad (meaning banks declaring losses), then a few defaults, then panic, then recovery.
I would expect index investments made today will seem like bad investments in 10 years. I would never dream of predicting 50 years out. To be fair, I would have told you the same a year ago (not about the recession playbook, but probably everything else listed in this post).
Also if you look at long term history you'd conclude something similar : the US has had a very long (if somewhat disappointing) economic recovery since 2008. We're due a bust.
And finally, the playbook from earlier recessions does appear to be unfolding : manufacturing production has dropped by a lot, and services has flatlined. This is very much like the start of previous recessions. Next up is bad loans to commodity producers (ie. miners) and manufacturers actually going bad (meaning banks declaring losses), then a few defaults, then panic, then recovery.
I would expect index investments made today will seem like bad investments in 10 years. I would never dream of predicting 50 years out. To be fair, I would have told you the same a year ago (not about the recession playbook, but probably everything else listed in this post).
I mean nothing more than that if you were to put the S&P 500 graph over the last 15 years and extremely naively look at it, you'd conclude it was very high at the moment.
High based on what metric? When I look at this graph, it looks like it's been relatively flat for the last half decade: http://i.imgur.com/3gIwjbh.png
High based on what metric? When I look at this graph, it looks like it's been relatively flat for the last half decade: http://i.imgur.com/3gIwjbh.png
What? This looks flat to you?! :
http://finance.yahoo.com/echarts?s=%5EGSPC+Interactive#{"ran...
It's up 53% over that 5 year period, for a CAGR of 8.9% (excluding dividends).
http://finance.yahoo.com/echarts?s=%5EGSPC+Interactive#{"ran...
It's up 53% over that 5 year period, for a CAGR of 8.9% (excluding dividends).
I'm not trying to give investment advice, just explaining why you should be somewhat credulous about any sales pitch from a guy with vested interests in where you should put your money. It's not as simple as Buffett makes it seem.
> It's not as simple as Buffett makes it seem.
Yes, actually, it is. That's the whole point.
Yes, actually, it is. That's the whole point.
No, it isn't. If everyone in the room were passive investors, and a company like GM starts losing money quarter after quarter, the passive investors will not sell GM. The company will continue to maintain the same stock price. They will continue to issue stock to cover their losses. Issuing stock increases market capitalisation, passive investors will buy in, and keep giving the company cash. On the other hand, new companies will have no active investors looking at them. No active investors to issue IPO's to.
The economy will stagnate. Eventually the entire portfolio the room holds will be money losing companies, burning up the country's capital.
The half of the room who are active investors contribute greatly to the economy's long term growth. They could either have negative long run returns as passive investors, or positive long run returns that are less than passive investors.
The economy will stagnate. Eventually the entire portfolio the room holds will be money losing companies, burning up the country's capital.
The half of the room who are active investors contribute greatly to the economy's long term growth. They could either have negative long run returns as passive investors, or positive long run returns that are less than passive investors.
This analysis is dead-wrong. Passive investors will sell GM, not buy in.
Index funds are weighted by capitalization. So whether GM's capitalization goes up or not is actually irrelevant: what's relevant is the ratio of its capitalization to the size of the total capitalization of all companies in the market, and how that changes.
Setting that point aside, here's some basic math that shows why this analysis is completely wrong and why GM's market cap will go down. Let's say today, I am the CEO of GM, and I issued 1 million new shares, bringing the total up to 1 Billion outstanding shares. I dump them on the market, when the price was $50. The price drops some amount, because shares are being sold.
How much money did I, as CEO of GM, raise? At most $50 million
How much could market cap possibly have gone up? Exactly the amount that was raised: at most $50 million
How much could market cap possibly have gone down? Drop in stock price * 1 Billion
So market cap increase is precisely equal to the amount of capital provided by investors, which is finite and won't run away into a vicious cycle as suggested by the poster. Market cap decrease can be... well... 100%, all the way to zero. And the more shares issued, the more downward pressure on market cap... as the effect of crossing the bid-ask spread on market capitalization gets amplified.
Index funds are weighted by capitalization. So whether GM's capitalization goes up or not is actually irrelevant: what's relevant is the ratio of its capitalization to the size of the total capitalization of all companies in the market, and how that changes.
Setting that point aside, here's some basic math that shows why this analysis is completely wrong and why GM's market cap will go down. Let's say today, I am the CEO of GM, and I issued 1 million new shares, bringing the total up to 1 Billion outstanding shares. I dump them on the market, when the price was $50. The price drops some amount, because shares are being sold.
How much money did I, as CEO of GM, raise? At most $50 million
How much could market cap possibly have gone up? Exactly the amount that was raised: at most $50 million
How much could market cap possibly have gone down? Drop in stock price * 1 Billion
So market cap increase is precisely equal to the amount of capital provided by investors, which is finite and won't run away into a vicious cycle as suggested by the poster. Market cap decrease can be... well... 100%, all the way to zero. And the more shares issued, the more downward pressure on market cap... as the effect of crossing the bid-ask spread on market capitalization gets amplified.
>> I dump them on the market,
I'm sorry, that's an invalid assumption. Especially in a world with only passive investors.
GM has been losing $1 billion a quarter for 10 quarters. GM's stock price is $30 as it has been since 10 quarters ago, market capitalisation $40B. It is running out of cash building unprofitable products. The underwriter calls various index funds, telling them there will be a capital raising of $10B, at $28 per share, representing a ~5% discount, and as a result of that, GM's weighting in the index is going to be re-weighted upwards at the next index balance in three weeks, so they might as well sell other (more productive) stocks, which will be weighted downwards, and buy GM at a discount. The capital raising is "oversubscribed" because of this arbitrage opportunity. As a result of the discount, the stock price of GM falls from $30 to $29.50 ($2 times by roughly 25%). GM's stock price falls 0.16% per quarter, and can sustain this rate indefinitely because of passive investors.
In a stock market with active investors, GM's fall in stock price would be a lot more than 50 cents.
Passive investors represent inertia that will keep the current ratios of market capitalisation between companies listed on the stock exchange constant, even if those ratios are suboptimal economically. As a result of the stunted capital allocation, the economy will begin to shrink, over the long run, as it continues to support unprofitable companies by depressing the share prices of the more productive companies, since, ironically, those more productive companies raise much less money than the unprofitable ones, and those capital raisings funded by selling the other companies that aren't raising money.
I'm sorry, that's an invalid assumption. Especially in a world with only passive investors.
GM has been losing $1 billion a quarter for 10 quarters. GM's stock price is $30 as it has been since 10 quarters ago, market capitalisation $40B. It is running out of cash building unprofitable products. The underwriter calls various index funds, telling them there will be a capital raising of $10B, at $28 per share, representing a ~5% discount, and as a result of that, GM's weighting in the index is going to be re-weighted upwards at the next index balance in three weeks, so they might as well sell other (more productive) stocks, which will be weighted downwards, and buy GM at a discount. The capital raising is "oversubscribed" because of this arbitrage opportunity. As a result of the discount, the stock price of GM falls from $30 to $29.50 ($2 times by roughly 25%). GM's stock price falls 0.16% per quarter, and can sustain this rate indefinitely because of passive investors.
