I occasionally see questions on internet forums, including the WCI Forum, the Facebook Group, the Subreddit, and comments on blog posts that are well-intentioned but reflect a lack of understanding regarding some of the fundamental principles of investing in the stock market.
It can be difficult to make a quick reply (much less actually answer their questions) because it requires a lot of teaching about how the stock market works (and doesn't work) in order for them to understand why the question is not a very good one. The simple asking of the question tells those “in the know” that the questioner doesn't actually understand and makes them look uninformed.
That's okay, we've all been ignorant at some point in the past and there are no stupid questions, but I'm hoping this post will help those people understand why their question is dumb (and give me a post to link to when they ask it.)
Let me show you a few examples of what I'm talking about:
Marijuana stocks are a favorite these days it seems.
Yup, even companies that have paid dividends sometimes cut them.
Ah…the eternal dilemma, does a dropping price mean buy or sell?
Not enough income to even have to pay taxes. Doesn't seem like a winning strategy.
Would the original 30 stocks in the Dow qualify as kings? Because none of them are in the Dow any longer.
The conversation below I post not because the question is particularly terrible, but because the answers become even worse than the question. Truly a case of the blind leading the blind.
The whole conversation is cringeworthy once you understand a bit about picking stocks. So today, I wanted to explain a few things about stock market investing, the proper way to do it, and WHY that is the proper way to do it. Then I will address a few common “rebuttals” to my arguments.
# 1 Professionals Can't Pick Stocks
There are thousands of professionals out there whose job it is to pick stocks. These folks manage mutual funds, pension funds, hedge funds, family offices etc. They have advanced certifications and degrees like MBAs and CFAs. They have dozens of smart people working for them and the most advanced computing resources available on the planet. It turns out that if you actually analyze how good they are at doing the job they purport to be doing, that they are terrible at it.
In reality, their job is gathering assets and charging a fee on them, not outperforming the market. If you think you can hire a pro to outperform the market, you are sadly mistaken. It isn't because these people are stupid. It's because they are so darn smart and there are so many of them. They become the market and their opinions on what market prices should be, dictate the prices at which stocks are bought and sold.
Despite their best efforts, on average these folks underperform the simple approach taken by a well-run, low-cost index fund that just invests in all of the stocks in a given market. This is not a matter of opinion. This is fact. Well-documented fact. Fact that is documented again every year. Take a look at a document SPIVA puts out every year. Here's the edition for 2018.
Spend just a second here and look at what this is saying. It is saying that over a 15 year period (2003-2018), 89% of actively managed funds underperformed the stock market. For any given asset class, that number ranges from 79% to 97%. And this is after only 15 years. Over your investment horizon of 50-60 years, those numbers would be even higher. But wait, there's more. This doesn't even account for survivorship bias. The worst funds close and drop out of the dataset. The winners certainly don't close. So how many of those funds closed over 15 years? Let's take a look:
Over 15 years, 57% of the funds simply disappeared out of the data set. And 60% changed their “style” i.e. gave up on their original goal and started pursuing another one.
It isn't just limited to US stocks either.
Or even just to stocks:
Yes, there are some funds that outperformed a comparable index fund over this time period. But identifying them in advance is just as difficult as choosing the stocks that will outperform the market in the first place. And the outperformance is usually minimal while the underperformance is often dramatic.
To make matters worse, much of the outperformance that does occur is simply due to luck. The question isn't why some people managed to beat the market, but why more of them did not do so. Statistically speaking, random chance should have led to more outperformance than is seen in the data. By the time you can prove a manager is skilled instead of just lucky, that manager has likely already retired.
But wait, there's more. This data only applies inside a retirement account. Once you move into a taxable account, the advantages of an index fund over an actively managed fund become even more substantial. By their very nature index funds have very low turnover and are very tax-efficient. Almost all the dividends are qualified, almost all the distributed capital gains are long term, and very little capital gains are distributed in the first place.
But what about hedge funds, that only the truly wealthy can get into? Do they do better than all of these silly mutual funds for the masses? It turns out they do worse, especially after paying the higher fees!
The pension fund managers aren't much better.
Consider the return for the total stock market index fund over the last 10 years is 16%, almost twice as much as the pension funds. Even the Vanguard Balanced Index Fund (60% stocks, 40% bonds) managed 11.22%.
# 2 You Can't Pick Stocks Either
So if the pros, with all the resources they have, cannot do this successfully over the long-term, imagine the hubris it takes for a doctor with no financial training, no staff, and no advanced computing resources to think he can do this in between patients. Pretty cocky right? When you're buying and selling all those shares of stock, who do you think is on the other side of the trade? You're not trading with Randy down the street. 90%+ of trades are institutional trades. You're trading against pros with far more information and resources at their fingertips.
So, what should you do if you think you may have this skill? Well, the first thing to do is to find out if you are right. How do you do that? You meticulously track your returns (and perhaps even have them audited by an outside firm so you can prove your rare ability to your future investors.) Be sure to include all costs including taxes and the value of your time.
If after a couple of years you find out that you are right and that you are at least lucky if not highly skilled, you can open up a hedge or mutual fund and start cashing in on the big bucks. If, like most, you realize within a few months or years that your crystal ball is just as cloudy as everybody else's, then you can quickly abandon the effort before it dooms you to a lifetime of investing underperformance and join the rest of us as index fund investors.
# 3 Newsletter Writers Can't Pick Stocks Either
But what about newsletters? Can they pick stocks? Well, the first question you should ask yourself is “If I had this very rare, very valuable ability to predict the future and choose the winning stocks and avoid the losers, what would I do?” By any measure, the answer should be something like:
- Tell no one, leverage up everything you own and can borrow and get very rich, very quickly, or
- Start a mutual or hedge fund, gather billions in assets and charge a percentage of it and get very rich, very quickly.
