Better Index Funds
May 12, 2009 General Nonsense |
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.
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.
Votes: +8
Comments
0
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%
0
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 :)
0
May 16, 2009
Hm. I'd say, the certificates issued by your typical index fund have a high chance of being neither truly top nor truly bottom.Or, in your own words, a company in your index fund has an 80% chance of not being top. Now, if you find out, how many percent of index constituents are bottom performers you know the usability of an index fund for your scheme.
But be aware that EVERY successful strategy so far has defeated itself after a while. It's unlikely that this will change.
Whenever someone figures out a way to make more money with a certain subset of the market, the price of that subset will rise because demand rises. The more money is put into executing the strategy (for instance by reinvesting the gains or betraying the secret) the more the shares will rise, up to the point where the gain of the strategy is priced in fully and the advantage has disappeared.
-1
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.
May 13, 2009
Funds are great for the people that manage them. To the rest, not so good. They are risk free and worthy only for the managers, to the victims of them it is at best, a way of earning much less than they could have won investing by themselves. I think that people continue using bank products because they dont understand that banks are in the business of thriving on others people poor understanding of economics, like lottery. I like to think that there would not be crooks if there werent tons of greedy and uninfrmed people everywhere, eager to fall in tons of little schemes that promises money without any effort, and after reading about how the actual economic situation occurred, I think we can conclude that it is a product of uninformed greedy people and crooks that took advantage of that. I recommend using the bank just as a safe box deposit and stay away of everything they offer. Just like going to a cassino, as long as you only go to the restaurant and the restroom you are safe.Various members of my family have worked on banks and one thing they all have in common is how appalled they felt when each of them realised that all the entity for which they worked was about, was exploiting people bad understanding of complex economic factors to get their money.
On a final note of caution for the ones that will not listen and continue using bank products..
You would be fools to ignore the dangers of variable interest rates!
+1
May 12, 2009
Scott you forgot the disclaimer you previously used many times for such posts, which went something like this "Don't take investment advise from a cartoonist".You're welcome.
-1
May 12, 2009
ideo·logueVariant(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:
Webster
-1
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.
0
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.
+5
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?"
-1
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.
-1
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
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.
-1
May 12, 2009
You know though, the market is always a better gauge for outcomes and results than the pros that are hired to predict said market. Take Vegas for example. Vegas betting is like the stock market for everything. Those that wager invest more time in research because there is money on the line, so the theory goes. For whatever reason, Vegas usually gets presidential elections right on, shoot 90 % on the Final Four, etc. That said Scott, I say follow those short sellers over time, glean the target patterns, subtract them and like companies from the S&P and diversify your own portfolio accordingly. depending on how many companies you can invest in you could further narrow the field with a little Due Diligence of your own, but the starting point is less of a crap shoot.
Hmm, maybe I will do this too. =)
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?
+1
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
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. ;-)
Webster
0
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.
