Long-time readers and avowed Bogleheads will not be surprised to see the title of this post, however, they may be surprised by the data presented. Way back in 2011 — two months after this blog started — I told you not to take uncompensated risk by buying individual stocks. Here is yet more data that supports that recommendation.
JP Morgan took a look at how difficult it was to pick individual stocks. They looked at data from 1980 to 2014 using the stocks in the Russell 3000 (98% of the US market.) What they found was the following:
Individual Stocks Have a High Risk of Permanent Impairment
40% of stocks would, at some point, suffer a “catastrophic decline.” This decline represents a 70%+ decline in value from which the stock price DID NOT recover. At all. 40%. This isn't like buying the entire market where you wait out the bear market. The company just goes out of business. 40% of companies over a 35 year time period. The percentage was higher than 40% in the Telecom, Biotech, and Energy sectors.
Individual Stocks Underperform, On Average
67% of stocks would underperform the Russell 3000. The index returns (and thus those of a mutual fund tracking the index) heavily depend on the relatively few winners for their gains. By only owning one or a few stocks, your risk of missing out on those winners is quite high. Even actively managed mutual funds do better than 67% underperformance in a given year (although it is even worse over the long term.)
Helping baby sea turtles reach the sea is way more interesting than investing
Lower Returns AND Worse Risk Control?
Wait, it gets worse. It turns out when you start looking at the volatility of the stock prices of individual stocks, that things get even worse. On a risk-adjusted basis, it turns out that 75% of the “concentrated stockholders” they looked at would benefit from additional diversification. I'm surprised the number was that low. So even those who buy a whole bunch of individual stocks, still lack adequate diversification.
Good Investing is Boring Investing
I often run into people who list “investing” among their hobbies. I can't help but think about what a stupid hobby that is. Don't get me wrong. I think many of the financial concepts behind investing are interesting. But the actual activity? You've got to be kidding me. If you're enjoying this, you're doing it all wrong.
I mean, let's think about what I do when I “invest.” I log into my 401(k) and see there's a chunk of money sitting there that has been taken out of my paycheck. I open my spreadsheet and see that I'm a little low on US stocks. So I go back to the 401(k) and place an order to buy as many shares of VTI as that chunk of cash will buy using a limit order at something close to the current price. A few minutes later, I see my order was filled. I update my spreadsheet a few weeks later when I get around to it. What's fun about that? Nothing. It's one of the most boring things I do all week.
So if you're enjoying investing (researching, buying, selling, discussing etc), at least in the stock market, chances are good you're spending a great deal of time and effort engaging in an activity that is actually decreasing your returns. Do yourself a favor and get a hobby that makes money, a free hobby, or at least one that costs you less than stock picking. You know, like boating.
What do you think? Do you buy individual stocks? Why or why not? What percentage of your serious money do you have in individual stocks? Comment below!
Interesting post. Thanks for the “ammo” for when co-workers try to convince me of their “diversified” portfolios of individual stocks.
I pick induvidual stocks in my gambling account. It’s better than going to the casino or playing cards with boys. It’s not an investment but every now and then you win and you win big. Example oil companies are low right now. They are gonna comeback strong in next year or so small fortunes will be made on little coin now.
don’t be so sure. I bought VDE (vanguard energy sector ETF) in my “gambling” account last year May 1st for $115, after it dropped 21% from its previous high of $145 with this same optimism. It has now dropped 35% to $75.
You cant predict these things!
I have a Scottrade account that has about 2-3k in it. I have a few individual stocks that I’ve played around with for the last 8 years. Most of them supply good dividends that I reinvest or withdrawl. This is my “fun” account that I do not invest any additional money then my original 2k investment (I’ve withdrawn about 1-1.5k).
It doesn’t matter a great deal what you invest a small “play money” account in, whether it is individual stocks, sector funds, P2P loans etc. In fact, some have recommended that those switching from stock picking to index funds keep a 5% play money account to scratch that itch. In my experience, among those who actually track their returns accurately, very few stock pickers beat the index fund approach, especially after taxes, fees, and accounting for their time.
I can rebuttle every point you mentioned in this article, but don’t have much time to write another blog. There are many investors(not financial advisors) who are doing good while investing in individual stocks. ‘Mutual funds are safe’ is a lie perpetuated by fee/comission collecting industry. They tell you to stay the course, buy and hold but if you look at TURNOVER RATIO of mutual fund holdings, it is above 50-80%%. It means fund manager is buying/selling/reshuffling stocks like a drunken monkey. There is no Just check turnover ratios on vanguard fund site. Try paper/virtual trading(e.g. TD ameritrade allow it) with individual good quality, dividend paying, stocks for 1 year, compare results with MFs, Do it yourself, rewrite blog again. Thank you.
Who wants to respond to this one?! 🙂
See my post below – applies to active investing even when the active investor is you. I am a reformed stock picker myself. The time it took was not worth the effort to me. Yes, I beat the market, most likely due to luck. But, I did not outperform by enough to be worth my time. Jim’s last paragraph really resonates with me.
