Just a question that popped into my head: what would happen if everyone followed a passive strategy, ie, no one was active? Isn't some sort of active strategy required, somewhere, for funds to be directed at all?
Though, I do think on average fund managers probably don't actually make anything like useful predictions. But perhaps we do need someone, somewhere, looking for good investment.
My guess is that there is a role in society for some conservative, value based investing, but at the moment there are more people trying to do this than is useful, and even more people trying to find good investments by worthless strategies (like trying to predict future movements from past movements).
The advice against trying to beat the market is based on the fact that there are tens of thousands of highly intelligent people paid to analyze securities, and they're all feeding off each other's behavior. To beat the market, you have to beat a conventional wisdom based on the accumulated expertise of a lot of people. For instance, if you want to buy stock in a Malaysian steel company, you have to decide that you understand the current value of this stock better than a crowd-sourced price generated by the research of a horde of steel industry specialists, people with intimate knowledge of the Malaysian economy, business environment, and political environment, people who can afford to spend all day reading forecasts of economic conditions in the countries where this company's steel is consumed, and people who have a drink with a VP from the company and get gossip about the CEO's health and the competence of his likely successor.
If no one was trying to beat the market, it would be easy to beat the market. But since so many people are busy trying, it's silly to try to compete unless you want to take it as seriously as the professionals do and get plugged in the way they are.
The "random walk" hypothesis says you can beat the professionals. About half the time. By flipping a coin. But the professionals are insiders, and as well-regulated as the stock market is, I would assume that an outsider playing against insiders in a 50/50 game will not quite win his full 50% share.
The hope that a person can price stocks better than the market as a whole rests on a couple of possibilities:
1. Beating full-time professional analysts at analysis in your spare time, because you're just so bad-ass.
2. Identifying a price that is heavily influenced by ignorant people and beating them by just being reasonably well-informed -- but this is not an original idea and hence is a special case of #1.
3. Finding a niche that you know intimately for some reason, and in which you have no professional competition. Oh, wait, this is just #2 again. Or maybe you found a niche small enough that it doesn't get a lot of attention from professional analysts, and you can make a little bit of money at it. That might work!
4. Being the first one to take into account a new idea or source of information. This one will make you wildly rich, and it's fun to dream, but while you're looking for that brilliant idea, there's no reason to risk real money on your ideas-in-progress.
I index for a very good reason, some of the smartest people I know chose to work on Wall Street, and they're putting in 60+ hours a week working on this stuff. If you have tens of thousands of people like that, I don't care how smart you are you just aren't going to beat them. Better to insure you are at least average (which net fees probably puts you in the top 30%) than to chase being in the top 5% and failing miserably.
For a specific example, look at how the "hobbyists" are beating the "professional" analysts at predicting Apple's quarterly performance, time and time again.
There are many objective studies that show that individuals with their own specific trading/investing strategies can beat the street. But that's not really the point.
The point is that AAPL is now only second to XOM in terms of market cap, and is not exactly a tiny blip on the radar. It is a stock that is being watched by literally millions. If these "professional" analysts have so many resources at their disposal, have the inside track on confidential information and are operating at such an uneven playing field as the parent postulates, then why would they consistently be beaten by the "hobbyists"?
Well, the fact that Apple is so large actually serves my point: there is a lot of information on Apple. The information asymmetry between hobbyists and analysts is nil for Apple.
In fact, I'd argue the information asymmetry tilts in favor of individuals, considering that analysts publish their forecast. I wouldn't be shocked if these guys use "analyst expectations" as an input.
Anyway, this is bad news for the analyst, because the one resource they don't have is time to focus on one company. Hobbyists, however, can focus on Apple all they want. So I'm not surprised that Apple fans nail their earnings forecast.
As you suggest, we do need "value traders". In particular we need traders who buy and sell stocks in reaction to news. These traders don't have to be necessarily the active fund managers the article is talking about. They could be prop traders working for their own account or for a bank, broker or hedge fund.
"News" is any new information that affect the expected present value of a company cashflow. It could be a new product, a possible merge or macroeconomic indicator.