In a stock market with active investors, GM's fall in stock price would be a lot more than 50 cents.
Passive investors represent inertia that will keep the current ratios of market capitalisation between companies listed on the stock exchange constant, even if those ratios are suboptimal economically. As a result of the stunted capital allocation, the economy will begin to shrink, over the long run, as it continues to support unprofitable companies by depressing the share prices of the more productive companies, since, ironically, those more productive companies raise much less money than the unprofitable ones, and those capital raisings funded by selling the other companies that aren't raising money.
Buffets position is also backed by reality. On average, managed money will do worse because of the fees. The people making outsized returns are the minority.
It's like going into a casino and arguing that the casino is losing because you see one guy hit a jackpot on the slot machine.
It's like going into a casino and arguing that the casino is losing because you see one guy hit a jackpot on the slot machine.
Again, I'm not advocating for one strategy over another, just pointing out that Buffett's explanation is simplistic and that it is worth considering metrics other than average returns.
I mentioned this above, but I think you're missing the point. For what you suggest to be worth considering, you have to believe you're something other than an average investor.
But you aren't. That's who he was speaking to and speaking about. Average investors.
But you aren't. That's who he was speaking to and speaking about. Average investors.
Hes not arguing managed makes more money, just that within hedge funds there is variation, where there is no variation within index. The both have the same avg, but wildly different max/min/etc
This can cause an interesting dilemma if you assume that what people invest in makes a difference to the output.
It may make more sense selfishly to be in the low-energy group, but the overall returns might be lower the more people go that route.
A flawed car analogy: A driver and passenger will both travel the same distance, but the driver spends a lot more effort per mile.
So it might both be better for each individual to be low-energy yet better for everyone if people were more active.
It's an interestingly complex problem.
It may make more sense selfishly to be in the low-energy group, but the overall returns might be lower the more people go that route.
A flawed car analogy: A driver and passenger will both travel the same distance, but the driver spends a lot more effort per mile.
So it might both be better for each individual to be low-energy yet better for everyone if people were more active.
It's an interestingly complex problem.
The passive side gets the same results as the active side (before fees), but the active side determines what the result will be.
[deleted]
Interesting analogy. I'd say that trains and buses are generally better than cars: arguably we do better with higher efficiency (less effort for similar gain). Why would making "more effort" be better for the value of stocks, if the net result is the same? I would like to think that it is CEOs and boards that manage companies actively, not investors that simply want a certain ROI.
In your analogy, I'd say investors are car leasing companies, and it's unclear if they provide a value that can't be just as well provided by the driver(s) buying their cars outright. It would mean that the driver(s) would have to be on more equal footing to the investors, though (they'd have to be able to afford the car).
In your analogy, I'd say investors are car leasing companies, and it's unclear if they provide a value that can't be just as well provided by the driver(s) buying their cars outright. It would mean that the driver(s) would have to be on more equal footing to the investors, though (they'd have to be able to afford the car).
Interestingly, the more bad (under average) investors move to passive investment, the better the average outcome will get. And the more good (above average) investors move there, the worse it'll become.
All counted, isn't it great when incentives align almost perfectly with the global optimum?
All counted, isn't it great when incentives align almost perfectly with the global optimum?
Ah but then we come to something I'm going to coin as "Zeno's Investors".
Passive investors achieve the average return. Active investors receive some distribution of return but obviously it must range from some above to some below average. 1/x investors get a worse than average return, despite their efforts. For simplicity, let's say that 1/2 of the investors 'win' and half 'lose'.
That losing half would do better if they moved to passive investments, allowing the top half to make the real gains. Now, we're back in the same situation. Does this not continue on until it's selfishly best for everyone to be a passive investor, even though overall that might be worse?
Ways I think I might be wrong:
- The maths doesn't really work quite that way once the balance shifts away from 50% each side. It may be possible that some proportion of active investors will always make more profit than the passive investors. I don't think this is right but if it is then it'd entirely break the reasoning.
- Changes that happen from one step to the next. The winners now own more capital and therefore we don't see the same converging series. I don't think that matters other than prolonging the outcome, but I'd not be surprised if I'm wrong on this count, I've not thought it through fully.
(I'm trying to be more cautious about making overly bold claims and so am trying to point to things I know might invalidate what I'm saying, if it seems annoying then let me know)
Passive investors achieve the average return. Active investors receive some distribution of return but obviously it must range from some above to some below average. 1/x investors get a worse than average return, despite their efforts. For simplicity, let's say that 1/2 of the investors 'win' and half 'lose'.
That losing half would do better if they moved to passive investments, allowing the top half to make the real gains. Now, we're back in the same situation. Does this not continue on until it's selfishly best for everyone to be a passive investor, even though overall that might be worse?
Ways I think I might be wrong:
- The maths doesn't really work quite that way once the balance shifts away from 50% each side. It may be possible that some proportion of active investors will always make more profit than the passive investors. I don't think this is right but if it is then it'd entirely break the reasoning.
- Changes that happen from one step to the next. The winners now own more capital and therefore we don't see the same converging series. I don't think that matters other than prolonging the outcome, but I'd not be surprised if I'm wrong on this count, I've not thought it through fully.
(I'm trying to be more cautious about making overly bold claims and so am trying to point to things I know might invalidate what I'm saying, if it seems annoying then let me know)
The rational optimum with no transaction costs[1] would be finding the best investor, and letting him make all the decisions. Everybody else should invest on the index.
Put transaction costs there, and you get an adversarial system. Now the top investors will try to convince the others of their own incompetence. Didn't do the math, but the outcome is probably bad.
Now, fill the market with real humans and irrationality will make sure enough incompetent investors will be active to let a big enough amount of competent ones make a win. Stable again.
I'm really unconcerned about index funds.
[1] A spherical cow in vacuum.
Put transaction costs there, and you get an adversarial system. Now the top investors will try to convince the others of their own incompetence. Didn't do the math, but the outcome is probably bad.
Now, fill the market with real humans and irrationality will make sure enough incompetent investors will be active to let a big enough amount of competent ones make a win. Stable again.
I'm really unconcerned about index funds.
[1] A spherical cow in vacuum.
Isn't there a danger that if not enough people actively manage their money, the market won't 'correctly' set prices?
If you own all of the stock in the US, and no-one actively trades in any single stock, how do you know how much one sort of stock is worth against another piece of stock?
I think this eventually drives trading of individual stocks, as the market looks to set prices/trade things this that it thinks are over/under valued.
So I think that it's true that on average an active investor will make less money than a passive one, it's the active one's doing the work/generating the value, as well as giving money to the passive investors!
(presuming rational actors, laws are obeyed etc etc)
If you own all of the stock in the US, and no-one actively trades in any single stock, how do you know how much one sort of stock is worth against another piece of stock?
I think this eventually drives trading of individual stocks, as the market looks to set prices/trade things this that it thinks are over/under valued.