…and I have a short proof of Fermat’s Last Theorem. I’d write it, but there’s not enough room in the comment box.
“Individual good quality, dividend paying, stocks”… Like Enron?
No, more like WorldCom:)
Bear in mind when I’m talking about mutual funds, I’m talking about very low cost, low turnover, no load, generally index/passive mutual funds. Fees, commissions, and turnover are not an issue there. For example, one of my largest holdings, the Vanguard total stock market mutual funds has no loads/commissions, turnover of just 3.5%, and fees of just 0.05% per year. That’s practically free from an expense stand point. No manager risk, no tracking error, maximal diversification etc.
There is no doubt if we’re discussing terrible mutual funds that it is much easier to pick stocks and come out ahead.
Like I tell the whole life guys, if you want to pick individual stocks be my guest. No skin off my nose. If you save enough money, or have low enough retirement goals, you can invest any way you please. But the data is quite clear about the likelihood of you picking stocks well enough over the long run to beat an index fund, especially when you consider fees, taxes and the value of your own time.
It is not about Index or Active funds. See this performance data from Vanguard website. Low cost, high turnover active funds from Vanguard(??) are not bad at all as your website readers think. And Index funds ‘Not Neessarily’ beat active fund in many cases. See table below. Thanks
VANGUARD Cumulative returns as of 01/31/2016
1-year 3-year 5-year 10-year
VG ACTIVE FUNDS
Diversified Equity -3.67% 33.60% 60.22% 75.34%
Dividend Growth 2.44% 39.29% 73.53% 122.90%
Equity Income 0.67% 34.07% 74.02% 102.83%
Growth and Income -0.94% 39.18% 71.45% 74.73%
Morgan Growth 1.07% 42.60% 63.54% 87.29%
PRIMECAP Admiral Shares -2.60% 49.22% 75.88% 122.34%
PRIMECAP Core -3.53% 44.95% 71.95% 116.72%
U.S. Growth 2.59% 47.04% 78.41% 85.10%
U.S. Value -5.24% 32.24% 69.32% 62.91%
Windsor -7.30% 26.72% 52.13% 60.13%
Windsor II -4.48% 27.03% 55.02% 67.96%
Capital Opportunity Admiral Shares -5.59% 47.60% 72.72% 116.46%
Capital Value -16.14% 14.72% 24.89% 54.36%
Mid-Cap Growth -7.37% 27.89% 56.09% 97.20%
Selected Value -8.66% 26.59% 51.59% 90.74%
Strategic Equity -8.37% 37.05% 72.17% 72.55%
Explorer -10.42% 22.05% 45.31% 62.73%
Explorer Value -5.66% 23.26% 49.76% —
Strategic Small-Cap Equity -8.32% 32.25% 63.87% —
VG INDEX FUNDS 1-year 3-year 5-year 10-year
500 Index Admiral Shares -0.69% 37.73% 67.53% 87.27%
Dividend Appreciation Index Admiral Shares -0.83% — — —
FTSE Social Index -1.53% 41.26% 72.22% 69.39%
Growth Index Admiral Shares -1.34% 40.06% 71.04% 106.51%
High Dividend Yield Index 0.37% 36.05% 76.10% —
Large-Cap Index Admiral Shares -1.49% 36.66% 65.83% 89.16%
Tax-Managed Capital Appreciation Admiral Shares Info -1.33% 37.00% 66.19% 87.65%
Total Stock Market Index Admiral Shares -2.59% 34.93% 63.88% 87.99%
Value Index Admiral Shares -1.62% 33.69% 61.01% 72.64%
Extended Market Index Admiral Shares -10.08% 22.95% 47.82% 81.00%
Mid-Cap Growth Index Admiral -7.43% 28.44% — —
Mid-Cap Index Admiral Shares -6.84% 31.60% 56.11% 87.53%
Mid-Cap Value Index Admiral -6.43% 33.75% — —
Small-Cap Growth Index Admiral -10.60% 20.09% — —
Small-Cap Index Admiral Shares -9.06% 23.96% 50.39% 83.92%
Small-Cap Value Index Admiral -7.76% 26.44% — —
Tax-Managed Small-Cap Admiral Shares -4.93% 30.32% 61.50% 87.57%
I agree that low cost matters more than passive/active. The reason passive investing works is the Low Costs Hypothesis, not the Efficient Market Hypothesis.
Bogle calls it the CMH, the Cost Matters Hypothesis, and has said the superiority of indexing relies on the CMH and not the EMH, the Efficient Market Hypothesis.
Yes, that’s what I meant. I guess I just made up the term low costs hypothesis. I agree with Bogle on that point.
For a moment, if costs kept aside or considering before cost results, who comes ahead? Index or Active fund?
Someone sure will come up with ways to reduce costs(like ETFs vs MFs) of active funds, Then what?