In no circumstance does it make sense to sell a newsletter for $15 a month (or even $500 a month) to other people and share that information, much less give the information away for free.
So, what does that tell you about the ability to pick stocks of those who sell newsletters? That it is all a clever masquerade in order to make a few bucks. Is that what we find when we look at the data? It sure is. Consider this article by Paul Merriman that discusses Mark Hulbert and his life's work — to track the returns of investing newsletters.
Imagine that you're publishing an investment newsletter. How do you attract attention and get people excited enough to subscribe? You certainly don't do that by recommending buying index funds and holding onto them.
Almost by definition, you have to do something different: Something that appears to be “the right thing.” Something that gives your subscribers a reason to think you have something special.
Sometimes that “something special” is a massive amount of data along with a bit of analysis and some predictions….
Other times, the “something special” is a system, either subjective or mechanical, for knowing when to get into and out of the stock market. Timing the market is an enormously appealing idea, and once in a while it works very well. But very few investors do well with this approach over the long haul.
Hulbert tracked a dozen timing newsletters, with returns ranging from 0.1% to 8%. The average was 4.3%. [The market return over this time period was 5.6%-ed] That 0.1% return, by the way, was from the most famous market-timing letter in the industry, Successful Investing, published by Doug Fabian.
All of the returns in that article, of course, do not include the cost of the newsletter, the cost of the trades, or the taxes due from the often frequent trades. Those returns would be even lower.
Don't Look Dumb
So, now you know why you look ignorant if you're talking about picking stocks (or sectors) for yourself, choosing actively managed mutual fund managers, or talking about investing newsletters. You're broadcasting to the better-informed investors out there that you have no idea what the empirical data actually shows about how these investing methods have worked in the past and are likely to work in the future. To make matters worse, you are taking on risks that the index fund investors aren't taking on. You're taking on manager risk (that a manager could retire, die, or lose his touch) and uncompensated risk when picking individual stocks (you will not be compensated for risk that can be diversified away.)
Some Objections
Okay, now that we've listed out the basic information every stock investor should be aware of, let's get into the objections that some people still have to just investing in index funds.
Objection # 1 The Market Isn't Efficient
The first objection that usually pops up is data showing that the market isn't perfectly efficient at pricing securities. That's probably a true statement. The issue, of course, is that it doesn't matter. While not perfectly efficient, the market is efficient enough that assuming it is efficient is still the right course of action and the market is getting more efficient all the time.
Objection # 2 I'm Picking Small or Value Stocks
The idea behind this objection is the data out there suggesting that small and value stocks had higher long term returns in the past and there are many good reasons why this trend should continue in the future. Great. So buy a low-cost, broadly diversified small or value or small value index fund. You capture that investing “factor” and if the premium shows up, you will get it without running uncompensated risk or wasting your time following newsletters, monitoring mutual fund managers, or picking your own stocks.
Objection # 3 I'm Small and Agile
This objection relates to a complaint you occasionally hear Warren Buffett talk about. He recommends investors invest in index funds (rather than the stock of his own company) because he feels it would be very difficult for him to outperform the market given how much money he has to invest. His investing fund is just too large so he can only invest in the biggest companies out there. Since those are also the most heavily analyzed, it is tough to get an edge there. In addition, when he buys and sells with that enormous sum of money, he actually moves the market price–the more he buys, the higher the price goes. A mom and pop investor doesn't have this problem, the argument goes.
Objection # 4 I Only Care About the Dividends
I've written about the follies of dividend investing before. Focusing on income instead of total return is a good way to have a low return despite high income and it is even worse if it causes you to also run the uncompensated risk of individual stock picking. Dividend investing isn't even the best way to get a value tilt. But if, for some crazy reason, you just cannot avoid investing primarily in dividend stocks, at least use a low-cost, broadly-diversified dividend-focused index fund.
Objection # 5 It's Fun or I Find It Interesting
This one often comes up last after you counter all of the other silly arguments that have been used. “But I really enjoy it” or “it's my hobby” or “I just do it with play money.” Well, let's run the numbers here. Let's say you're investing a million bucks and you're underperforming by 2% a year, which would not be uncommon at all. That's $20K. Do you really enjoy this hobby enough to SPEND $20K a year on it? Because you are. And that doesn't even count the opportunity cost (i.e. the value of the time you are spending doing it). Is that REALLY the best way to drop $20K in an attempt to increase your happiness?
Hey, it's your life and your money, but I would encourage you to think long and hard about this one. Even if the gambling aspect of it is what you enjoy, is that really the most fun way to gamble? Those people in Vegas seem to be having a much better time than you are there hunched behind your keyboard while the sun is shining outside.
Sometimes people like to watch CNBC or read the WSJ or get newsletters because they just find all this news about individual businesses super interesting. However, once you realize most of that “investing porn” is completely inactionable as far as increasing your investing success, the interest level usually wears off pretty quickly and you turn your attention to something else.
Objective # 6 Low-Cost Active Funds Work
This objection usually comes from fairly advanced investors who have learned that the main reason index funds outperform actively managed funds is because they keep their costs so low. It isn't that these professional stock pickers can't pick stocks better than the market, it's that they can't do it well enough to overcome the costs of doing so. The data is quite clear that the best predictor of future mutual fund returns is a low expense ratio, after all. So these folks say, “Well, if I just limit myself to choosing from actively managed funds with very low costs, perhaps I can outperform index funds.” Certainly, their chances are better. Vanguard, the low-cost mutual fund powerhouse, boasts that
For the 10-year period ended December 31, 2018, 9 of 9 Vanguard money market funds, 41 of 60 Vanguard bond funds, 20 of 23 Vanguard balanced funds, and 129 of 146 Vanguard stock funds—for a total of 199 of 238 Vanguard funds—outperformed their Lipper peer-group averages.