If you invest in an index fund, you're basically following the trades of those value traders. You won't make as much money as them, because often you'll be buying "good" stocks after they've already increased in price, i.e., by the time passive fund managers buy the "good" stock, the price will often have already incorporated the value of the good news. The same holds for the "bad" stocks.
There will always be market participants with vested interest in specific shares, and by definition they are following an active strategy by associating with that company. It follows that they will have a vested interest in hedging against dangers that might adversely affect that company.
“Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S & P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.” - Warren Buffet
> Their opposites, passive investors, will by definition do about average. In aggregate their positions will more or less approximate those of an index fund. Therefore the balance of the universe—the active investors—must do about average as well. However, these investors will incur far greater costs. So, on balance, their aggregate results after these costs will be worse than those of the passive investors.
This argument is wrong? edit: it's like saying this about strategies of chess players, one group is using strategy A and another is using strategy B:
Chess players using strategy A are known to perform about average (by the nature of their strategy). So this new strategy, B, has to perform about average too.
This neglects that there are other strategies than A and B. The whole world is not either passive investors or hedge funds.
And he's saying something even stronger: there is no subset of B players that is better than average.
So while he may well be correct in his prediction, he makes it sound like he has a mathematically tight argument for why he is correct. But the conclusion of his argument (that active investors will perform about average) is not the prediction of his bet (that hedge funds will perform about average, and because they have higher operating cost they will lose).
He's making the (correct) assumption that the speculative stock market where active investors expect to make their money is a zero-sum game. For there to be winners in "buy low, sell high" there have to be an equal amount of losers.
So, if there are going to be winners, there have to be an equal amount of losers. It's difficult to siphon money off of someone passively invested in an index fund, so the active investors are competing against themselves.
Because active investment has a much higher cost than passive, as a group they will be significantly worse off compared to passive investors. This is so self-evident as to be not even worth betting against.
Note that this isn't to say that there won't be big active winners individually. But in a chess tournament, if the top players use strategy A that wins 90% of the time, and others use strategy B that wins 51% of the time, that guarantees the existence of some other strategy that performs below average.
The stock market isn't necessarily a zero-sum game like chess because companies pay dividends, but that's rare and small enough to be insignificant compared to the amount of money gained and lost through speculation.
That's exactly part of what I'm saying. The other part is: Even though you can't siphon money off passive investors, you can siphon money off other active investors.
Index investing (applied to extremely wide market indexes) makes an assumption that there will be a continuous and infinite increase in the total market capitalization of that index. As time marches forward I beleive we will experience a deceleration of worldwide market cap increase.
This has crossed my mind a lot of times and I think the comment is right - market capitalization of index cannot increase to infinity. There is a finite number of companies that the Index is comprised of and there has got to be a theoretical upper limit to that.
Moreover, the investment psychology also comes into play here. The growth rate of index may slow down as it becomes large because investors always compare today's index with the previous values and are likely to conclude that the index is "over-valued" if it keeps rising.
I'll be curious to find evidence of deceleration as the index value rises.
Actually population growth all over the wold is slowing down. China is already at almost neutral and growth is even slowing in India and Africa.
And a static or shrinking population would have an adverse affect on total market cap, however it would also mean a great job market, because even as the economy shrinks the labor pool would shrink faster.
So your investments would not do well, but you'd always be able to get a high paying job.
I have several concerns with index fund/ETF investing:
1. How much of the underlying stocks, that make up the Index, are really owned by the Index fund/ETF? I doubt that such funds/ETF actually own 100% of the required underlying stocks, may be using some sort of option/hedge strategy.
2. In what scenario, not owning the actual underlying stocks can be detrimental to index fund/ETF? I am looking for what may cause failure of such funds/ETF and who may lose.
3. Is index fund/ETF investing artificially inflating price for underlying stocks compared to price of the rest of the non-index stocks in the market?
a) Full Replication. All stocks are 1 to 1 in the ETF.
b) Swap based. EU swap ETFs can have up to 10% (but not more) in swap (what you mean by option/hedge), the rest is stocks. Oftentimes ETF issuers have an insurance on those swaps. If the swap counterparty goes bankrupt you loose that 10%.
c) optimized sampling. You have different stocks (or not all of that index) in your ETF. The idea is to find stocks that corelate closely to those in the index.