In short, theory and actual returns of actively managed funds are not bad. Otherwise Bogle wouldnot have allowed Vanguard management to Run Active funds in first place !!
On average, active funds = index funds before costs. The total of the active funds IS the market. That’s just math. Obviously there are far more active managers who can beat the market if costs are ignored, but unfortunately, that’s not the world we live in. It turns out that after cost, very few can do so, especially over any kind of a longer-term time period, and you can’t identify them in advance. Might as well eliminate manager risk from your portfolio and just accept the market returns. No positive alpha but no negative alpha either.
Here is the full-length version of How to Win the Loser’s Game, the landmark documentary serialised on SensibleInvesting.TV from August to October 2014.
80 minutes long, it contains interviews with some of the biggest names and brightest minds in the investment world.
The aim is to provide ordinary investors with the information they need – and to challenge the industry to offer consumers a fairer deal.
https://www.youtube.com/watch?v=SwkjqGd8NC4
What’s your view on passively managing individual stocks? Commission fees are low nowadays and it seems there should be a very large benefit from tax loss harvesting, allowing you to postpone capital gains until the very end (or never with a stepped up basis.) My thinking is that if for example 60% of stocks in an index go up and 40% go down over a period of time for a modest gain overall, there is no TLH opportunity from an index fund but a substantial one from a passive stock portfolio.
I think you can probably get enough tax loss harvesting just using a few funds. I think the additional risk is worth the very minor benefit available from tax loss harvesting individual positions. This, of course, only applies in a taxable account.
“Losing game” depends from individual to individual. Averages mean nothing at the individual level unless you fall within that section. The average American household has $6000 in the bank – this means nothing to our house hold. The average retirement fund in America of $102000 – this also means nothing to our household. The average household credit card debt is $7200 – this means nothing to our household either. Most of these “averages” don’t apply one bit to our household so I don’t need to bother with them. Mutual fund results cannot be compared to self directed individuals investing in stocks either… they operate under two very different contexts. Picking individual stocks has been working fine for me since I first started in 2005. 85% of my portfolio is in individual stocks. The rest are index funds and one mutual fund in the retirement accounts. The index fund portfolio has been a drag on the over all portfolio and I would have gone to individual stocks any day if I could. In my context, there is no convincing reason to go index funds when I’m doing much better with individual stocks.
Isn’t it interesting when someone else tells you what you should or should not enjoy or that what you enjoy is “stupid” because of the way *they* do it as if everyone does it that way (which is nothing close to what I do)? I enjoy investing and the process of going through investments, reading reports, 10Qs and 10Ks, articles, watching documentaries etc. I enjoy investing…it’s my second favorite hobby after programming. I’m a software engineer and my wife is a fellow. I don’t know why enjoying investing is “stupid” because of the way the author does it. My wife is a good saver but she isn’t interested in investing one bit… she doesn’t even know what index funds are. Before we got married, her retirement accounts were all cash. I think the vast majority of folks who do not enjoy investing like the author should maybe just stick with index funds. They are a great vehicle for investing if someone does not want to bother themselves with the finer details. It doesn’t make sense for me to change from something that I enjoy and has been working quite well.
I think you’re what we would call “the exception that proves the rule”. Of course generalities don’t apply to every single person. This reminds me of people who think there’s no obesity problem because BMI is indicative of health in bodybuilders.
The question is: does the amount of effort/time you put into investing match up to people who do it professionally and with better support/technology, such that you can extract value out of the market that justifies the cost?
Error: that should read “NOT indicative of health in bodybuilders”
>> does the amount of effort/time you put into investing match up to people who do it professionally and with better support/technology, such that you can extract value out of the market that justifies the cost?
I don’t see it as a cost. I enjoy doing this. I do this for time-pass. Sometimes the first thing I do in the morning in bed is to scroll through mobile apps reading through news and other investment alerts. I don’t know why people have to associate a cost to something you enjoy doing for relaxation? Is this unheard of??? I love playing chess. Does that mean I should consider the time I play chess and watching chess videos as a cost? I love programming too… I program at work and I program at home. Should I calculate the cost of programming at home and consider it not worth it?
Okay. So you would continue to spend your free time researching stocks even if you were convinced that you were subtracting value from your portfolio? Really? That’s a worthwhile hobby to you? Call me skeptical. If it is true, then you surely must realize how rare you are.