While that is an enviable record, keep in mind two things. First, 39/238 funds underperformed, that's a 16% chance of picking a real loser that an index fund investor doesn't have to run. Second, Vanguard is comparing their funds to the AVERAGE fund. Remember that according to that SPIVA data, the typical index fund outperforms 85% of funds in their category, not 50%. If you actually compare Vanguard funds to the relevant index fund, things don't look quite so good at all. Consider their Large Cap Value funds for instance:
Three of these are low-cost actively managed funds. The fourth is an index fund. Guess which one outperformed over the last 1, 5, and 10 years?
How about Large Cap Blend?
Of the 8 surviving funds for which we have 10-year data, 5 are actively managed and 3 are index funds. The index funds rank 3rd, 4th, and 5th among those eight funds. You had a 40% chance of picking a winner and a 60% chance of picking a loser. The 5-year data makes the case even more strongly–only 1 of 6 actively managed funds managed to beat the index funds, and that fund isn't even open to investors.
Yes, if you're going to attempt to pick actively managed funds, a major factor should be the cost of the fund. But I wouldn't recommend the practice.
Objection # 7 I'm Smarter or Work Harder
While I suppose it is entirely possible that you may be smarter or work harder than a mutual/hedge/pension fund management team, the question you should be asking yourself is whether that is really the best use of your time. Let's say by applying your smarts and hard work to your portfolio that you can boost the returns on your $1 Million portfolio by 1% per year. That works out to be an extra $10,000. I don't know exactly what that will work out to be on an hourly rate for you, but the likelihood that this is the best place to spend extra time and effort as a physician seems very low to me. I can think of three ways that are likely to have a higher return for your time and effort:
# 1 Work more in or on your practice
Most docs make $100-300 an hour. $10,000/$300 = 33 hours. For less than one additional hour a week of work, you could generate more of a return on your time.
# 2 Put your effort into a less-efficient market
Looking for an inefficient market where your efforts can make a real difference in the performance of your investment? Look out your front window. Becoming an expert in your local real estate market is far more likely to generate a higher return on your time and effort than pouring over company reports and bouncing ideas off of others on the internet.
# 3 Start a small business or side gig
This one has worked out particularly well for me, although many docs would be better off just working an extra shift, taking an extra call or extending office hours a bit. Certainly, it is a better idea than trying to beat Wall Street at its own game.
I hope that helps you to understand the best way to invest in publicly traded stocks (low-cost, broadly-diversified index funds) and why people are snickering in the background when you start talking about your newsletters, actively managed mutual funds, and random stock trades.
What do you think? Why are there so many investors who have not yet figured this out? Why do mom-and-pop investors persist in individual stock picking? Comment below!
I’m going to have this article’s URL copied on my clipboard so I can paste, paste, paste away in the forums. Too many people come to this community to talk about individual stock advice from “their guy” or are looking for someone to tell them the next “hot pick.” That isn’t what Bogleheads or white coat investors believe in.
Glad you made a post about this. It is an overdue topic. This is all stuff we learned along the way but it sums things up nicely for the inexperienced investor tho thinks he already knows everything. I like JL Collins Bruce Lee analogy but analogies only go so far. This really spells it out.
I think the point that every trade has another side and most of that time the person on the other side is a “Professional” or at least someone with more skill, time, resources, and information then you.
Great post, probably one of your best. It would be interesting to see the correlation between people who pick individual stocks and gambling on sports. Almost everyone I know who picks individual stocks also regularly gambles on sports. The trifecta is doctors I know that pick individual stocks, gamble on sports, pick healthcare related stocks to their specialty. In my opinion gambling on sports is a better proposition, because at least it is entertaining.
Good points and clearly index fund investing with low cost is the lowest risk, safest way to generate market returns with little effort. At the same time, real estate is often touted here and many other sites as a wonderful investment, yet it can be a major time consuming effort not without significant risk especially in a downturn. I don’t think people should be afraid of stocks and should consider a portion of their investment portfolio in them. Peter Lynch said it best, “All you need for a lifetime of successful investing is a few big winners, and the pluses from those will overwhelm the minuses from the stocks that don’t work out.”
One great investment can change your life. And a handful of multibaggers can help you create all the wealth you’ll ever need. You’ll never get that from index funds.
That’s actually why index funds work best. You never miss a multibagger. You got them all. And yes, they overwhelm the minuses from the other stocks. Unfortunately, when you pick individual stocks, you miss the majority of the multibaggers. But if this post doesn’t convince you of the folly of picking individual stocks, there’s not much else I can say. The good news is with a typical doc income and a good savings rate, you’ll probably still reach your financial goals even if you underperform the market by a few percent like most.
A very timely post. One relative of ours insists on holding individual stocks of a company they work for. The stock pays dividends, which obviously sounds nice, but it is difficult to briefly and concisely explain all the problems with such a practice.
Yikes! Approach it peripherally- “I worry about all these WalMart associates whose whole retirement savings is in WalMart… (or use IBM, or PanAm…) if they get laid off because Amazon makes WalMart worthless, their retirement plan has also collapsed.” Not that I ever had company stock in which to invest, but made immediate perfect sense to me.
Until this subject it taught in schools the public will remain financially illiterate and waste billions in fees and foolish investing
American College NY Life Center for Retirement Income did a study confirming this illiteracy(2017)
Look it up and take the test
Maybe someone can post it here
I was curious about that quiz, so I looked it up: http://retirement.theamericancollege.edu/retirement-101/2017-retirement-income-literacy-quiz
When you have questions like
Q23. What is the proportion of the population that is going to need assistance with activities of daily living (need long-term care) at some point?