2.) By buying the ETF you "own" the stocks. ETF are regulated like mutual funds (at least in EU).
3.) ETF are only a small fraction of the worldwide trade. But obviously if your company gets into a popular index (s&p 500) you can be quite happy.
4.) If everybody would only invest in indices, the market won't play anymore and it would be smarter to buy individual stocks again. This is the index investing paradox. But very unlikely to happen.
The problem is that "ETF" is actually quite a broad term. As far as I can tell, many ETF's do run a sort of "fractional reserve" ratio. There was an article here not long ago wringing its hands over that danger which I can't find right now.
The answer to 2 I think depends on how dividends are handled. Obviously if you hold the shares yourself, you control what happens to the dividends, and are free to take them or reinvest them as you wish.
For 3, it depends on the ratio of index trackers to managed funds in the market, but yes, this can have a noticeable effect. A share price always dips when the it's removed from one of the larger indices; you can see an example here: http://uk.finance.yahoo.com/q/bc?s=TATE.L&t=2y&l=on&... - they were removed from the FTSE100 in March 2009.
1. read the prospectus. if the fund is comprised of stocks as opposed to derivatives it will be comprised of stocks. Of course fund will only buy whole and large amounts of shares, so say you put 1 ETF share worth $100, the fund won't be hurrying to buy shares with it, until they got $1000000 to start buying wholesale.
2. Of course if fund is derivative based all risks associated with derivatives come into play for fund investors. Same is true for any securities that are owned by funds - their risk is transferred to shares of fund. But I think you're familiar with risks associated with equity investing.
3. Maybe, maybe not, depends on stocks and market conditions. Of course the company is "more valuable" if it's included in some popular index like S&P, but then again ETF's and funds can make purchases wholesale, so there might be some benefit too.
4. Yes, but since traditional non-derivatives based funds are linked 1-to-1 to underlying shares, I don't see a huge problem. Unlike with derivatives-based funds.
Of course fund will only buy whole and large amounts of shares, so say you put 1 ETF share worth $100, the fund won't be hurrying to buy shares with it, until they got $1000000 to start buying wholesale.
The ETF will actually never buy the shares. You can only buy existing ETF shares from other traders.
ETF shares are created by large financial institutions - JPM/GS/other big players have the option to make an in-kind trades of share in securities for ETF shares. I.e., if an ETF is 50% MS and 50% AAPL, a large trader can trade 50k shares of AAPL and 50k shares of MS for 100k shares of the ETF. (Similarly, they can perform the reverse trade.)
From what I understand when the ETF achieves cash position needed to generate 1 creation unit (usually 50k ETF shares, as you correctly point out), then the fund is absolutely required to purchase underlying shares that index it's tracking requires it to hold. It can't just hold cash and promise to track index nevertheless. Or do you mean that first comes the Creation Unit, and then people can buy shares in ETF?
In case of ETN there's absolutely no obligation to purchase anything, as they're simply debt of issuer; a promise to repay you in the future according to predetermined index or underlying movement.
Maybe you meant ETNs?
P.S. I re-read what you wrote, and I think what you're saying is that large institutions are intermediaries between ETF and investor. That is absolutely correct, and probably is so 99% of the time in the market anyway regardless of whether shares purchased are of individual companies or funds. But ETF is still required to hold the assets it states it will hold, that was my point.
You don't trade cash for the creation unit, you trade one creation unit of shares in the underlying securities. If 1 share of AMSETF is claimed to be equal to 0.5 shares in AAPL and 0.5 shares in MS, you hand 50k shares of AAPL and 50k shares of MS to the managers of AMSETF. They create 50k shares of AMSETF and hand them to you.
No cash changes hands (unless cash is one of the underlying assets of the ETF), so the ETF is never sitting on cash with the obligation to purchase shares.