So I think that it's true that on average an active investor will make less money than a passive one, it's the active one's doing the work/generating the value, as well as giving money to the passive investors!
(presuming rational actors, laws are obeyed etc etc)
When people withdraw money from an index fund -- say, to put a downpayment on a house or move it into a fixed income fund for retirement -- they are effectively placing a sell order on every stock in the index.
And if they put money in from their monthly paycheck, they're placing a buy order.
As long there is a reasonably good balance of buyers and sellers of mutual funds, the underlying securities will find equilibrium.
And if they put money in from their monthly paycheck, they're placing a buy order.
As long there is a reasonably good balance of buyers and sellers of mutual funds, the underlying securities will find equilibrium.
> Isn't there a danger that if not enough people actively manage their money, the market won't 'correctly' set prices?
If this stuff interests you, I recommend reading the previous post (http://www.philosophicaleconomics.com/2016/05/passive/), which discusses this exact topic.
If this stuff interests you, I recommend reading the previous post (http://www.philosophicaleconomics.com/2016/05/passive/), which discusses this exact topic.
> Isn't there a danger that if not enough people actively manage their money, the market won't 'correctly' set prices?
There is no "correct" price aside from the price set through the market.
There is no "correct" price aside from the price set through the market.
I think you're right that there would be a natural balancing. If too many passive dollars went into certain companies, they should become more clearly over-valued than a peer not in the index.
The fundamental flaw in that argument is the assumption that the inactive and the active groups share of ownership remains the same. Which it would have to only if:
(1) the initial split was formed by splitting each company into halves between the two groups, and
(2) no new companies were ever formed, or, if they are, they are from initiation split ownership exactly 50/50 between actives and inactives.
(1) the initial split was formed by splitting each company into halves between the two groups, and
(2) no new companies were ever formed, or, if they are, they are from initiation split ownership exactly 50/50 between actives and inactives.
He implies that market will always grow. Lets say we have Japanese market. How do you make money here?
Dividends?
The key (absurd) assumption is that 100% of assets are passively-investable.
Well he does say "To be clear, I’m not arguing that an entire market could ever go passive."
Which kinds of begs the question, how much passive investment can there be, and what is the limiting factor, if not a Grossman-Stiglitz model where 'arbitrage ' (in this context market-making, market-timing etc.) makes prices boundedly efficient, and less arbitrage means higher spreads, less liquidity, less pricing efficiency.
There must be a 'Bernstein peak' and mixed strategy equilibrium, where if you have too much active, expenses are too high, and if you have too little active, liquidity suffers and costs from spreads and volatility are too high.
http://abnormalreturns.com/2016/02/19/the-bernstein-curve/
Which kinds of begs the question, how much passive investment can there be, and what is the limiting factor, if not a Grossman-Stiglitz model where 'arbitrage ' (in this context market-making, market-timing etc.) makes prices boundedly efficient, and less arbitrage means higher spreads, less liquidity, less pricing efficiency.
There must be a 'Bernstein peak' and mixed strategy equilibrium, where if you have too much active, expenses are too high, and if you have too little active, liquidity suffers and costs from spreads and volatility are too high.
http://abnormalreturns.com/2016/02/19/the-bernstein-curve/
No, the hypothetical assumes that 50% of all assets are passively-investable. 50% low-energy, 50% high-energy. There are a lot of brilliant, resourceful people in that high energy crowd who are establishing the share prices that the low-energy crowd then gets to take advantage of for nothing. High-energy percentage could likely be much, much less than 50% and passive investing would still work.
There is no real danger that so many people are going to turn passive that it won't work; there are plenty of people out there who think they can do better (and always will be, given human nature), despite the evidence that they won't.
There is no real danger that so many people are going to turn passive that it won't work; there are plenty of people out there who think they can do better (and always will be, given human nature), despite the evidence that they won't.
> No, the hypothetical assumes that 50% of all assets are passively-investable.
No, it assumes that all assets are passively investable, and each asset is half held by passive investors and half held by active investors. Under any other set of assumptions (particularly, if its just a 50%/50% split of initial market value across all but not each individual investment), the equal-returns conclusion does not hold.
No, it assumes that all assets are passively investable, and each asset is half held by passive investors and half held by active investors. Under any other set of assumptions (particularly, if its just a 50%/50% split of initial market value across all but not each individual investment), the equal-returns conclusion does not hold.
I don't think the parent posted here meant that passive investors could or couldn't buy up 50% or more of a total market.
I believe he meant that active fund managers may be able to get positions or create/use instruments that are not available to the general public.
I believe he meant that active fund managers may be able to get positions or create/use instruments that are not available to the general public.
[deleted]
Wouldn't that be true iif all investing was zero sum game? As far as I know it isn't, at least not in equities.
Brilliant. Only a person of the caliber of Buffett can get away with repeating what has been common knowledge since the 1970s and is nowadays written in pretty much every financial self-help book to a rapt audience who record his every word and quote him on Internet forums.
Index funds were scorned for many years. The first index fund was started by John Bogle in 1976, but he had a difficult time attracting investors. They didn't really become popular until the nineties.
This Planet Money episode talks about it in detail.
http://www.npr.org/sections/money/2016/03/04/469247400/episo...
This Planet Money episode talks about it in detail.
http://www.npr.org/sections/money/2016/03/04/469247400/episo...
He's not claiming it's new information or something only he knows. In fact he attributes most of his knowledge to Graham.
Read some of the other comments in this thread and you'll see it's not common knowledge either.
Read some of the other comments in this thread and you'll see it's not common knowledge either.
So the tortoise and the hare fable caste as passive vs active investors.
it's worth noting that buffett doesn't believe markets are "efficient":
"[D]iversification is protection against ignorance. It makes little sense if you know what you are doing."
"[D]iversification is protection against ignorance. It makes little sense if you know what you are doing."
Here's what I haven't found a good answer to yet...
What is the risk when a large percentage of the middle class and others are all in low fee index funds?
This seems on the surface to be ripe for exploitation in some way, or like we'd be all exposed to the same black swan event and thus potentially trigger another major market event simply because everyone is in the same funds.
I am not a super educated investor so if this is impossible due to the nature of indexes please correct me, but I can't help but feel that this push towards the Bogleheads approach may have the unintended side effect of proverbially putting "all of our investors in one basket."
What are the risks if main street investors truly do shift to this style of investing en masse? It seems that the investments of our middle class and upper middle class would all take big hits at the same time which could cripple the nation moreso than if people were in other investments.
Again, I'm probably missing something here so would appreciate being educated on why my fears are invalid. I haven't been able to find any info on this from googling.
What is the risk when a large percentage of the middle class and others are all in low fee index funds?
This seems on the surface to be ripe for exploitation in some way, or like we'd be all exposed to the same black swan event and thus potentially trigger another major market event simply because everyone is in the same funds.
I am not a super educated investor so if this is impossible due to the nature of indexes please correct me, but I can't help but feel that this push towards the Bogleheads approach may have the unintended side effect of proverbially putting "all of our investors in one basket."