– 10%
– 25%
– 50%
– 70%
– Do not know
I lose faith in the conclusions that are made based on “passing” rates.
Missed the “I really love and believe in the product” crowd….doesnt make it a good business.
Self serving because this is what I do personally, but I think excuse #5 is legitimate if the $$ is reasonable. If one carves out a small allocation to be active with (Sub 10% of market investments) I think that is completely fine.
Great post! Thanks for sharing.
Correction-the financial literacy test can be found at American College NY Life Center for Retirement Income
Study done in 2017
Maybe someone can post it
What you say is true–except for those people Fidelity discovered. They had picked stocks and held them through death and beat the daylights out of most investors. So what is the lesson: buy excellent companies and go play golf.
I think I know the study you’re referring too (although it may be the apocryphal one that those who were dead already had the best returns.) At any rate, imagine having to invest 50 years ago. What was the right move? Buy and hold individual stocks. Mutual funds were super expensive with loads and high ERs and poorly performing active management. So when you’re comparing to that, sure, picking stocks might have been a better move especially if you had good behavior with them! But now we have super low cost, no load index funds that guarantee you the market return at essentially zero cost.
I certainly agree that, in general, index funds are the way to go. One problem that I think you overlook is that picking stocks is completely unrelated to all these hotshot’s knowledge of the markets. Possibly they overanalyze things and use complicated formulas that have very little correlation to anything. Most of my holdings are index funds and I am very happy with these returns. However, about 20% of my holdings have been in individual stocks for the last 20 years and, overall the individual stocks have outperformed the S&P. I have held McDonalds, Walmart, Apple, and Amazon. That’s all. Walmart and McDonalds have not performed as well as the S&P but AAPL and AMZN have greatly outperformed it. Since about 80% of my individual stocks market value are in AAPL and AMZN it would appear that my individual stocks have beat the S&P over the last several years. I don’t claim to be a stock picking guru and I still think the S&P is the way to go. But I have enough cushion to do this and I do not believe that these so called experts know any more about investing or picking stocks than anyone else. At least their results leave a lot to be desired. BTW, I probably would have sold these individual stocks 7 or 8 years ago if I couldn’t afford to lose this money. But the point is you don’t need all this education and training to pick a few stocks that will outperform the EXPERTS.
So if you’re not smart, you’re apparently lucky. Are you really going to bet on that again?
>> So if you’re not smart, you’re apparently lucky. Are you really going to bet on that again?
WCI, reflect on what you’ve done here. You’ve merely shown the truth of Keynes’ maxim in The General Theory of Employment, Interest, and Money: “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
If you don’t win the approved way, you were just lucky! Ha!
Look, there’s no question that the vast majority of people shouldn’t pick stocks. But I’ve owned a butt-ton of Apple also for two decades 20 and it’s outperformed to put it mildly. Just like IBM before it, and MS followed that (MS has levitated again, but I’m skeptical of the extreme optimism on its 2nd coming). And note when those largest of tech stocks in the best economy in the world collapsed? They never did, though the torch was past. People had decades to decide how to get out if they wanted out. Enron and GE? Any individual investor was stupid to be anywhere near them ever.
Luck is always involved in any financial success. Look, people seem to implicitly endorse the idea you should never do anything that you wouldn’t recommend to others. But individuals aren’t financial advisors, and those with any sense have never recommended anyone to do anything financially except save more and spend less. But for some reason financial advisors insist that since 98% of the public shouldn’t invest in individual stocks then 100% shouldn’t. And the 2% that succeeds at it? Lucky bastards! 🙂 Unlike today’s financial advisors, Keynes was broadly educated and put his finger precisely on the issue and his remark is deeply informed by human nature and timeless.
But go ahead and say it again. Lucky bastard! You know you want to.
I’m not saying you got lucky, you did. (“I’m no guru”). I’m saying you may be skilled (in which case you should be managing a lot more money than your own) or you may be lucky (in which case you should not be picking stocks yourself.) Follow the logic?
I wasn’t making a distinction between word and fact as you seem to think. Recall I said “luck is always involved”. I’m lucky in a whole bunch of ways, as are you. Taking advantage of what luck brings our way is the whole point of succeeding, yet many fail to recognize or do this. No, I was distinguishing between the element of luck and your professional need to assert it, and you didn’t disappoint. In fact you’re making my point.
Again, I’m not a financial advisor. I’m a tradesman and an individual investor. Because of that, as I said, I never recommended anyone to do anything other than save more and spend less, and never will. But you don’t seem to follow my logic because you’ve simply doubled down on the error by declaring that if skill was any part of my individual financial success I “should be managing a lot more money than your own”. That doesn’t follow in any way, unless one thinks the only valid means of investing involve quant techniques and/or mean-variance portfolios. Which is why current members of the finadvisor industrial complex feel the need to assert not just the element of luck, which is ever present, but insinuate or imply pure or “dumb luck” could only be responsible for any success which falls outside their professional domain. Follow the logic?
No. Maybe someone else understands your logic though. I confess I cannot follow it.
I think you follow it well enough. I also wonder why you’re not asking yourself why you’re not managing other people’s money. Ah well. I grew up watching Wall $treet Week with Louis Rukeyser with my businessman dad, and for many years listened to him and my uncle the local banker discuss business and finance at family events. Now we have modern portfolio theory and such and the quants, with no apparent sense of history, telling us the only valid perspective is theirs, and I find it amusing and have to admit I enjoy toying with them. Thanks for being a good sport.
“The people who know the edge of their own competency are safe, those who don’t, aren’t” –Warren Buffet
The reason I don’t run an actively managed mutual fund is because I don’t believe I can pick stocks well enough to beat an index fund after costs so I feel I would be doing those investors a disservice.