In general, it's very unusual to hand cash to an ETF in return for shares (unless cash is one of the underlying assets). I'm not even sure it is legal to do so.
It sounds like you are expecting the ETF would be creating more shares frequently which it does not. That would have to happen as a secondary offering and it would dilute the value of all the other shares in circulation, Assuming they are the same class share.
There's no dilution with ETF. When ETF shares are created (via formation of Creation Unit), the ETF holdings increase by equal amount of underlying assets. You can create as many ETF shares as market demands (until you run out of possibility to buy underlying assets).
2) The world's industry, per capita, is getting more valuable over time.
3) Even if the first two were untrue, there is still a time value to money. People will spend capital to get value immediately, and investing is the opposite of that.
If you believe it's feasible for economic growth to continue, then you believe it's feasible for the indexes to continue to rise, perhaps to something that rounds to infinity (at least for my purposes).
I think this has to do with the age distribution in Western countries. As the baby boomers retire, they no longer are adding but start removing funds from the system.
A friend and I talked about this 20 years ago when 401(k)'s became the rage, lamenting that we were on the wrong side of the boom.
Financial markets can't beat the real economy forever. As a bet on the future growth, they must return to reality from time to time. Furthermore, as growth as we've known it will most probably soon end forever (or for the long term at least), financial markets are on for some future "correction" of humongous proportions when the sovereign debts will be wiped out by inflation.
Warren Buffet said sort of the same thing in one of his annual shareholder letters a few years ago. That exponential economic growth has natural limits, and that if we extrapolate the stock market's 20th century returns to the 21st century, you end up with a mind bogglingly (and unrealistically) large market cap in 2099.
I forgot what year he wrote that, but it was sometime between 2006 and now. I don't have time to dig it up and find it, but here are his letters for anyone interested:
Edit: Got myself curious, had to find it. Here it is, from the 2007 letter, ps 18-19:
"Decades of option-accounting nonsense have now been put to rest, but other accounting choices remain – important among these the investment-return assumption a company uses in calculating pension expense. It will come as no surprise that many companies continue to choose an assumption that allows them to report less-than-solid “earnings.” For the 363 companies in the S&P that have pension plans, this
assumption in 2006 averaged 8%. Let’s look at the chances of that being achieved.
The average holdings of bonds and cash for all pension funds is about 28%, and on these assets returns can be expected to be no more than 5%. Higher yields, of course, are obtainable but they carry with them a risk of commensurate (or greater) loss.
This means that the remaining 72% of assets – which are mostly in equities, either held directly or through vehicles such as hedge funds or private-equity investments – must earn 9.2% in order for the fund overall to achieve the postulated 8%. And that return must be delivered after all fees, which are now far higher than they have ever been.
How realistic is this expectation?
Let’s revisit some data I mentioned two years ago: During the 20th Century, the Dow advanced from 66 to 11,497. This gain, though it appears huge, shrinks to 5.3% when compounded annually. An investor who owned the Dow throughout the century would also have
received generous dividends for much of the period, but only about 2% or so in the final years. It was a wonderful century.
Think now about this century. For investors to merely match that 5.3% market-value gain, the Dow – recently below 13,000 – would need to close at about 2,000,000 on December 31, 2099. We are now eight years into this century, and we have racked up less than 2,000 of the 1,988,000 Dow points the
market needed to travel in this hundred years to equal the 5.3% of the last.
It’s amusing that commentators regularly hyperventilate at the prospect of the Dow crossing an even number of thousands, such as 14,000 or 15,000. If they keep reacting that way, a 5.3% annual gain for the century will mean they experience at least 1,986 seizures during the next 92 years. While anything is possible, does anyone really believe this is the most likely outcome?
Dividends continue to run about 2%. Even if stocks were to average the 5.3% annual appreciation of the 1900s, the equity portion of plan assets – allowing for expenses of .5% – would produce no more than 7% or so. And .5% may well understate costs, given the presence of layers of consultants and high-priced managers (“helpers”).
Naturally, everyone expects to be above average. And those helpers – bless their hearts – will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group – the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win.