What are the risks if main street investors truly do shift to this style of investing en masse? It seems that the investments of our middle class and upper middle class would all take big hits at the same time which could cripple the nation moreso than if people were in other investments.
Again, I'm probably missing something here so would appreciate being educated on why my fears are invalid. I haven't been able to find any info on this from googling.
Perhaps overly generalizing, most everyone's portfolio is a poor approximation of the overall market with extra fees taking away even more -- hence the index funds tracking the overall market (or just the traditional top companies like S&P 500) will generally do better. When the market goes tits up, pretty much everyone will take a hit at the same time, index-fund holders and people with more specific portfolios alike. The people that won't be hit hard will be those with more "safe" investments (that don't outpace inflation...) like bonds, those who saw it coming and invested in negative-indexes, or those who get lucky with e.g. penny stocks / startups.
> What is the risk when a large percentage of the middle class and others are all in low fee index funds?
One risk is that index funds aren't really unmanaged, they are managed by people who set and apply rules as to what is included in the index. The greater proportion of total investment that is passively (i.e., without deep research into the practices behind the index) invested in such funds (and, particularly, the proportion that is passively invested in any one such fund), the greater the risk of the rules and practices of setting the index being manipulated.
One risk is that index funds aren't really unmanaged, they are managed by people who set and apply rules as to what is included in the index. The greater proportion of total investment that is passively (i.e., without deep research into the practices behind the index) invested in such funds (and, particularly, the proportion that is passively invested in any one such fund), the greater the risk of the rules and practices of setting the index being manipulated.
The risk worries me too. Look at it this way: the whole purpose of a market is to allocate capital to productive ends. If everyone invests in index funds, market capitalization (and thus capital allocation) becomes a function of inertia and ceases to have anything to do with actual performance (because nobody is interested in looking at actual performance). As a result, I'd expect productivity growth to slow.
Guess what? Productivity growth has been slowing.
Guess what? Productivity growth has been slowing.
I doubt that the world economic slow growth projections are due to the 36% of equity and bond assets which are indexed instead of actively managed.
If that were true, then the 64% of actively managed funds would have a clear opportunity to capitalize on this fact for higher returns.
If that were true, then the 64% of actively managed funds would have a clear opportunity to capitalize on this fact for higher returns.
Index funds expose you to essentially the entire market; it's the sum of thousands of tiny pieces of businesses all across America. We're not putting all our eggs in one basket, rather, we're all distributing them across many.
If you can pick an investment that will weather an economic downturn, and still provide a decent return — let me know, because I want to get in on it ;)
If you can pick an investment that will weather an economic downturn, and still provide a decent return — let me know, because I want to get in on it ;)
But when everyone invests in everything equally, we all end up investing in nothing!
The previous post on the same blog debunks this. http://www.philosophicaleconomics.com/2016/05/passive/
http://www.ironbridgellc.net/PDF/hidden_risks_of_passive_inv... is an interesting countervailing read
What you're missing is that the stock market isn't a zero sum game. More money comes out of it than goes into it, because it represents companies that generally do useful things.
Except the biggest index by far is only 500 of the companies, not even remotely "the entire market".
You are thinking about this wrong. The S&P 500 is a capitalization weighted index meaning the larger the market cap the larger the weight. If you constructed a total market index using the same capitalization based weighting scheme, you'd find the S&P 500 would account for about 80% of the index value. In that light it is actually pretty close to "the entire market."
Vanguard total stock market fund (VTSMX) has over 3000 stocks, right?
Oh, there are definitely indexes/funds with broader coverage but the S&P500 funds continue to get a disproportionate share.
Are you sure about that? I mean, have you actually verified that with any particular fund family? I did, for the Vanguard family.
Vanguard S&P 500 index fund has $227.5B net assets (across all share classes)[1]. Vanguard Extended Market Index fund (which is the set difference of Vanguard Total Stock Market Index Fund and the S&P 500 fund) has $42.8B net assets (across all share classes)[2].
That is 18.8% of funds in Extended Market. The true ratio is 19% of funds in Extended Market[3]. Not so different.
Now you can argue that funds like the SPYder are the ones which receive a disproportionate share of attention. I would counter that (1) SPY is a smaller fund than Vanguard's (2) How much of that is investors vs. traders who use it for the liquidity.
In conclusion, I'm unconvinced that S&P500 index funds receive a disproportionate share of attention in investment, apart from investment professionals discussions. Even Buffet doesn't appear to care, and may simply use the S&P 500 because it is more well-known:
> Okay, so gold is not a screaming buy to Buffett. What should a typical upper-middle-class person in the U.S. buy to prepare for retirement?
> "Equities," Buffett answers without a moment's hesitation.
> "The VTI?" I ask.
> "That's good enough. Maybe a selection of high-dividend-paying stocks that are likely to raise their dividends. Maybe the top 100 dividend payers of the S&P 500."
>Then, after a second's thought, he adds, "Well, maybe not that, but equities."[4]
[1]: https://personal.vanguard.com/us/funds/snapshot?FundId=0040&...
[2]: https://personal.vanguard.com/us/funds/snapshot?FundId=0098&...
[3]: https://www.bogleheads.org/wiki/Approximating_total_stock_ma...
[4]: http://archive.fortune.com/2010/10/18/pf/investing/buffett_b...
Vanguard S&P 500 index fund has $227.5B net assets (across all share classes)[1]. Vanguard Extended Market Index fund (which is the set difference of Vanguard Total Stock Market Index Fund and the S&P 500 fund) has $42.8B net assets (across all share classes)[2].
That is 18.8% of funds in Extended Market. The true ratio is 19% of funds in Extended Market[3]. Not so different.
Now you can argue that funds like the SPYder are the ones which receive a disproportionate share of attention. I would counter that (1) SPY is a smaller fund than Vanguard's (2) How much of that is investors vs. traders who use it for the liquidity.
In conclusion, I'm unconvinced that S&P500 index funds receive a disproportionate share of attention in investment, apart from investment professionals discussions. Even Buffet doesn't appear to care, and may simply use the S&P 500 because it is more well-known:
> Okay, so gold is not a screaming buy to Buffett. What should a typical upper-middle-class person in the U.S. buy to prepare for retirement?
> "Equities," Buffett answers without a moment's hesitation.
> "The VTI?" I ask.
> "That's good enough. Maybe a selection of high-dividend-paying stocks that are likely to raise their dividends. Maybe the top 100 dividend payers of the S&P 500."
>Then, after a second's thought, he adds, "Well, maybe not that, but equities."[4]
[1]: https://personal.vanguard.com/us/funds/snapshot?FundId=0040&...
[2]: https://personal.vanguard.com/us/funds/snapshot?FundId=0098&...
[3]: https://www.bogleheads.org/wiki/Approximating_total_stock_ma...
[4]: http://archive.fortune.com/2010/10/18/pf/investing/buffett_b...
I think you are already on the right track. In the end it's always hard to predict how something will turn bad. But you can already tell that a monoculture of simplicity will turn bad at some point. That's already enough to make a judgement call.