It was a rhetorical question.
Of course, index fund managers pick individual stocks. They just pick them based on market cap and domicile.
So if you as an individual invest in a large cross-section of individual stocks roughly weighted by sector/market cap, aren’t you accomplishing the same thing as an index?
What you are really criticizing is active management. Best to be a long-term investor in the market, not a trader. But that doesn’t mean you have to own SPY/ACWI/VTSMX or some combination. You can buy and own individual securities. The Dow 30 is a good example of this.
Now that makes someone look even dumber. Why would you do that yourself when you could pay Vanguard 0.03%/year to do it for you or Fidelity 0.00% a year to do it for you?
Do you seriously think that’s worth the effort? I question your assessment of the value of your time.
You’re not acknowledging the point. Active management or speculation is “dumb”. Schumpeter: “the difference between a speculator and an investor can be defined by the presence or absence of the intention to ‘trade’, i.e. realize profits from fluctuations in security prices.”
You can speculate or trade in marijuana stocks or junk bonds or index funds or sector ETFs or anything else that fluctuates in price. It is wiser to be an investor; get passive exposure to a cross-section of businesses that are in aggregate representative of the global economy and that will in aggregate grow along with the global economy over time. Whether you get that exposure through ownership of individual securities or an index fund or a cross-section of index funds is largely irrelevant.
You’re conflating ownership of individual stocks w/ speculation. Perhaps because you are assuming that all individual stock owners are speculators which is itself a dumb assumption.
No, there is an additional element above and beyond the speculation aspect. It’s uncompensated risk. And if you buy enough securities that you no longer have that, you have introduced additional complexity for which you are not rewarded.
So is your recommendation to your readers that they should only get equity exposure through the All Country World Index or similar? Whether you have $1MM or $10MM or $100MM – one line item for your equity allocation -> ACWI.
Is that what you recommend?
I have no idea why you have jumped to that conclusion. I recommend people pick a reasonable asset allocation and stick with it. I recommend against picking individual stocks as discussed in the post above.
Re #2 my dad or a teacher- maybe both? Had us ‘invest’ an imaginary $10K in the market and monitor its fate in the newspaper. Good game for kids and doctors who think they are ahead of the pack, with no real losses.
The problem I see with your analysis is that it is an either or analysis. For instance, I have held McDonalds, WMT, AAPL, and AMZN for years along with S&P index funds. I have most of my stock holdings in S&P Vanguarx index funds. WMT and McDonalds have not performed as well as the index but AAPL and AMZN have greatly outperformed so my individual stocks have outperformed. I don’t believe that all the Beta analysis that the Brokerage houses and analysts do amount to a hill of beans. They just try to complicate the situation and skim money from investors. I certainly am no stock picking guru and only hold 4 individual stocks, but 80% of my individual stock holdings are AAPL and AMZN. You certainly don’t need complicated analyses to buy individual stocks. As Warren Buffet said, “If you’re not willing to hold a stock for 10 years, don’t hold it for 10 minutes”.
So you think it is a good idea to concentrate 80% of your equities (at least your individual equities) in two positions? I’m not sure what I can say that will convince you that isn’t a good idea. It is patently obvious to most. Congratulations on your pick, but bear in mind that you are also picking it for the next 5, 10, 20 years etc and that bet may not work out nearly as well.
Yes, it’s either/or. Either you’re talented or you’re not. If you’re talented, you could be a billionaire by doing what you’re doing for others. If you’re not, you should not be doing it for yourself. Which is it? I suspect you don’t know, but you hope you’re talented. You’re just not sure you are enough to do it for anyone else and you’re willing to live with the likely underperformance if it turns out you’re not. That seems to me to be a foolish way to invest.
Hi WCI
Good post. I like what you have written in general. I think you have lost a bit of the nuance though and the second level thinking here. I’m not trying to prove your thesis wrong as I think it is generally right, but I think some healthy push back is of value.
First, let me say where I agree.
Agree 90+% of investors should do index investing as their path to wealth.
Agree that SPIVA data makes the dynamic look painfully obvious to index instead of actively invest and does not factor in survivorship bias which would skew the discrepancy further.
Agree that many pursue active investing as an ego driven process because the desire to beat the market is so enticing.
Let me go into the nuance now.
1. First, the diversification value of owning thousands of stocks via indexes is overblown.
Mathematically, diversification is achieved by about 30-40 stocks in varying sectors and each additional stock adds minimal percentage of additional diversification.
2. You stated that via indexing you would never miss the big winners because you own them all. Peter Lynch would not have considered this a win because the allocated bet size on that particular stock is such a small percentage it would not cancel out the losers.
We must first acknowledge that there is a percentage of active investors that will beat the market and decide if it is random luck or is there an actual path to success.
The following piece by Buffett needs to be critically appraised by indexers in my opinion:
https://www8.gsb.columbia.edu/sites/valueinvesting/files/files/Buffett1984.pdf
3. You need to look at how incentives are aligned in the world of investment management.
In my opinion, a decent percentage of money managers are not really trying to beat the market. On closer analysis, there has often been 20-30% of retail funds that are essentially mimicking the index and charging 1-2% fees to do so.
This is of course highway robbery and strengthens the distrust of the financial industry, but it skews the stats calculated by SPIVA because these funds will be a guaranteed failure against the index.
In my opinion, any fund that has 150+ stock holdings should automatically be written off as a closet indexer. A closet indexer can be measured by something called “active share”. The higher the active share, the less correlated to the index a portfolio is.
4. A closer look at why active funds choose to closet index is also instructive.
You nail it on the head when you say that the vast majority of the industry increases its direct profits through fundraising and increasing assets under management vs. Profits from great excess returns.