I should mention that people who expect to earn 10% annually from equities during this century – envisioning that 2% of that will come from dividends and 8% from price appreciation – are implicitly forecasting a level of about 24,000,000 on the Dow by 2100. If your adviser talks to you about double-
digit returns from equities, explain this math to him – not that it will faze him. Many helpers are apparently direct descendants of the queen in Alice in Wonderland, who said: “Why, sometimes I’ve believed as many as six impossible things before breakfast.” Beware the glib helper who fills your head with fantasies while he fills his pockets with fees."
I'm not the person to refute Warren Buffet, but I will point out that the Dow Jones had abysmal performance from 1970-1979. One decade isn't enough to judge the economy for the next century.
Do I think DJIA will hit 2 million in 100 years? No. But I don't think it's unreasonable to expect hundreds of thousands.
For those watching at home, 100k from 13k in 92 years would mean 2.24% annually, 500k 4.05% and 1M 4.83%.
I agree that over 5% is optimistic, but 3% for the century might be achievable. Note, though, the given that the rate of growth isn't constant, the most impactful rates are the ones we're getting early, i.e. now.
Look at the DAX index, it includes re-invested dividends, and thus mirrors the actual performance of a passive-investment strategy better than a pure-stock price index.
Index funds were as widely adopted as you could ask for back in 1996 when I first started investing in them. And it was common knowledge even then that the S&P 500 tended to outperform 70%+ of managed mutual funds.
If that's the message this article is trying to convey, it certainly has the wrong title.
Having also read this a lot, it makes me wonder how the clever financial world will find a way to take a lot of people owning index funds and somehow fleece them.
I also find myself pondering the macroeconomic effects of a lot of the market simply being in index funds, though I'm sure we're a long ways from that.
My personal rule-of-thumb "By the time you've heard of it, it's too late to get in on it" is also triggering, though I have to admit for the life of me I really can't imagine how to exploit this tendency. But I am anything but a financial wizard.
take a lot of people owning index funds and somehow fleece them
There are strategies to do this now, but they're hard to execute. One example is to target stocks that are likely to enter or drop off indicies. Index funds will be looking to buy or sell them soon.
Mostly these strategies depend on your ability to set up a very high speed link to the computers that clear trades and interpret the algorithms that index funds use to establish their samples of the market. If you can get in just ahead of the index funds and their monster volume, you can shave a few tenths of pennies from the investors.
You can make millions with those strategies but it's a drop in the index fund bucket. Quite a lot of "quant" trading activity is about ripping off ordinary people by unnoticed fractions by getting in ahead of them. Much more innocuous than the large scale bribery and fraud that makes up so much of the financial industry.
This was covered in a WSJ article yesterday.
http://online.wsj.com/article/SB1000142405274870400870457563...
"Over the long run, sharp traders getting out in front of these forced portfolio changes have poached at least 0.38 percentage point of annual return away from Russell 2000 index funds, estimates a new study in the Journal of Empirical Finance."
Not all index methodologies are created equal, the way that Russell handles periodic reconstitution is particularly susceptible to front running. Other indexing methods are not as bad.
Another idea is to make things so confusing that the customer is no longer sure what they're getting. Just name a managed fund something confusing that makes it seem like an index fund (but still include all the fees like a managed fund).
The recent surge of high frequency trading is in some part just that (fleecing of index funders) since these guys try to extract value from all trades happening in the market (and index funds will do some trades, albiet fewer than active funds)
Just because a question is interesting doesn't mean it has multiple right answers. (I need to stop talking like this or they'll take my ArtSci degree away...)
true, you get this advice everywhere. but actually implementing it for realz isn't for the faint of heart. it's not impossible either, especially if you don't mind horseshoes-and-hand-grenades approximation.
If you want optimal as in mathematically optimal fund selection, then Bill Sharpe's startup, Financial Engines, does that (if you have at least $100k at Vanguard, you get it for free, also through many employers).
https://personal.vanguard.com/us/insights/retirement/financi...