There's a number of risks associated with ETFs that isn't associated (or less) with individual stocks.
As a rule of thumb you might assume that if the index goes down, the index fund will add 1-5% going down (large index funds only), and if the index goes up, the index fund will "lose" 0.1-0.5% of that value going up. ETFs are similar. Why ? Lots of reasons:
1) gating (during periods of heavy activity, the adding or removing shares process can block. Additionally, due to new regulation the management of the ETF can impose this without recourse for you. So if the ETF drops 20% in an hour, but you notice this 5% into the drop and want out, chances are good you won't be able to)
2) slippage (due to time delays, contracts, fees, the fact that fractional share ownership doesn't exist, ...) $100 added to an ETF does not result in $100 increase in ETF value. This affects smaller ETFs more than larger ones, but it means that when the S&P 500 goes up 10%, SPY goes up 9.9% or so, when it goes down this makes the drop worse (so, say 10% -> 10.1%). There have been cases where slippage has been large, especially in smaller ETFs).
Note that the reverse is also true, unless you're a billionnair (or at least dozen millionaire). Maintaining "your own", say, SPY equivalent account by owning individual shares will likely cost you more in fees than it would cost you to own the equivalent SPY shares. Additionally if you have less money than the ETF, you'll have to have a rougher approximation.
4) slippage due to add/removes from the S&P 500 index. Since the ETF will have to make suboptimal (very large) trades when the index changes, this will cause the value of the ETF to "slip" compared to the index itself. Putting it separately since it results in bigger amounts.
So the SPY index tracks something between the S&P500 and this list : http://siblisresearch.com/sp-500-additions-removals/
This has, in the past, affected the difference between an S&P 500 index and an ETF more during recessions and that will continue.
5) Global synchronization. Many people use an ETF like SPY as an alternative for a 50% bonds 50% stocks portfolio. Needless to say, this is less diversified, and carries more risk.
6) Generally speaking, an ETF is of course vulnerable to the same risks as the individual stocks, to a lesser extent. However, bad things will happen to the ETF when bad things happen to any large holding. The thing is that the odds go up much faster than I bet people would expect.
Let's say the odds of something really bad (getting economic sanctions, default, bankruptcy, ...) happening to a top-10 S&P 500 company are 1% (happens once every century). We all (should) know the formula that determines risk across SPY as a result of that, but do you know what value it gives for this scenario ?
It's just shy of 10%.
So under these assumptions you can expect a 6-7% drop in the SPY etf every decade that won't be reflected in the index (index can, "for free", just remove failed stocks and replace them, the ETF can't). I hope you agree those are reasonable assumptions.
As a rule of thumb you might assume that if the index goes down, the index fund will add 1-5% going down (large index funds only), and if the index goes up, the index fund will "lose" 0.1-0.5% of that value going up. ETFs are similar. Why ? Lots of reasons:
1) gating (during periods of heavy activity, the adding or removing shares process can block. Additionally, due to new regulation the management of the ETF can impose this without recourse for you. So if the ETF drops 20% in an hour, but you notice this 5% into the drop and want out, chances are good you won't be able to)
2) slippage (due to time delays, contracts, fees, the fact that fractional share ownership doesn't exist, ...) $100 added to an ETF does not result in $100 increase in ETF value. This affects smaller ETFs more than larger ones, but it means that when the S&P 500 goes up 10%, SPY goes up 9.9% or so, when it goes down this makes the drop worse (so, say 10% -> 10.1%). There have been cases where slippage has been large, especially in smaller ETFs).
Note that the reverse is also true, unless you're a billionnair (or at least dozen millionaire). Maintaining "your own", say, SPY equivalent account by owning individual shares will likely cost you more in fees than it would cost you to own the equivalent SPY shares. Additionally if you have less money than the ETF, you'll have to have a rougher approximation.
4) slippage due to add/removes from the S&P 500 index. Since the ETF will have to make suboptimal (very large) trades when the index changes, this will cause the value of the ETF to "slip" compared to the index itself. Putting it separately since it results in bigger amounts.
So the SPY index tracks something between the S&P500 and this list : http://siblisresearch.com/sp-500-additions-removals/
This has, in the past, affected the difference between an S&P 500 index and an ETF more during recessions and that will continue.
5) Global synchronization. Many people use an ETF like SPY as an alternative for a 50% bonds 50% stocks portfolio. Needless to say, this is less diversified, and carries more risk.
6) Generally speaking, an ETF is of course vulnerable to the same risks as the individual stocks, to a lesser extent. However, bad things will happen to the ETF when bad things happen to any large holding. The thing is that the odds go up much faster than I bet people would expect.
Let's say the odds of something really bad (getting economic sanctions, default, bankruptcy, ...) happening to a top-10 S&P 500 company are 1% (happens once every century). We all (should) know the formula that determines risk across SPY as a result of that, but do you know what value it gives for this scenario ?
It's just shy of 10%.
So under these assumptions you can expect a 6-7% drop in the SPY etf every decade that won't be reflected in the index (index can, "for free", just remove failed stocks and replace them, the ETF can't). I hope you agree those are reasonable assumptions.
I love passive investing (vanguard admiral shares anyone??) but there are several things that I find lacking:
1. It's really boring. There's no earnings to follow, no products to watch, etc
2. You can't get rich from most indexes. The risk and reward is too low. It's unlikely to invest in a index that gives you a 10x return, though it does happen.
In the end I keep the bulk in a low fee composite index but I like to speculate with a little, even if I invariably lose money on the spec part. It's more fun.
1. It's really boring. There's no earnings to follow, no products to watch, etc
2. You can't get rich from most indexes. The risk and reward is too low. It's unlikely to invest in a index that gives you a 10x return, though it does happen.
In the end I keep the bulk in a low fee composite index but I like to speculate with a little, even if I invariably lose money on the spec part. It's more fun.
I do the same. I take 10% of total net worth and invest wherever the hell I want. I call it my 'casino fund'.
For me I don't care about #2. If you had the most boring investment in the world that returned exactly 7% every single year I would put 90% of my assets there immediately. But I'd keep trying to beat that 7% in my casino fund.
For me I don't care about #2. If you had the most boring investment in the world that returned exactly 7% every single year I would put 90% of my assets there immediately. But I'd keep trying to beat that 7% in my casino fund.
It's unlikely to invest in a index that gives you a 10x return.
Average return from S&P500 from 1928-2015 is 11.41% [ source : http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/... ]
Note that this is not inflation adjusted; inflation is about 3.4% historically.
It'd take a little over 21 years to get a nominal 10x return at 11.4% average return.
Average return from S&P500 from 1928-2015 is 11.41% [ source : http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/... ]
Note that this is not inflation adjusted; inflation is about 3.4% historically.
It'd take a little over 21 years to get a nominal 10x return at 11.4% average return.
Yeah, this is basically why passive is great. People say hedge funds are good in a downturn, but the odds of a downturn in any given year are not actually that high.
