A stock index fund buys stock in every company that is a member of some defined index, such as the S&P 500. The idea is that if you own, for example, a little bit of 500 different companies, you'll be well diversified and generally do better than the professional stock pickers, thanks in part to lower fees and lower taxes.

The reason index funds are so popular is that it's hard to pick individual stocks that will outperform the average. But I wonder if it is just as hard to identify stocks that will surely NOT be stars in the next year. In other words, could you have the best of all worlds by starting with, for example, the S&P 500 stocks and subtracting the ones that have no realistic chance of being stars?

Much of the growth in an index fund comes from about 20 percent of its stocks. It's hard to know in advance which stocks will be in the top 20 percent next year. But is it just as hard to forecast which stocks will NOT be in the top 20 percent? On the surface, that seems easier.

So called short sellers make money betting stocks will go down. As a group, and over time, they don't do better than the people betting which stocks will go up. That might tell you that identifying the stocks that will go down is just as hard as identifying the ones that will go up. But for my hypothetical index fund you don't need to identify the stocks likely to go down a lot, which is where short sellers make their money. You simply need to identify stocks that are unlikely to be top performers on the up side. Isn't that a relatively easy target?

The quick answer is "no." If it were that easy there would already be such funds and everyone would be rushing to invest in them. A big reason the economy is in such a mess is that lots of investment ideas seem like obvious winners but aren't. I laugh every time I see a commercial on CNBC for some product or brokerage service that boasts it will help you use your own excellent theories to invest your money. What the world really needs is a product that will prevent people from using their own dumbass ideas to invest.
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Sep 4, 2009
I got to this blog item searching for "Dilbert Index".

The "Dilbert Index is the percentage of daily Dilberts in the last month that appear to be the result of Scott snooping at your workplace. Like the UV index indicates how dangerous it is go to out in the sun, the DI is a rough measure of how dangerous going to work will be today.

I'd like to see the ability to register ones DI on this site (and maybe anonymously aggregate it for employers or industry sectors). How Dilbertian is the tech sector today?

I wonder if it would have any correlation to the index funds mentioned above.

My current DI: 33%

Jun 1, 2009
Most individual investors do better than the pros, should become a fool over at the motley fool :) my player name on caps is lordhep and my average pick beats the S&P by 25% (at the moment) :) My favorite Warren Buffet quote is "diversification is a great strategy for someone who doesn't know what they are doing" (maybe paraphrased). The fool school is a great place to start :)
-2 Rank Up Rank Down
May 13, 2009
i dont think you understand the beta. its the ratio of how fast a stock goes up in relation to the rest of the market. a beta of 1 means its rises and falls = to the market average. less than 1 say a utility like duke moves up and down a lot less. something with a high profit margin like caterpillar will move up a lot faster and have a beta > 1.
the sds ultrashort sp500 has a negative beta because it runs inverse to the sp500.

when the market goes down for a long run one could dive into the low beta safety stocks. going short is like trying to drive your car backwards on the interstate. you better know what you are doing. there is also no end to the maximum down side of short which is infinity. the maximum downside of long has to stop at zero.

working with relatively small amounts of money is a lot nimbler than being a whale like warren buffet. large amounts of money move conspicuously.

most of those dumbasses that trade every day know a whole lot more than you.
+1 Rank Up Rank Down
May 13, 2009
...and thus ended the public capital markets
-1 Rank Up Rank Down
May 12, 2009

Variant(s): also idea·logue ˈī-dē-ə-ˌlȯg, -ˌläg
Function: noun
Etymology: French idéologue, back-formation from idéologie
Date: 1815
1 : an impractical idealist : theorist
2 : an often blindly partisan advocate or adherent of a particular ideology

The usage in my comment below is 2:

May 12, 2009
The other problem with the idea is that there's a second reason index funds are popular: low handling fees, since they require very little analysis to manage. Add more analysis, and the fees go up.
May 12, 2009
This product already exists. Its called Capitalism. The knowledge that if you invested your money and lost it that you and your family would starve to death would either prevent you from investing, or rid the world of someone this stupid. Its win win.
May 12, 2009
This reminds me of the story of when Sony bought Columbia Pictures.