If I would be making more money through index funds, then I would have definitely been putting most if not all my money in them. As my portfolio stands right now, the four index funds I have in our portfolio S&P500 (FXSIX),international (FSSIX), midcap FSEVX and US total bond (VBTLX) from my wife’s OPT have pretty much been a drag on the overall performance. It’s just 15% though so I’ll let it ride. I actually didn’t want to put any money in internationals for quite sometime because everyone knows and has known that international developed have been in horrible shape since the EU crisis began years ago. But I didn’t have much of a choice and still don’t because the S&P hasn’t had a major correction and emerging markets index funds are horrible and have been horrible for the last few years but I’m sticking to it for the sake of MPT and there’s plenty of time for retirement. If I could hold individual stocks, I would find good companies that have corrected some ~35% to 25% with along with their sectors and scale in overtime if it gets lower. Even if I stopped putting money in individual securities, I would still keep going through financial statements and articles because it’s always interesting what you will find in them. I just received hard copies of the annual reports from DIS, COST and WBA which I’ve be going through this weekend. I regularly interact with many other people on various forums who enjoy the process of researching companies and discussing about companies. Sounds like an alien concept here. It’s fine if anyone is skeptical. My wife is fine with me pouring over financials because she thinks it’s a productive use of my time while she’s busy with her residency and now fellowship. I’m not really bothered with convincing anyone with anything because whatever I’ve been doing has been working out for me for quite some time
Sounds like a really enjoyable weekend. I taught myself how to snowboard today. That sounds less painful to me than reading annual reports from WBA, whatever that is. But I’m sure lots of people think my hobbies are dumb.
I’m glad your investing strategy works for you. Assuming that’s true (and I have no idea if you actually know how to calculate a return or even if you’re being truthful in your statements) consider how generalizable your strategy is. For example, what are the odds that your wife would enjoy spending a weekend pouring over financial reports? How do you plan for her to manage her money when you’re gone?
Sorry, off topic. There is a great youtube series of short clips on learning to snow board, ?ski school? i cant remember it was years ago but simple and quick. Best part was not over doing the moves, lifting toes up and down (like squishing a grape) to maneuver. Did that because i almost broke everything the first time I tried it, had a great day after those videos.
Yea, I’ve had about 4 days and I’m doing black diamond groomers, so I’m feeling pretty good. Still hurts to catch an edge though. The hardest part for me is actually the flats. If it’s steep enough that I’m just carving from edge to edge, it’s really the same thing as skiing. But skiing on flats is simple, not so on a board.
Flats and false flats up where you are wishing you had some poles.
>>For example, what are the odds that your wife would enjoy spending a weekend pouring over financial reports?
Oh, we have fun alright… we’ve probably traveled some $20,000 bucks worth of free travel through airline miles thanks to the wonderful credit card industry. We just did a round trip to India and came back from my sister’s wedding. We travel atleast once a month over weekend to some place. She’s in orthopedics and it’s very demanding as a resident and fellow that requires her staying up late and studying and when she does, I get my “me-time” to do things I enjoy. Win-win situation 🙂
>>How do you plan for her to manage her money when you’re gone?
That’s a big thing on my mind… anything can happen to me at anytime. Once she gets a job (she finishes her fellowship this year), the loss of income from my side won’t matter. I take care of all the finances and try to keep her involved and in the know. I have a consolidated spreadsheet where she can access all this information, her student loans, our credit cards, insurance, due dates, amounts, utility accounts, frequent flyer accounts, taxable brokerage, ORP, 403b, 457, IRA, Roth IRA, secret questions, credit monitoring and report accounts etc. There are some 50+ individual accounts to track. Once a month I get her to sit with me and go through our Mint and Personal Capital accounts which are great tools to have a holistic view of your finances and track your assets and debts. I have her go through every transaction and watch the saving/spending/networth trends. It’s interesting for me but she has become complacent by depending on me for everything which is fine for now. We are close with our families and trust worthy. I’ve told her if anything happens to me, have her sister or father sell all the stocks and funds. But I will have to come up with a full blown plan on what to do after that – have her consolidate bank accounts, cancel credit cards etc. For investments, I’m leaning towards having her just putting everything in a low cost target date fund. She won’t need that money for a long time and she is very frugal. Worst case, there’s family we are close with and trust – her parents and sisters, one of which is good with money can guide her.
If you can pick stocks better than an index fund, why not open a mutual or hedge fund and make billions? That is the question you’ll need to answer yourself. For most people, the answer is one of the following:
1) You’re not actually beating the index fund. Either you are mistaken, don’t know how to calculate a return, or are lying.
2) You’re not actually beating the index fund once you account for risk.
3) You simply got lucky over a decade.
4) You’re not sure if you’re lucky or skilled.
5) You didn’t actually beat an index fund once you account for the value of your time.
You might want to also consider what your instructions to your wife will be in the event of your untimely death.
If picking stocks works for you, knock yourself out. No skin off my nose. I don’t make more money either way. But at least be familiar with the data about the vast majority of stock pickers, whether you want to believe you are in the tiny minority of those who can outperform the indices on a risk-adjusted basis after costs and taxes or not.
I dont think its impossible to beat an index over some period of time. There is however heavy discounting of luck, and usually when risk adjusted it of course goes away. Most people dont concern themselves with risk adjusted returns, theyre just happier if they did well…but it matters. I’ll take the higher risk adjusted returns, and if you can guarantee low volatility throw that on as well.
Oh, it’s far from impossible. Someone will do it. Good luck identifying them in advance.