I've come to be suspicious of anything in finance claiming to be "mathematically optimal". You can only optimise according to some simplified model, and simplified models of complex systems have a tendency to unpredictably break down.
Don't throw out the baby with the bathwater. Just because you have a large industry of sharks doesn't mean the good work being done by reputable investment houses is invalidated.
In general, index funds work. Some are better than others because of fees or their stock selection process. But they do work. The reason is that stocks in a sector have high covariance, and the outliers that might pop up occasionally with low covariance are only a small part of the index anyway. It is trivially easy to optimise on variance with some goal such as a limit on the number of holdings.
> (if you have at least $100k at Vanguard, you get it for free, also through many employers)
Actually, the people my employer go through just dumped Vanguard and a few other funds and would've automatically enrolled us all in a fund that changes every single year to be "optimum" for your age.
I opted out and I informed my coworkers that there were good reasons to be incredibly suspicious of this move, but I wonder who actually took my advice.
All I could think was that they were going to churn everyone's funds every single year so that they could get huge fees under the guise of "optimizing" our portfolios.
good to be suspicious; employer-selected investments are like employer-provided health care, there's a big imbalance in incentives.
2 things to watch: fund expenses and composition
if churning is an issue, it will be reflected in the expense ratio. but if the expense ratio is comparable to actively-managed funds and the fund's composition is index funds, then it might be ok since you're only paying for management services once.
Oh, the new age-balanced funds are not composed of index funds at all. They're composed of a mix of pretty much everything that they swap out every year for something else. So when you're young, you get mostly stocks, when you're old, they buy more bonds. But they have to trade them around all the time to generate fees.
Anything that didn't generate enough fees got kicked out of the program (unless you opted out). Thankfully, I was in one of the safer funds (the only one currently showing a profit) before the crash. I wish I could move it over to Vanguard now, but it's too late. They didn't give us much warning, and they certainly gave us no time to switch, when we either had to opt out or get enrolled in their shiny new fee-generating fund.
You probably have a breadth of knowledge that comes from reading sites like HN, but the problem of course is that most people get their investment advice from banks and other investment professionals.
I suppose index funds are fine if you can time buys/sells with the booms and busts. These days I sure don't feel like holding them. It's sad but the best bet is just picking the hot algo stocks.
it's impossible to time the market, so instead you use dollar cost averaging to invest at a constant rate, regardless of how things are in the market. put money in both when it's expensive and cheap to do so.
That depends very much on exactly what you mean by "time the market".
It is impossible to reliably predict whether the market will go up or down on any given day. It is also impossible to reliably predict exactly when a market will hit a peak or trough. Dollar-cost averaging is a great strategy to reduce the risk associated with the inability to "time" markets in this sense.
But it is completely possible to recognize that a particular asset (or class) is over- or under-valued, as long as you have good enough information. You can't necessarily predict how long it will take for its value to be more accurately reflected in the price (another sense in which you "can't time the market"), but you can recognize that certain assets are on sale or commanding a premium price, and therefore get a good price on/for certain assets.
Portfolio rebalancing is, in part, meant to help capture this. Investing more in assets that have fallen behind, and less in those that have gotten ahead, is a (very rough) mechanism for selling high and buying low. Value investing is even more about this -- explicitly putting money into assets when it is cheap to do so, and selling assets that people are putting money into when it's expensive to do so. The idea is not to "time the market" in the sense of knowing exactly what day the market will turn, but simply to take advantage of really good deals (in the long-term sense) when they present themselves.
Agreed - I believe there are some ways to time the market. For example, if you want to make a 5-10 year investment, then doing so in the S&P500 when it is significantly down will yield better returns (on average) than doing it at a random time:
http://saffell.wordpress.com/2008/10/26/does-timing-the-mark...
It should be noted that your 10, 20, and 30 year charts actually show an advantage to investing in off years; your conclusion that "there is no significant advantage" is mistaken.
On the 30 year chart, the peaks on the 20-50% line are a couple percent above the peaks on the all line. Boosting returns from 7% to 9% over 30 years, or from 12% to 14% over 30 years, results in over 70% more total wealth after compounding. The visual difference is not as striking on the 30 year chart as on the 5 year chart, but that's because you're presenting annualized rather than total returns.