The interesting thing is that many studies have shown that even those investors that “picked” the winning active retail funds often actually underperformed the fund and also the index!
This initially makes no sense but points to the reason why managers closet index their funds. A good active manager would tend to underperform the market at least 30% of the time but their outperformance tends to be outsized. This is because their portfolio structure is more concentrated (20-30 stocks) and there is a high active share.
The problem for the individual investor is they all jump into the fund after a few years of the excess outperformance eye popping return years. These years are then followed by periods of underperformance. The individual investor decides the funds outperformance was luck and leaves the fund. This is buying high and selling low.
Often these funds have wild fluctuations for inflows and outflows of assets. The stocks within them are typically more obscure and not just the recent high fliers like FANG because you have to be different to beat the market. The individual looks at these obscure stocks in periods of underperformance and becomes suspicious since they don’t recognize any of the names.
Compare this to a closet indexer:
Your regional bank creates its large cap fund and can always point to the solid Dow-like stocks in it amongst the other 150 stocks and they all look like good solid companies. The investors in these funds tend to be just “trusting” their advisor and rarely critically appraise them. They accept the underperformance perpetually and are less likely to pull their funds.
The fund manager at many of these Fidelity or BofA type funds are judged and paid by AUM, not by outperformance.
Hence their incentives are aligned to not rock the boat too much.
The 1-2% fee is a massive performance drag in this type of environment and can’t be overlooked on its effect to why indexing appears to kill active management in objective data sets.
5. Most active funds don’t “eat their own cooking”
Most people don’t critical appraise what percentage of the portfolio managers personal assets are within the funds. Most retail funds have very little “inside ownership” of their own fund and therefore have little alignment of interest to their investors.
Compare this to Buffetts original partnership where he was the largest owner and his compensation was funnelled back into the fund.
His fee structure was also fully aligned:
No annual fixed fee.
6% a year hurdle rate (to mimic SP500 expected return) and then charge 25% of profits for any excess returns over that.
All the active managers I know worth their salt have similar type of structures for their investors. They often can’t pull off no annual fee but charge 30-50 basis points to cover operating expenses and their personal compensation only comes from outperformance. They also keep it as their main vehicle for personal assets which aligns them with the investor.
6. You assume that anyone who can outperform the market would be stupid not to be managing at 2/20% structure because they have such a unique skill.
This ignores the short term thinking of investors and the influence that has on money managers.
When you are being measured on your monthly return profile against an index and receiving phone calls from investors after 1 quarter of underperformance, this dramatically influences behaviour of a portfolio manager (not that it should but it will skew them to short term thinking)
You can talk to your investors all you want about long term thinking, but when you can easily compare to indexes each month, investors can be fickle.
If an investor pulls their funds, a portfolio manager is forced into action to sell assets. Conversely, if the fund is doing well and AUM grows quickly they may be forced to buy something just for the sake or choose to sit on huge amounts of cash. How many investors are excited about paying fees on the fund sitting with 30-40% cash?
The active managers that do well tend to carefully pick their investees, eventually cap their fund to any further outside investors and have a high percentage of their net worth within the structure. Finally, their fee structures are aligned with shareholders similar to the Buffett partnership.
None of the above guarantees that active manager outperforming the market because it is still hard to do! At least you would know all the incentives are set up to make it more likely to happen though.
7. Finally, as an individual investor that has outpeformed the market (CAGR 17% annually for 10 years) I would have no interest in ever taking on additional investors.
The only way I would consider it would be if I could lock up the funds for 10 years to prevent any forced selling by the investors. Otherwise you would put the fund at risk of forced selling in a bad market and liquidating at the bottom.
No investor should be willing to lock up for 10 years on faith and I would never expect them to. I have already achieved FI so there would be little value in taking the added stress of additional investors and managing their investing behaviour.
Keeping on top of my own biases and investor psychology is enough work!
Look forward to an engaged discussion
Cheers
FinanciallyfreeMD
2. It clearly does “cancel out the losers” to provide you the market return.
4. Actually the data shows that outperformance by active funds is usually minimal and underperformance is often significant.
7. I’d give up liquidity for likely outperformance. I have, do, and will in the future as well. That’s part of the reason for private real estate investments. They can look long term because they have the money for 5-10 years.
You’d probably like this post: https://www.whitecoatinvestor.com/how-to-pick-an-actively-managed-mutual-fund/
Hi WCI
Thanks for the link!
I liked the write up you provided and your editor response. I agree with most of it and your guest writer made many of the same points I did.
In regard to your response to my comment
2. Sorry I wasn’t clear. In Peter Lynch’s book he is talking about achieving outperformance to the market return. Therefore he is talking about how in a concentrated portfolio, a few actively selected winners will cancel out a number of actively selected losers that will still lead to an overall better than market return (this “cancelling out the losers”)
An index can’t by definition get better performance from an eventual market winner because it can’t hold it in a higher concentration then the market does.
You didn’t mention the Graham and Doddsville Superinvestors article by Buffett.
I feel like it is a relatively strong argument against reversion to the mean of active managers mentioned in the comment section of your linked article in selecting active management.
Do you have any thoughts on it being a statistical aberration or something may apply from Buffett’s observation that doesn’t fit the efficient market hypothesis?
4. Apologies as I don’t think I was clear. SPIVA data clearly shows active performance underperforms the index. As you state.