From the Professor Damodaran's historical returns link:
From 1928-2015, of the 88 years, 24 were down years. Probability of a down year is 27%
From 1928-2015, of the 88 years, 24 were down years. Probability of a down year is 27%
If you want "fun investing", go to Vegas. I personally don't think of investing as a source of entertainment.
I quite enjoy listening to the conference call for a company. It really does tell you a lot about what's happening behind the scenes, and before anyone else knows it. It's like the company telling you little secrets :-)
Investing in specific companies rather than indexes (which I assume is what everyone means by "fun investing"?) isn't very much like gambling in Vegas. With gambling in vegas you have a negative expected return with a high variance. With stock picking you have a positive expected return with a high variance (where do index funds fit in? positive expected return with low-ish variance).
Although picking stocks is still not rational if your only concern is your long run wealth, it's not irrational for the same reason as gambling. It's bad because you have the same expected return as low cost index funds, and you exert effort or pay fees for the privilege. That doesn't mean I look down on everyone who actively invests though-- they may have good reason to think they are special and can pick stocks better than average or they may just enjoy it, as the person to whom you responded said he did. And then it would be rational to actively invest at least some of the time.
Although picking stocks is still not rational if your only concern is your long run wealth, it's not irrational for the same reason as gambling. It's bad because you have the same expected return as low cost index funds, and you exert effort or pay fees for the privilege. That doesn't mean I look down on everyone who actively invests though-- they may have good reason to think they are special and can pick stocks better than average or they may just enjoy it, as the person to whom you responded said he did. And then it would be rational to actively invest at least some of the time.
I disagree that you have +EV with stock picking in general. Most companies go out of business, most stocks go to $0.
Index funds, however, do have +EV.
Index funds, however, do have +EV.
The very essence of the EMH (which is frequently oversold, but holds to some degree) is that we can't know which stocks are going to go down or up just by looking at the current state of the market. The expected value of any given stock is the same as that of an index fund, assuming it's no transaction cost to obtain it. So ignoring fees, picking stocks randomly does have the same positive expected return as holding all a small bit of all stocks at once (which is what owning an index is), just a much higher variance and thus people choose to own indexes.
If you want to be sure of positive expected value, just pick randomly, with probability proportional to market cap. That gives the same expected value as an index fund, with much higher variance.
I see the error in my thinking here. My suggestion of rebalancing loses the high end component of variance while avoiding the 0 value case.
I guess im just too cynical to believe a company can operate indefinitely with indefinite growth!
I guess im just too cynical to believe a company can operate indefinitely with indefinite growth!
if you rebalance / repick, yes. If it's just buy and hold, I don't agree. The benefit of index funds is the failing companies are dropped before they hit $0.
That seems like a strange perspective to me. All of the theoretical justification for passive investing (you get the average return without the fees, maximum diversification, etc.) implies that you'll get the best result from holding every possible security in some proportion. You're saying that index funds work not because of any of that, but because they've observed a market inefficiency (low market-cap or recently-fallen stocks underperform the market), and make an active decision to deviate from the market portfolio in order to exploit it. Why believe that there's exactly one easily-exploitable market inefficiency, but no others?
[deleted]
I'd argue that you can get rich, just slowly.
Put 95% or so in passive, then use the rest for a few gambles. If you lose it all, no big deal, make sure you're comfortable writing it off. This way you can get the entertainment value, playing extremely risky with this money but without taking on much large scale risk. You can use leverage or options trading to maximize the risk/return for this if it doesn't feel like it's enough to be fun.
Some people say lottery tickets are the highest risk portion of the portfolio, but for people who like looking at numbers as you're describing, I think this is a better option.
Some people say lottery tickets are the highest risk portion of the portfolio, but for people who like looking at numbers as you're describing, I think this is a better option.
If you have higher appetite for risk, take an efficient portfolio and lever it up to your desired risk level.
[deleted]
“Yes, you need to diversify... mix your more established growth names–e.g., your Microsofts, your Intels, your Ciscos, your Yahoos, basically, the reliable blue chip stuff–with higher-risk bets–something like an Astroturf.com, or an Iomega, or a JDS Uniphase, that will offer high-powered upside if things work out for those companies. That will give your portfolio balance, without sacrificing growth."
It's really a joke for this portfolio from some TV gurus from that time around '99, as every "blue chip" companies on the list mostly worth significant lower in '16 from their '99-00 heights: >-50%+ INTC, CSCO, YHOO (not to mentions it's on the selling block). Maybe MSFT is an exception. Those high-risk bets? more like busts: astroturf (?, never heard of it), IOM (from $100 to $3.56 when acq'd by EMC), JDSU (from ~$300 to $6 as VIAV and $25 as LITE). I really do not see what growth in such portfolio.
This just reminds me the moment that Jim Cramer and other pundits on TV urging investors to buy and hold Lehman Brothers stocks before its fall in '08 "because it's too big to fail".
It's really a joke for this portfolio from some TV gurus from that time around '99, as every "blue chip" companies on the list mostly worth significant lower in '16 from their '99-00 heights: >-50%+ INTC, CSCO, YHOO (not to mentions it's on the selling block). Maybe MSFT is an exception. Those high-risk bets? more like busts: astroturf (?, never heard of it), IOM (from $100 to $3.56 when acq'd by EMC), JDSU (from ~$300 to $6 as VIAV and $25 as LITE). I really do not see what growth in such portfolio.
This just reminds me the moment that Jim Cramer and other pundits on TV urging investors to buy and hold Lehman Brothers stocks before its fall in '08 "because it's too big to fail".
The main problem I have with index funds is the otherwise financially savyy people who tell me that index funds will get you on average x% a year. No! Index funds, in the past, gave x% a year. However past performance is not a predictor of future performance.
There is no law of physics/economics that says the S&P500 has to rise at x% a year on average.
There is no law of physics/economics that says the S&P500 has to rise at x% a year on average.
Past performance should be a predictor of future performance if the forces driving the market remain similar to the forces driving it in the past.
If they are not the same, then past performance may be a very bad predictor. But even in that case it is hard to imagine I'd do better by picking individual stocks unless I start researching companies as a full-time job.
If they are not the same, then past performance may be a very bad predictor. But even in that case it is hard to imagine I'd do better by picking individual stocks unless I start researching companies as a full-time job.
It sounds like your problem may be forming your opinion of index funds based on the comments of people who are not financially savvy. Extrapolating an opinion about people who you admit are not financially savvy to the question of whether the financial products themselves are a good investment doesn't make too much sense to me.
on top of that, the entire argument is predicated on us stock returns over a 100-150 year time period (an unusual one at that). what's the real expected investment life of the audience? the sample is ridiculously small.
Impact is nothing.
Whole point of indexed funds is match the market. If you feel that as an investor you're able to beat the market, which includes indexed funds, good luck.
"Fool and their money are soon parted."
Whole point of indexed funds is match the market. If you feel that as an investor you're able to beat the market, which includes indexed funds, good luck.
"Fool and their money are soon parted."
The distinction between passive and active management is kind of a misnomer anyway, right?