The argument against market timing I've always liked comes from Malkiel's Random Walk:
> During the decade of the 1980s, the Standard & Poor's 500 Index provided a very handsome total return (including dividends and capital changes) of 17.6 percent. But an investor who happened to be out of the market and missed just the ten best days of the decade—out of a total of 2,528 trading days—was up only 12.6 percent. [...] market timers risk missing the infrequent large sprints that are the big contributors to performance.
The "ten best days" argument is a good argument against short-term timing (you could, at random, miss just those 10 days and nothing else if you're trying to guess good and bad days.) But it's not a very good argument against the particular type of long-term timing discussed in this sub-thread. The 10 best days tend to be clustered somewhat, but often interspersed with several bad days; if you're simply looking for a good price and then buying, you're not going to miss the 10 best days without also missing a large number of bad days. Missing both the best and worst 10 days of the decade gives you almost exactly average returns. Furthermore, the 10 best days tend to occur in the "short sprints" that follow a down market; the strategy described above says to buy in to a down market, which means you'd hit most of those 10 best days -- and, quite likely, miss at least a few of the 10 worst days, generating net above-average returns. (The parent post's graphs showed this exact result: buying into the market after a largeish downturn gets you great returns, long term.)
Invest in S&P 500 ETF (SPY) starting at inception
Growth of $100,000 from 1/29/1993-8/30/2010
Buy and Hold: $324,330.15
10 Best Days Removed: $156,354.12
10 Worst Days Removed: $692,693.90
10 Best and 10 Worst Days Removed: not listed, but very close to Buy and Hold (the green line in the chart)
Rob Bennett's followup comments are quite good, as well.
I certainly disagree with you that it is impossible to time the market. There are many forms of technical, statistical and fundamental analysis that help to time the market. A key element to trading is removing emotional bias. I am aware of many people that are successful traders.
I will note that the market is much different today than it was in 2004. Today HFT accounts for 70% of volume. That is huge. I think having an investing strategy that does not assume an asset will always go up is important.
> I certainly disagree with you that it is impossible to time the market. ...
> I am aware of many people that are successful traders.
You have to ask then if they own personal airplanes, yachts and private islands? If the answer is 'no', then you have to wonder why not?
I think the problem is that individual successful traders are just traders who are randomly successful. You hear about them because they are the ones that get lucky and brag about it. Those who are unsuccessful will probably remain forever anonymous to the public and even their friends.
The only ones that can "beat" the market are the ones that do it via technical means (minimum latency to the exchange, fastest computers, insider info, etc.) I think these are just the large investment banks.
>> I am aware of many people that are successful traders.
> You have to ask then if they own personal airplanes, yachts and private islands? If the answer is 'no', then you have to wonder why not?
I am a software developer. Am I not successful because I dont own personal airplanes and a private island? I don't think these things define my success. Regardless, you have provided a straw man argument.
The people I know who are successful traders all have different MOs. What defines there success is that they stay in the black. Hence, they are able to time the market.
You don't need minimum latency to the exchange, fastest computers, insider info. As an example check out the performance of Fund My Mutual Fund. This is a virtual mutual fund that is soon to launch for real.
As a developer you are bounded by how much you can develop in a fixed amount of time, how much someone will pay you for it, and how many customers you have. If you could, would you not get payed more for your work? If you are working for someone, as I am, then you essentially have only one customer and they are paying you a fixed amount (+ some bonuses and raises). Or you could be like the author of minecraft, so you could be racking in hundreds of thousands a month.
Now if you say you have found a way to beat the market through research, technical or fundamental analysis, your limit would be unbounded (theoretically). Your charts looks good and are very impressive, but it is only 2 years and you would not be showing them if they didn't do well. So for all I know you are just one of the random lucky ones that beat the market. Now if you had a way to consistenlty get 10% (and maybe you did!), in a decade or so you could be another Donald Trump. You need to convince others that you can do it and then soon you will start getting large investments.