Its our personal bias to confuse success with skill though and totally discount luck. Thats why many veterans say the most dangerous thing for an investor to experience early on is wild success. Gives them a sense of skill and ability that is likely systematic and random in nature.
I mean was there a method of investing that did not work between 2011-2014? Not really. Likewise the last year and a half has been tough on everyone, especially active investors. Some of the smartest guys with long term excellent track records got absolutely demolished. Never confuse a bull market with skill.
IMHO, volatility works in favor of the long term investor who is looking to buy fundamentally sound companies at a good price. Some of the best buys I’ve got were during market overreaction and panic. Amazing returns. They were clearly market over reactions but the market and analysts are very short term so there are tons of mispricing that goes on in the market over the short term. It doesn’t have to be skill…. maybe some discipline and having the stomach to go through big moves in securities. Some of the “smartest guys” you refer to are professional money managers. But they cannot be compared to the average investor as they operate under strict regulation, have different goals and investing asset class rules and are responsible for other people’s money. Hedge funds have gone broke because of high leverage plays that went the other direction or the shorts that haven’t worked inspite of everything they do spread fear.
As Peter Lynch said, you just need 5th grade math to analyse stocks.
That’s why it is so easy to beat the market, because so many of us have taken fifth grade math.
Yeah, Peter Lynch clearly doesn’t know what he’s talking about.
I agree.
And yet he chose to retire early. If he kept going would the Magellan fund revert to the mean or worse the way Legg-Mason’s value fund did?
Lynch is often quoted out of context. He did encourage people to observe consumer trends. But he also said that beating the market took all of his time. He studied company reports many hours daily. It was stressful and took all the time away from his family. He reached FIRE and quit while he was ahead.
>>If you can pick stocks better than an index fund, why not open a mutual or hedge fund and make billions?
That’s like saying if I can do my lawn and garden better than the average household owner, I should start a lawn and gardening company and make billions. And like I said and you should already be knowing, mutual funds and hedge funds operate under very different contexts.
Sure, I know there is a bunch of luck involved shortlisting companies after going through fundamentals, company filings and analyst reports to identify companies that I can expect to grow sales and make profits over time even if they face blips during certain periods. I’m lucky that there is really good management in some of these companies to navigate through the most dynamic and unstable operating environments – domestically and internationally. I’m lucky that MCD crashed by some ~10% after a bad earnings report in late 2012 and I could buy it at 52 week lows because it was still having great operating cashflow and making profits. I had to wait 3 years while collecting north of 4% dividends to see it go from nowhere to ~40% within the last 3 months. I’m lucky that some of the companies I own have been doing very good over the years and there are great opportunities to buy them at a discount when the market over reacts due to some panic – like Taper Tantrum in 2013 sending blue chip REITs down by ~30% to 40% or Malaysia airline disaster 2 and Ebola sending cashrich, profit growing airline stocks like ALK, DAL and LUV down by ~20% to ~30% in a matter of 3 months back in 2014 inspite of the declining oil trend that started early in the year. The share price of some of those airlines grew between ~60% to 90% in a years time from that market panic. It should have been an obvious buy because everyone knew that Malayasia 2 and Ebola in Africa have no impact on domestic travel here in the US with some of these companies that were growing sales and profits QoQ for some 3 to 4 years straight. I work in the IT industry and knew when a famous hedge fund manager announced his DLR short crashing it down by some 40% during taper tantrum, that was a golden opportunity to grab a bluechip REIT in the data center business at a massive discount with a ~6% yield at the time. 3 years later, it’s not only recovered but reached all time highs thanks to the low interest rate environment and the bright future in the cloud business from those lows and has grown dividends and Free cashflow from operations QoQ. Everyone in IT even as early as 2010 knew that cloud was the future of computing and data centers would be at the heart of it. AAPL declining by ~40% from Sept 2012 to Mar 2013 because of rumors and not beating inflated analyst expectations inspite of having a cash pile that could buy a few countries in Europe and revenues every quarter that could bail out greece a few times over. Or one of my favorites – individual stocks tanking because a govt. shutdown fear – great stocks like CVS and WAG (now WBA). Even the oil decline has given further opportunities cash rich refiners like PSX which slumped along with E&P and integrated super majors but quickly recovered early 2015. When oil was declining and below the 50/bbl market, one look at their quarterly cash balances, free cashflow, sales and losses with debt due should have made it obvious who would in a tight spot. Even the August correction last year brought us some great discounts in blue chip cash rich companies bringing their prices lower than historical PE averages showed… healthcare companies like JNJ, MDT, CVS. In the short term, there will be a lot of noise, market overreaction and panic in the market that will present opportunities to buy fundamentally sound companies that have good management at discounts that investors can scoop up.