There's no reason an "active" manager can't just select x00 companies by some criteria, publish that list and then just invest in that basket with modest adjustments?
At this point, the primary advantage that "passive" management has is extraordinary marketing, mainly through the selection of S&P 500 components.
There's no reason an "active" manager can't just select x00 companies by some criteria, publish that list and then just invest in that basket with modest adjustments?
At this point, the primary advantage that "passive" management has is extraordinary marketing, mainly through the selection of S&P 500 components.
[deleted]
Dealing with retirement investment policicies offered in Ireland, I see two sides:
1. Actively managed funds diversified across equitieis, bonds, cash, etc
2. Index funds for specific indices, such as "top 4,000 US companies"
The danger with 2, they say, is you're not diversified. That'll be up to me I suppose to try to diversity into other areas.
1. Actively managed funds diversified across equitieis, bonds, cash, etc
2. Index funds for specific indices, such as "top 4,000 US companies"
The danger with 2, they say, is you're not diversified. That'll be up to me I suppose to try to diversity into other areas.
What they mean is that it's all in highly correlated assets.
It lacks diversification across non-correlated asset classes.
Stocks (US and emergent), bonds and cash are less correlated than US companies even 4000 of them.
Most popular index funds are very diversified. 4000 companies not diversified enough for you? There is research that suggests any 50 companies picked at random will give you quite a bit of diversification.
The real lack of diversity is that it's weighted towards US companies which some people have decided they want and others don't, and apparently it's weighted towards stocks as an asset class as well.
I don't think weighting is the same as lacking diversification, although certainly you are lacking one kind of diversification.
The real lack of diversity is that it's weighted towards US companies which some people have decided they want and others don't, and apparently it's weighted towards stocks as an asset class as well.
I don't think weighting is the same as lacking diversification, although certainly you are lacking one kind of diversification.
I would think that generally one means different things. Specifically, a diversified portfolio would hold stocks and bonds.
Or, if one is of the "stocks don't go up over the long term" persuasion, it means stocks + shorts (for a net market neutral portfolio) and bonds.
So no, popular index funds are not diversified. There are exceptions, of course.
Or, if one is of the "stocks don't go up over the long term" persuasion, it means stocks + shorts (for a net market neutral portfolio) and bonds.
So no, popular index funds are not diversified. There are exceptions, of course.
Maybe that is a function of your market, but indexing doesn't prevent you from becoming diversified.
Gold gave better returns in last 10 years http://www.nsegold.com/why-invest-in-gold.php
Passive investing is popular when markets are good. And there wasn't any significant crisis since 2008-2009.
When markets make a downturn, passive investing is not a great idea.
When markets make a downturn, passive investing is not a great idea.
When the market takes a dive is the best time to invest in index funds. The problem comes when people panic and pull out their money in a recession, realizing the loss. If the market rebounds you come out ahead and if it doesn't, you've got much bigger problems.
The best policy is to put money in the market every month, through the best and worst of it, especially if you're young.
The best policy is to put money in the market every month, through the best and worst of it, especially if you're young.
> The problem comes when people panic and pull out their money in a recession,
This doesn't happen only because of panic.
In a recession, by definition, bad things happen: people lose cushy jobs, they end up uninsured just before an illness happens, very close relatives (parents, kids) fall on hard times them-selves and you have to bail them out etc etc. All these new problems require liquidity, which can be very easily obtained by selling your stocks, even if at a loss. Multiply this across the whole middle-class and the end-result won't be pretty.
This doesn't happen only because of panic.
In a recession, by definition, bad things happen: people lose cushy jobs, they end up uninsured just before an illness happens, very close relatives (parents, kids) fall on hard times them-selves and you have to bail them out etc etc. All these new problems require liquidity, which can be very easily obtained by selling your stocks, even if at a loss. Multiply this across the whole middle-class and the end-result won't be pretty.
Fair point; this stuff certainly doesn't happen in a vacuum.
I should have mentioned that investing comes with the caveat that one should also have a plan for major life events like a job loss. Having 6+ months of living expenses on hand in cash is a must. I firmly believe that 70%+ of the stress and anxiety of losing one's job is the pressing need for cash flow. I can't imagine the kind of stress that produces for someone who lives paycheck to paycheck.
That brings me to a larger (slightly off-topic) point: people don't save enough money. 10% is the absolutely minimum one should be saving, despite that being the common advice which no one follows. Most people, even high-earners, spend nearly all of their money. There are tons of people out there making $75k+ per year who are a couple paychecks from being on the street. Those people are simply doing it wrong and will absolutely get bit in a down market.
For those still reading, do this: Get an emergency fund that you can live on for 6+ months. Pay off your debts. Contribute to your IRA, 401k, or whatever else, putting all of that money into a boring index fund that tracks the market (I like VTSAX because Vanguard's fees are incredibly low). Make sure at least 20% of your money is invested. The only people who this might not work for are those earning at or near minimum wage with dependents. If you're not in that group, just do it. You do not need that 20% of your money right now. You may think you do, but you don't. You're spending money on stuff you don't need.
My apologies for getting so far off topic. This is just something I feel very passionately about.
I should have mentioned that investing comes with the caveat that one should also have a plan for major life events like a job loss. Having 6+ months of living expenses on hand in cash is a must. I firmly believe that 70%+ of the stress and anxiety of losing one's job is the pressing need for cash flow. I can't imagine the kind of stress that produces for someone who lives paycheck to paycheck.
That brings me to a larger (slightly off-topic) point: people don't save enough money. 10% is the absolutely minimum one should be saving, despite that being the common advice which no one follows. Most people, even high-earners, spend nearly all of their money. There are tons of people out there making $75k+ per year who are a couple paychecks from being on the street. Those people are simply doing it wrong and will absolutely get bit in a down market.
For those still reading, do this: Get an emergency fund that you can live on for 6+ months. Pay off your debts. Contribute to your IRA, 401k, or whatever else, putting all of that money into a boring index fund that tracks the market (I like VTSAX because Vanguard's fees are incredibly low). Make sure at least 20% of your money is invested. The only people who this might not work for are those earning at or near minimum wage with dependents. If you're not in that group, just do it. You do not need that 20% of your money right now. You may think you do, but you don't. You're spending money on stuff you don't need.
My apologies for getting so far off topic. This is just something I feel very passionately about.
I feel exactly the same way as you. I'm 37 and financially "stable" (i.e. I would be "okay" for a while if I lost my job today), but I wish I had gotten started earlier. I constantly am trying to get my girlfriend, who is just 21, started in saving and investing. She's recently became interested in "credit" (building a credit history, etc.) and so I still have my fingers crossed I can get her starting to save.
Part of the problem, I think, is instant gratification -- the younger generation, especially, wants everything NOW. I'm guilty of this as well, running out to order the newest tech gadgets. She sees me doing this and wants to do it as well, not really realizing that I can do that a little easier because I make multiple times what she does.
There was a time not long ago when I would have been screwed if I had suddenly lost my job. Fortunately, if that happened today I could enjoy a few months off before even starting to look for new employment, let alone stressing about how to pay my bills. The difference in anxiety / stress levels is astounding.