The executives at Columbia explained to the Sony executives that in a given year if they produce 10 movies they will make 1 blockbuster, 4 successes, 2 break-even picks and 3 flops, or some such mix of box-office success. A very astute Sony executive asked:

"Why don't we just make the successful ones?"
May 12, 2009
I always laugh at the notions people have on investing. Buying stocks is ownership in a company. Buy in companies you know, and regularly do business with. Or start to see showing up all over the mainstream. Most likely they are the businesses that are making a profit.
Day traders, short selling, options, and all that other stuff is gambling.
Buy 10-20 stocks of companies you know and trust, and hold them. Review every 2-3 years. One may be ripe to sell, another might be a good buy you started to see a trend as far as "buzz" that your friends and neighbors are discussing. Other than that forget it. I beat the averages most years, and am doing so now. There are several companies making money right now, that you know and love, and keep doing business with. I like being the part owner of these companies.
May 12, 2009
I looked into this once; if you broaden your search, you can identify some likely underperforming stocks. If you pick the best-performing mutual funds in any given year, on average they underperform the market the next year. This is because they are more likely to have performed well by chance, and to now be overvalued; than to have performed well due to the brilliance of the manager.
+1 Rank Up Rank Down
May 12, 2009
I have some ideas on the best way society can protect me from my own stupidity, but I'll do me a favor and keep them to myself.
May 12, 2009
If you can pick the top performing 20%, why are you putting your money in a fund instead of just picking that top 20%? Probably because you value the relative stability and diversity of the fund arrangement. If you want more risk, then just invest less money in the fund and go pick those top 20% on your own. Are you making this more complicated than it needs to be?
May 12, 2009
The S&P500 is capitalization weighted. 25% of the index's movement comes from 15 stocks. 50% comes from ~25 stocks. the rest just reduce the volatility (as would a cash position). It would be EASY to identify hundreds of stocks that would have to have a HUGE move to have ANY impact on the index. But what's the point, you would just increase the volatility.

+2 Rank Up Rank Down
May 12, 2009
Scott Adams said, "What the world really needs is a product that will prevent people from using their own dumbass ideas to invest."

This difficult but achievable programming challenge could represent the long term salvation of Microsoft Corporation. The universal introduction of the MS Stupidity Filter.

The only downside being that a few of the Scott Adams Blog regulars would be unable to post their comments. But I could still post, of course -- because I'm a Mac Guy. ;-)

0 Rank Up Rank Down
May 12, 2009
Unfortunately, your quick answer (no) is correct. Accurately picking the top 20 is the same problem as accurately picking the bottom 20 and it is difficult to solve.
May 12, 2009
Scott, this is quite basic actually, but you can outperform the index by choosing the 20% (I would go for 40%) companies that are believed to do the WORST in the future, that is, those companies that have lowest multiples.

This has to do with people being shortsighted and overconfident about predictions, and something called "regression to the mean" on the other side.

The interesting part is that due to human nature this advantage is not likely to disappear anytime soon.
May 12, 2009
Why try to beat the index?
May 12, 2009
All stocks are guaranteed to go up.

All stocks are guaranteed to go down.

The question is: How much and over what period of time?

I wonder about short-selling. Short sellers try to buy low and sell high just like other investors. I asked about this and it was explained to me that the difference is that short-sellers "borrow" stocks and sell them and then buy them back at a lower rate and return them. Where do they borrow and what kind of interest do they pay? And if short-sellers were interested in your stocks, would that be an incentive to sell them instead?
May 12, 2009
I use Google reader to get the RSS feed from your blog. The ad accompanying your blog was for a stock trading site guaranteeing 75% return on investment in 1 hour.
May 12, 2009
Why are these "unlikely top 20%" stocks in your fund in the first place? I mean, if you can pick which stocks are not likely to be top performers, then why are they in your fund? The only reason I can think of is having a graduated portfolio like a commenter mentioned previously where every year, the managers get together and publish their top 20% and then investors can choose how they'd like to spread their money. Say 50% in the top 20% and 50% spread across the rest.
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