My point in mentioning all those factors was saying that a multivariate problem likely has complexity in why the outcome occurs. It might not be as simple as “the market is impossible to beat and the market is highly efficient”
To test the hypothesis that indexing is a clear winner against ALL forms of predictable active management, apply some modifications to the analysis to:
A)remove closet indexers
B) remove funds that have no alignment with shareholders
C) search for optimized fee structures like the ones I suggested and see if indexing still wins
I always see the Buffett bet against a 2/20% hedge fund vs an index being quoted as the slam dunk that passive management always will win. But no mentions that Buffett has been an active investor his whole life and doesn’t believe the market is highly efficient.
He does believe that the average investor is better served by an index and avoiding high fees though. And he believes that value investing is conceptually easy, but practically hard.
No one looks for the multiple active funds that mimic his old fee structure which is highly aligned.
I see no downside for the passive oriented investors for wanting to find out the result of such a modified SPIVA because we are all interested in achieving the best risk adjusted market returns.
7. I also give up liquidity for outperformance via real estate but I don’t think the majority of investors can actually do this on a practical level.
Similar to how many would not have the behavioural finance skills to self manage a portfolio.
Thanks for the discussion!
FFMD
2. Why aren’t there more Buffetts? Statistically there should be far more than there are, simply due to chance.
4. The problem is that you end up data-mining and then it takes forever to prove your hypothesis with prospective data. It’s not about the efficient markets hypothesis, it’s about the cost matters hypothesis. If you want to improve your chance of winning with active management, you should start with cheap funds.
The cost analysis is paramount and is why the individual investor is clearly better off to just index.
I agree we are quibbling about minutiae to some degree and I take your point on data mining.
If the financial industry did an overhaul where it was based on a 6% hurdle with a high watermark and manager only gets paid after that with excess profits, the cost analysis you speak of would shift considerably.
I agree this model is far from ever being the standard model because there is no guarantee of profit for the manager and typically only works with a small number of clients.
Thus you are correct to recommend avoiding active management for most ind
>> Yes, it’s either/or. Either you’re talented or you’re not. If you’re talented, you could be a billionaire by doing what you’re doing for others.
This is nonsense. Talented at what? You seem to pretend that having talents in statistical things appropriate to quant aspects of investing is the only type of talent that could matter, even to an individual investor. This is the most obvious question begging. If this were true WCI should be managing a fund. Any other arguments in this entire thread are downstream of this false assumption. Which has been my point all along.
Look I agree with Buffet that the vast majority of investors should be in index funds. Probably 98% of people should be. And I also agree that managing very many individual stocks isn’t manageable. You shouldn’t own any more than you can have deep and intimate knowledge of, and that assumes good judgment and a certain temperament. The combination is rare, and of course none of that doesn’t mean you won’t lose your shorts anyway. But nothing about modern portfolio theory or quant thinking means your money won’t be outstripped by inflation either and you end up broke. Pick your poison. But one things for sure. If you lose your money the latter way, the WCI will be there to console you that at least you became broke the approved way. That will no doubt be comforting.
You don’t have to be Nietzsche to sometimes wonder if the stridency of finadv industrial complex is because it exists not as much to preserve wealth as to ensure wealth remains directly proportional to one’s income. You can’t help but wonder sometimes if they don’t think that’s the right and natural order.
I have no idea what you are arguing about. You seem to be in agreement on everything I’m saying.
Perhaps I can help. You can’t stridently and repeatedly make specific assertions with multiple people and then go back into generalities and declare there to be no argument. After all, you could’ve stayed within generalities and been less absolutist so as to recognize exceptions. I’ve already said the issue really comes down to claiming 98%=100%. What is best for 98% of population doesn’t invalidate what the other 2% is doing, nor allow you to characterize them or what they’re doing any self-serving way you choose. Generalities are fine; absolutes are not.
The argument is over a seeming lack of distinction between the goals of an individual investor and an institutional investor. Or at least that’s the way it seems to me by the distinction you’re asserting between skill and luck, which it seems to me is actually an attempt to distinguish between what you think is scientific and what you think isn’t. But all the reasonable people I know and trust say it’s more art than science, and that’s my own view. Reasonable people may differ, there are quant and fundamentals mindsets, but insisting that skill = repeatability = should be a money manager seems to reject such differing viewpoints.
Your insinuation that success amounts to a single event that would have to be repeatable in terms of magnitude for it not to be dumb luck I find very strange. A buy and hold decision over decades isn’t a single event. It’s a complex series of events over time including constant competitive research often having far less to do with things financial than the particulars of the company in question and it’s industry. I agree generic knowledge of sectors isn’t helpful. Now an active institutional investor would need to repeat, and they can’t reliably, and hence index funds. But an individual does not need to repeat a large gain. The whole point is to recognize sui generis business situations and circumstances *if* and when they occur within our sphere of competence. I seriously doubt I’ll find another company I’m comfortable investing a significant amount in my lifetime. That’s to be expected. There are many types of skill and many different goals towards which to apply them. There are no absolutes.
I don’t recall insinuating such a thing nor stating that 98%=100%. You’re creating a straw man argument and then acting surprised when I point it out.
If 2% of people (which honestly is probably a pretty high estimate) can reliably pick stocks well enough to beat the market, then it’s pretty cocky for a doc to look around at 49 of her peers and say “I can do this and all of them can’t.” Even if someone pulls it off for a few years, the logical thing to do is to assume you just got lucky. Why pursue a pathway with a 2% chance of success? It isn’t logical.
>> I don’t recall insinuating such a thing nor stating that 98%=100%. You’re creating a straw man argument and then acting surprised when I point it out.