Part of the problem, I think, is instant gratification -- the younger generation, especially, wants everything NOW. I'm guilty of this as well, running out to order the newest tech gadgets. She sees me doing this and wants to do it as well, not really realizing that I can do that a little easier because I make multiple times what she does.
There was a time not long ago when I would have been screwed if I had suddenly lost my job. Fortunately, if that happened today I could enjoy a few months off before even starting to look for new employment, let alone stressing about how to pay my bills. The difference in anxiety / stress levels is astounding.
I don't see the difference between having cash on hand and having stocks. You can sell on the market five days a week. Add multiple credit cards with a very high credit line on them you effectively have about 30 days to sell stock from the emergency point.
Why keep stocks over cash? Even if they don't appreciate, or even if it is a down year, they still pay dividends which can be reinvested.
Why keep stocks over cash? Even if they don't appreciate, or even if it is a down year, they still pay dividends which can be reinvested.
Consider this scenario (which is not out of the realm of possibility):
You stick $10k in the market when shares are $10 each. This means you get 1000 shares. Then the market crashes and now those 1000 shares are worth $5k. Normally this would be fine; you know the market will rebound eventually. Then you lose your job and have no cash on hand.
You're out of the job for a few months, and you slowly sell your shares until you find a new job. Say it takes $4k to keep you afloat for a few months. You now have $1k left in the market, 200 shares. That $4k of spending actually cost you $8k. Though the market rebounds eventually and your remaining 200 shares are worth the $2k they originally were, you're still $8k short and you always will be. That money is gone. It would've taken more than 20 years for inflation to turn $8k in cash into $4k.
In short, cash is a cheap hedge against some bad luck eating up your investments. The inflation that slowly devalues your cash is a much more acceptable risk than the one I describe. Markets can be rough in the short term. It's easy to hedge against them. Do it.
You stick $10k in the market when shares are $10 each. This means you get 1000 shares. Then the market crashes and now those 1000 shares are worth $5k. Normally this would be fine; you know the market will rebound eventually. Then you lose your job and have no cash on hand.
You're out of the job for a few months, and you slowly sell your shares until you find a new job. Say it takes $4k to keep you afloat for a few months. You now have $1k left in the market, 200 shares. That $4k of spending actually cost you $8k. Though the market rebounds eventually and your remaining 200 shares are worth the $2k they originally were, you're still $8k short and you always will be. That money is gone. It would've taken more than 20 years for inflation to turn $8k in cash into $4k.
In short, cash is a cheap hedge against some bad luck eating up your investments. The inflation that slowly devalues your cash is a much more acceptable risk than the one I describe. Markets can be rough in the short term. It's easy to hedge against them. Do it.
To that I say you can have an even cheaper way to hedge against risk by having put options on the stock you own.
Also your example assumes that all the shares were bought at the same time and declined 50%. If you've been investing for years, the value of your gains/losses wouldn't simply be a "market crash" it would include the price at which you bought the stock at plus any dividends you reinvested. So a 50% downturn from a certain high point could be much less from how much capital you initially committed. Add to that you can take capital losses as a way to reduce tax liability in a given year.
There's enough ways to hedge without having too high of a cash drag.
Also your example assumes that all the shares were bought at the same time and declined 50%. If you've been investing for years, the value of your gains/losses wouldn't simply be a "market crash" it would include the price at which you bought the stock at plus any dividends you reinvested. So a 50% downturn from a certain high point could be much less from how much capital you initially committed. Add to that you can take capital losses as a way to reduce tax liability in a given year.
There's enough ways to hedge without having too high of a cash drag.
Hedging with options is great... if you know how to hedge with options. Most people don't so the six months of cash on hand is more broadly applicable as a rule of thumb.
The cost of inflation (at, say, 3%) is $30 for every $1k you have in your emergency account. That's $150 per year if your emergency fund is $5k, or $300 if it's $10k.
I'd be surprised if the combination of the effort it takes and the fees that are charged are less than that for your method.
That being said, it's sounds like you have a firm grasp on your system and it works for you. That's much more than can be said for a vast majority of people.
I'd be surprised if the combination of the effort it takes and the fees that are charged are less than that for your method.
That being said, it's sounds like you have a firm grasp on your system and it works for you. That's much more than can be said for a vast majority of people.
Cash is a great thing, it's something you don't have to worry about and usually is FDIC insured. Personally, I'm holding onto quite a bit right now because I think much of the market might be overvalued. I think I was just trying to see if I could think out a case where you could in theory not worry about not having too much of it on hand.
Which is why a liquid emergency fund is the first recommendation for anyone trying to secure their personal finance situation.
Many treat credit cards as their liquid emergency fund.
Unexpected expense? Dig yourself deeper and push your credit closer to its limit.
Personally I think that is the intention of credit cards -- emergency liquidity -- and that nobody should carry credit card debt to the next month.
Unexpected expense? Dig yourself deeper and push your credit closer to its limit.
Personally I think that is the intention of credit cards -- emergency liquidity -- and that nobody should carry credit card debt to the next month.
This is absolutely a valid use for credit cards if you're careful and disciplined, but it can only stretch you for a maximum of one month before you've got to start making payments. What about when you're out of a job for six months? You've gotta have an emergency fund.
I agree with you, but, then again, saving money "under the mattress" or a high saving rate is usually frowned upon in the economic press.
Buying index funds in downturns provides more ling term value than buying the same index fund when markets are good.
That's true, but it's also true if you drop the "passive" part :)
An excerpt from the transcript [0] follows:
What I’d like you to do is for a moment, imagine that in this room, you people own all of America. All the stocks in America are owned by this group. You are the Berkshire 18,000 (or whatever it is) that have somehow managed to accumulate all the wealth in the country. Let’s assume we just divide it down the middle. On one side, we put half the people…half of all the investment capital in the world, and that capital is what a certain presidential candidate might call ‘low energy’. In fact, they have no energy at all. They buy half of everything that exists in the investment world – 50 percent – everyone on this side. Now half of it is owned by these ‘low energy’ people. They don’t look at stock prices. They don’t turn on business channels. They don’t read the Wall Street Journal. They don’t do anything. They are a slovenly group that just sits for year after year, owning half of America’s business. What’s the result going to be? The result is going to be exactly average as all American business does because they own half of all of it. They have no expenses – nothing.
What’s going to happen with the other half? The other half are what we call the ‘hyperactives’. The hyperactives’ gross result is also going to be half, right? The whole has to be the sum of the parts. This group, by definition, can’t change from its half of the ultimate investment results. This half is going to have the same gross results. They’re going to have the same results as the ‘no energy’ people but they’re also going to have terrific expenses because they’re all going to be moving around, hiring hedge funds, hiring consultants, and paying lots of commissions, et cetera. As a group, that half has to do worse than this half does. The people who don’t do anything have to do better than the people that are trying to do better. It’s simple.
[0] https://www.biznews.com/global-investing/2016/05/02/berkshir...