So yes, you have to do a lot of research and hope for a ton of luck in finding opportunities and hoping those work out over the long term. It doesn’t matter if the shareprice goes down when the company is fundamentally sound. That’s what the market does every day – offering you a price for the company you hold. It helps that you have plenty of cashflow to buy companies that are victims of these market over reactions and panic. Those are the best times to buy. People are free to invest the way they want and to find what works for them. It’s good that there are vehicles like index funds for people who do not find investing enjoyable or interesting.
TLDR.
You typed all that into a comment box on a blog? Why not submit a guest post if you’re going to write that much? That middle paragraph was a thing of wonder.
I actually had more in mind 🙂 I usually write in notepad. This isn’t much compared to the other forums I discuss in.
You should blog. You obviously have plenty to say. Who knows, maybe it’ll be really popular.
I actually did want to… to post my thoughts on some of the companies I have on my watchlist, portfolio and other micro/macro events but once I got married, I had to keep more time for my wife and family stuff with her timings and needs in mind. I used to run a programming blog and that got really intense and demanding. Had some 15K readers monthly. Readers develop expectations and you need to write really solid stuff. Was good and worth it. But really demanding.
I agree that blogging is too much work. But submit a guest post to WCI. He is open to it. And the rest of us can learn something.
I think there are great arguments on both sides of the indexing debate.
I have always had most of my “serious money” in passive index investing. Even back 25+ years ago. It was key to my financial success. But I have “beaten the market” on a ton of trades. My B-school profs used to ask me tips and several profited from it. It can be done.
Enron never had that great of fundamentals. George is right though, humans are still emotional and that emotion can be displayed during panics. In my opinion, if you’re going to try to do individual picks, it has to be very, very passive. The strategy that has consistently worked for me is keeping an eye on my (well researched) watchlist of companies and buying in during pullbacks. It requires a lot of patience though, as sometimes I will only make a few buys a year, and I have yet to sell any positions as I do focus on dividend stocks and hold for that. I wait and go for opportunities like George mentioned. Am I talented and can I run a billion dollar fund? Hell no. This type of strategy requires strict patience and my outlook is about 30-40 years so I can definitely wait for these opportunities to pop up. I’d probably get fired! Can I analyze a business, judge it’s fundamentals and management, make a decision and then wait for the right time to buy and scale my position? Hell yes. Plus I can reinvest dividends. The alpha over the long term has really made it worth it so far.
Why can’t your winning strategy be scaled up? Either it isn’t a winning strategy or it can be scaled up, certainly to a mere $1 Billion.
It sounds like you’re actually measuring your returns and that you’re actually beating a reasonable benchmark index fund. Why refuse to run money for others? Why not take your incredibly rare talent and use it to enrich the lives of those you care about?
You need a like button WCI so I can agree with you
//It doesn’t matter if the shareprice goes down when the company is fundamentally sound. // I used to think this way until Enron failed with great fundamentals.
It turns out that it’s just like WOPR said in 1983, “a strange game” in which “the only winning move is not to play.”
I’ve been through 35 tax seasons and seen my share of schedule D’s every year. Only 1 client in all that time consistently made money picking stocks (and he didn’t “beat” the market). Just 1.
As for a “fun” account, I have no problem when someone wants to set up a side account with a couple thousand dollars and play, same as they would limit themselves on spending $xx at craps in Vegas. They understand it can go to zero and it’s like buying a few lottery tickets – you might get lucky. (full disclosure – never bought a lottery ticket, can’t stand Vegas, don’t “play the market). I get that it’s a fun activity for some. Otherwise, I agree with WCI that investing your retirement account is not a “hobby” that makes sense.
Among all the comments and even more than the post itself, I found this comment to be the most persuasive. People might claim what they want anonymously on internet but there is no hiding from naked numbers when filing taxes.
And if you really want to double down on stock picking, fill your 401k with the stock of your employer. That way, if your company goes belly up, you not only lose a job, but you’ve lost your nest egg, too.
I found the language and a little harsh here. I do list “investing” as a hobby. Patients, friends, acquaintances see it listed about me and it is a conversation piece. On interviews, it has been used as something to talk about. I enjoy learning about investing, financial planning, and many other things. I do not enjoy boating. At all. Again, I think the words used to describe what I like to do with my time were a bit coarse and insensitive today.
#loveoneanother
Individual stocks are one way to “beat the market” but that’s not easily done without luck and/or illegal insider information. Yes, it can happen. No, it doesn’t happen for most. Professional fund managers fail to beat the index funds (which have very little turnover btw) at least 75% of the time year after year.
The main reason I avoid individual stocks is the fact that you have to make so many decisions to manage a portfolio of individual stocks. “Is it time to lock in a big gain? What if Apple keeps climbing after I sell? Should I cut my losses? I should’ve gone with my gut feeling last week.” I don’t need the stress and regret that would go along with hundreds of microdecisions throughout each and every year. If you enjoy it, go for it. It’s your money and your life. I’ll be more than content with my Vanguard index funds. A little rebalancing here, tax loss harvesting there. I won’t beat the market returns, but at least I’ll get them.