If 2% of people (which honestly is probably a pretty high estimate) can reliably pick stocks well enough to beat the market
No, you’ve got the straw man argument. I’ve never said–and was extremely clear and explicit in denying, over and over–that I was ever talking about or even had any interest in (as I don’t) *reliable* stock picking. My 2% was an imagined percentage of those who might have a reasonable shot at finding one good one in their sphere of competence and not screwing it up if they did. The question was whether it could ever make any sense to pick an individual stock, and whether or not if one did and succeeded that it was pure dumb luck. And the issue isn’t one of pride–needing to claim accomplishment and declare skill–it’s about whether or not it’s always and everywhere a foolish thing to do. In other words, the professional bias of the finadv industrial complex in recent years after drinking the Markowitzian Kool-aid.
Individual investors aren’t reliable stock pickers. I’m not a reliable stock picker. Over and over again I repeat it, and over and over again you miss the point. I don’t need to be a reliable stock picker, and I don’t even want to be since after once having a great run my goals have changed as my fortunes have changed.
I no longer have any idea what we’re arguing about. Nor do I have the time nor interest in doing so. No, I have no idea what point you are trying to make so I’m not surprised that I am missing it. You seem to believe picking individual stocks is not a wise use of your time. I believe the same. I’m moving on.
Excellent post. Nicely done. Thank you
I don’t see investing as something to play with.
For those who do, they can have their fun without buying stocks. If someone finds picking stocks to be fun, they can pick all the stocks they want. That is no reason to buy them. Make a list of stocks they think will do well, pretend they purchased them on a certain date at the ask. Then follow them to see how they do.
One would get all the fun of stock watching without distorting the portfolio.
Here is an example of a reputable active manager with skin in the game. His interests are wholly aligned with his investors and uses a value tint and long time horizon as his “value add”
Read his thoughts on “what is your edge”
And the section on how the hurdle rate compounds at 6% annually with no management fee. For an investor that is below that hurdle, they are getting active management for free
I know everyone will point to short term results not being predictive of future performance (which I don’t disagree with) BUT this is how you optimize your chances of achieving outperformance via compensation structures that align minority investor interests with the portfolio manager
Disclosure: I am not invested in Saber Capital and have no personal affiliation with the manager.
I do own some of the stocks he references.
https://www.dropbox.com/sh/rs96rkvntbl3axj/AACBLy2iqmFnGPg7Oo7eyeVIa?dl=0&preview=Saber+Capital+2019+Q3+Letter.pdf
No arguing with fools who trade stocks
I can only think of two reasons why you are not doing the 100% Low Cost Index Fund / 0% Active –
1. You belonged to exclusive club of 5% of the financial professionals who can beat the market
consistently over 20 years or greater.
2. You related to or lucky enough to have made an acquaintance with the person in 5% club.
Good luck!
https://www.forbes.com/sites/rickferri/2012/12/20/any-monkey-can-beat-the-market/#135654b4630a
The following though is from an article by Rick Ferri, an indexing advocate, in Forbes. He’s quoting work done by Research Affiliates.
“the company randomly selected 100 portfolios containing 30 stocks from a 1,000 stock universe. They repeated this processes every year, from 1964 to 2010, and tracked the results
“on average, 98 of the 100 portfolios beat the 1,000 stock capitalization weighted stock universe each year”
the average portfolio “outperformed the index by an average of 1.7 percent per year since 1964”
“From 1964 to 2011, the annualized return for the 1,000 stocks used by Research Affiliates was 9.7 percent. The 30 largest companies in the 1000 made up about 40 percent of the capitalization weight, but their return was only 8.6 percent annually. The other 970 stocks made up 60 percent by capitalization weight and their return was 10.5 percent annually. That’s a 0.8 percent per year premium return for smaller stocks over the 1,000 stock universe and a 1.9 percent premium return over the largest stocks. Any portfolio of 30 stocks randomly selected from the list of 1,000 stocks is bound to include mostly smaller companies.”
“the 30 stocks in the portfolio were equally weighted. This technique reduced the average market cap relative to the cap weighted index and helped boost the return. In addition, equal weighting “tilted” the portfolio toward value stocks, which earned a higher return than growth stocks over the 1964 to 2011 period.”
There would be increased transaction costs and taxes. If it’s from the largest 1000 US stock (that’s unstated), the transaction costs wouldn’t be too high.
But the important point is that a random 30 equal weighted stock portfolio turned over every year beat the market on average by 1.7% on a precost basis. That’s due to a tilt towards small and value.
What’s to stop any investor from selecting the 30 most valuey stocks out of the 1000, based on a value composite? And since scalability is likely less of an issue to you versus Vanguard, DFA etc, why not use the 3000 largest stocks instead of the 1000 largest? After all, the data for the value premium is stronger in small caps than large caps. And you have an ability to combine value and momentum that a fund with billions in assets can only dream of.
The following is from Patrick O’Shaughnessy’s blog:
http://investorfieldguide.com/2014115how-concentrated-should-you-make-your-value-portfolio/
“I set up portfolios which bought the absolute cheapest stocks trading in the U.S. (including ADRs). Portfolios ranged from 1 stock to 100 stocks, and stocks needed to have a minimum market cap of $200MM (inflation adjusted). Cheapness is defined as an equal weighted combination of a stock’s price/earnings, price/sales, EBITDA/EV, Free Cash Flow/EV and total (shareholder) yield. Each portfolio was rebalanced on a rolling annual basis (meaning 1/12 of the portfolio is rebalanced every month. Think of it like maintaining 12 separate, annually rebalanced portfolios). This means that the “one stock portfolio” will have more than one stock, because different stocks rise to the top through the months. This process removes any seasonal biases and makes the test more robust.
Here are the results, including return and Sharpe ratio. The best returns came from a 5 stock (!) portfolio. The best Sharpe ratio came from the 15 stock version. Both return and Sharpe degrade after 15 stocks.”
http://investorfieldguide.com/wp-content/uploads/2014/11/img7.png
With your own DIY small cap value portfolio, you can get a much stronger tilt , than you can with an ETF/MF.