> What defines there success is that they stay in the black. Hence, they are able to time the market.
If they can time the market, are they fully invested in it. Would they sell their house and get everyone they know to do the same so they can pour that into the market, then re-invest and eventually rule the world? Another way to ask the question is why haven't the big investment banks figured out the strategy, and as a result, diluted the strategy by now?
Also what about the ones that don't stay in the black. Will they tell you, would you know how many have tried and failed? That is the true criteria. You would have to have a large group of traders commited to making money in the market. Then they all try for a fixed amount of time and in the end you see how they perform as a group. Now, essentially, you are just pickding the ones that performed in the black and using that as an argument that invididual trading can be a 100% profitable business.
I got a wake up call about 4 years ago when my broker tried to convince me to buy into a hedge fund. Buried in the prospectus was an entry load of 8%. Fired him, and have been in index funds since.
I'm 28, and I don't want to end up like Liz Lemon ("well I have $12,000 in checking"). What's a good primer on investing? I don't have a ton of money but I'd like to get into it.
Depends on what country you (or your money) live in.
In the US has some low fee index funds. In Germany I used an ETF of max-blue.
Just find a low fee diversified index fund, and then get back to your normal work. (Unless you enjoy playing the stock market, than there's nothing wrong with active investment. Just as some people enjoy playing the lottery (only the expected value of active investment isn't as dismal as playing the lottery).) Benjamin Graham's "Security Analysis" is a good primer, if you really want to get into stock or bond trading, or are just interested on an intellectual level. It's a hard book.
Make sure you use a tax efficient way to invest. If you can invest with pre-tax money, do so.
You have to pay for a membership but the site is top notch. They parse investment fund's sec filings and allow you to backtest strategies to see how well they would have performed over a given time frame. You will find strategies that crush any index fund.
You can't just invest in a hedge fund, there are some crazy requirements. As an individual investor you have to make $200,000 for at least two years straight.
Index funds seem to me to work by reducing churn - the percentage of your stock that is sold and bought each year - because every time you sell then buy you lose a lot of money. I am not yet convinced you have to follow an index.
If you had a fund that did not sell anything and bought a random stock from an index as funds came in would this beat an index fund?
Think of the index fund as reducing the risk of depending on any one stock for your gains. I don't know what the distribution of gains is like on an index fund but an answer to your question would likely come from an examination of one.
My theoretical fund would have a wide range of stocks. It does not seem to be related to spreading gains or risks.
I have not seen any comparative table of stock churn rates for different funds, but my guess is that index funds do well because they reduce the sell-buy transaction costs, partly by eliminating the cost of human stock pickers, but primarily by reducing the percentage of stocks in the fund that are sold then bought every year. Maybe this is wrong?
My understanding is that an index fund sells and buys stocks to balance the proportions held in the fund as the market capitalisation of the companies changes inside the index. This imposes an apparently unnecessary cost on the fund. If we removed this cost by not selling and buying stocks to keep it equal to the index would the fund become more profitable? I am considering it to be a fund where people invest incrementally over a long period so there would be constant random aquisition of new stocks from the index.
Balancing portfolios is basically a universally recommended practice. If you manage your own portfolio, won't you have a similar "churn rate" to the index fund?
"Balancing portfolios is basically a universally recommended practice."
The 'balancing' is against a stock market index which will seriously over-represent a particular geography, industry sector, business size, asset class etc. Why choose that index? Because the stock market tells us to?
"If you manage your own portfolio,"
I was considering how to make a 'passive' index fund even more passive.
"won't you have a similar "churn rate" to the index fund?"
An index fund would have a higher churn rate and therefore higher costs than my theoretical fund, but I do not know how much money an index fund spends on index-following sell-buy transactions.
Though, I do think on average fund managers probably don't actually make anything like useful predictions. But perhaps we do need someone, somewhere, looking for good investment.
My guess is that there is a role in society for some conservative, value based investing, but at the moment there are more people trying to do this than is useful, and even more people trying to find good investments by worthless strategies (like trying to predict future movements from past movements).