If you’re going to do it you have to have a solid plan so there is zero thinking and things are on autopilot, thinking too much in the moment especially is a recipe for disaster in an already tough discipline. Have strict cutoffs for wins and losses. Even on indices I will use a trailing limit stop loss, anything beyond a 7% loss take a large gain to come back from. Nothing wrong with taking a profit, and nothing wrong with cutting your losses. Live to fight another day. I get stopped out of positions all the time (i have since moved to mostly indexing as its a better time tradeoff), its nice as it removes emotion. Also when things get screwy and dont make sense you need to just quit and reassess.
There was a good recent article about how the 80/20 principle applies to indices and stocks as far as advancing/declining the indices forward and weighting. Look at this year, a literal handful of stocks covered up a full on bear market in almost every other sector. Also a great article about how its hard to tell if youre just in a draw down or your system just plain stops working. Too much to worry about and you’re not really compensated for it to the degree you should be. Even though there are some who have consistently beaten the market over longer time periods, the sobering reality is the number of them that exist is wholly predicted by random chance given the number in the game. Not too mention the amazing set up they had as they all hail from the best investing period ever, 1980s-2000 (bull in bonds/stocks).
I have thought about the “fun” money, but in order for it to be a safe positioning size, even if you hit an absolute home run, it wont make much of a contribution, so I rather just put the whole to work.
I would list finance as hobby, not sure about investing as thats somewhat an action in the larger world of finance.
Warren Buffett just bought over billion dollars of Phillips 66 stock. Is he a loser?
Buffett is not trading stocks, he is investing for control of PSX. That is not what WCI was writing about.
I’m not sure you understand what this piece is about. If you are Warren Buffett in disguise, feel free to continue to pick individual stocks. Or you can take Warren Buffett’s investing advice:
I mean, you can pretend you’re Warren Buffett or you can just take his advice like I do.
Time will tell. He lost the crack spread when congress allowed selling of crude which was a huge built in profit during such times as now. He is buying a controlling stake and who knows what his ultimate plans are. This is not something achievable or that average investors (by investment stake size) should replicate.
Boating and stock picking – both can lose you big $!!! :O) Of course with only one, can you win big.
For the record, my stock portfolio is about 50/50 between individual stocks and ETFs. I haven’t had it long enough to really provide good metrics, but so far my picks have outperformed my ETFs. What gets me is I am not able to make large monthly contributions so at my amounts the commissions on individual stock picks hurt. All my dividends are reinvested back into the companies they came from.
You will never recoup your investment in a boat (will unless you are a classic boat collector and buy low, sell high). I don’t own a boat, but a Travel Trailer does own me. :O) If someone enjoys it and they have the funds to risk and recover, why not. A good boat is around $35K, I’m guessing. That would equal a lot of purchases on stocks by the way. Yearly maintenance, $1000? Interest on the loan, $700. Cost for trips to use the boat: $300/each. So maybe $2500 a year plus the original purchase price. That is a lot of $ down the drain. But you enjoy it and can afford it.
If you enjoy it and can afford it, why not be a stock picker hobbyist. We all waste money on things here and there, some more than others. And you could make an argument, but this is your retirement account. And they could make the same argument so was your boat. :O)
Everyone has to determine their own risk and satisfaction level.
cd :O)
Sure, if you get as much joy from picking stocks as wakesurfing, feel free to waste your money picking stocks. Odd argument but there are a few people out there who would rather research and pick stocks than do anything else with their time and money I suppose. But it would seem to me you could get just as much joy out of a play money account of a few thousand dollars while keeping your serious money invested in a manner consistent with the evidence.
Sure is!!! The only chance an individual has is with a concentrated portfolio of no more than 20 and LOTS OF LUCK
50% chance buying at right time and 50% chance of selling at the right time, NOT GREAT ODDS
Again back to the lack of financial literacy
I am like similar poster. Have an account that is “play” and is not a huge component of my portfolio. It can sometimes be “fun” or interesting, but I also tend to buy and hold longer in more stable, sound companies. I wouldn’t ever label myself a day trader, even with this portion. Has been doing pretty well;at least until lately, but then again so is the rest of portfolio. For now I feel more and more comfortable with index funds, cause who truly knows what the heck is gonna happen, and history is always the best teacher.
My favorite part of this post is your underhanded shot at all the people you give you crap about your boat.
Nah, but it might be a similar amount of money being spent and one seems a lot more fun to me.
First of all, I think indexing is a good way to invest. But it’s not without its faults.
http://www.forbes.com/sites/rickferri/2012/12/20/any-monkey-can-beat-the-market/#170dbf776e8b
Rick Ferri, in the above link, goes over evidence that randomly selected 30 stocks from the 1000 largest US stocks every year from 1964-2010 beat the index by an average of 1.7% per year. The 30 stocks were equally weighted. If one randomly selected 100 such portfolios each year, 98 out of 100 would beat the index. That ignores costs and taxes.
Perhaps we should ask Rick to stop by and comment about the intent of that piece. As I recall, the point of that example is that randomly selected stocks have a higher expected return than the overall market because they are higher risk- smaller and more valuey than the market average. If you adjust for that extra risk, there is no free lunch there. There are funds that do this-equally weight stocks. Unfortunately, their costs and turnover are such that there are better ways to get the same small and value tilt while keeping more of your money.
Your post is why stock picking is a bad idea. Stock picking is another name for security selection. The expected return of security selection is zero. After costs, it’s less than zero.
As you point out, small and value do beat the market. I agree that the small premium is a risk premium in part. IMO, some of the small premium isn’t a risk premium though. For US stocks from 1926-2012, the first decile had a return of 9.28%; the second decile had a return of 11.04%; subsequent deciles had similar returns as the second decile, except as noted later. Large institutional investors have to buy those large stocks due to liquidity constraints. One example of such investors are index funds. As pointed out by Rick Ferri, the largest 30 stocks of the top 1000 US stocks are 40% of the market cap of the 1000 stocks; those 1000 stocks are 90% of the total US stock market. But when you get to the two smallest deciles of the US stock market, expected returns increase. Also, costs increase in the two smallest deciles; it’s not easy to overcome that cost hurdle.
About the value premium, there are those who believe that it’s a risk premium. But those who believe it’s solely a risk premium are few. Commonly, a behavioral explanation is invoked. And there are reputable economists (Lakonishok) who provide good data that there isn’t a risk component to the value premium.
I make a link to an interview with Joel Greenblatt later in this thread. He makes the case that equally weighted stocks funds and fundamental index funds are not value funds. Instead, such funds are attempts to correct for the fact that index funds have a tendency to have too many expensive stocks and too few cheap stocks. However, there are funds that do attempt to obtain the small and value premia.
About stock picking, I think a good case can be made for a DIY small cap value fund. Instead of paying someone else to engage in security selection (stock picking), you DIY. Joel Greenblatt wrote a book about that. Several others have replicated his method, and found that it beats the market. In fact, it’s not that difficult to do better than his method. A DIY small cap value fund is able to go smaller than institutional investors can go. And the smaller you go, the greater the value premium.
The following is from the book “Value Investing” by James Montier.
Once again, an equally weighted portfolio of 30 stocks. Stocks are drawn from the world stock market, and must have a minimum market cap of $US250 million. The book was published in 2008, so that would be higher now. Every year, the 30 cheapest stocks are selected. Cheapness is defined using a value composite of P/E, P/B, P/CF, P/S and EBIT/EV. Each of these measures is ranked across the universe. These ranks are then totalled for each stock, and this combined score is ranked to determine cheapness.
Return is nearly 25% pa, almost 15% more than the world stock market. This is for the period from 1986 to 2008. In that time period, the 30 stock portfolio had 3 years of negative returns. The world index had 6 years of such returns. There were three years where the world index beat the 30 stock portfolio. In one year, the 30 stock portfolio underperformed the index by about 18%. In the other 2 years, the difference is considerably less than 5%. Costs and taxes are ignored.
Once again, I’m not saying indexing is a bad way to invest. But as Joel Greenblatt points out in the link below:
” So you actually don’t have to know for a market-cap weighted index whether a company is overvalued or undervalued; you just know if it is overvalued, you are going to own too much of it, and if it’s undervalued, you are going to own too little of it”
http://www.morningstar.com/cover/videocenter.aspx?id=617497
Do you really take investment advice from someone who charges 2.15% on his mutual fund? It seems pretty clear from his actions what his thoughts on individual investors are- that they are a cow to be milked.
http://www.morningstar.com/funds/XNAS/GARIX/quote.html
If he would like to send me a guest post explaining why he thinks it is okay to charge an ER of over 2%, I would be more than willing to publish it.
The funds that use Mr. Montier’s GMO’s recommended Asset Allocation at Wells Fargo are similarly ridiculously expensive.
I buy the data on the outperformance of value stocks, but I suspect expenses like that eat up most of (all of? more than?) the advantage. I disagree with your unstated assertion that you need to buy individual stocks to capture the value premium. That can be done with less uncompensated risk using a good, low-cost, passively managed fund or ETF.
The fund with a 2.15% expense ratio is a long short fund. Minimum initial investment $250K.
Vanguard also has a long short fund. Minimum initial investment $250K. Expense ratio is 1.64%.
A long short strategy is not cheap. There are costs to shorting stocks.
Vanguard states that its mutual funds are 82% less expensive than the industry average.
I certainly don’t think that you need to buy individual stocks to capture the value premium. DFA is a good example where an institutional investor has captured the premium. However, DFA may have been the first “smart beta” fund provider; Vanguard prefers the name “rules based active” to “smart beta”, and I would agree. IMO, a large part (the vast majority?) of the value premium is not a risk premium. The field is much more crowded now. If the value premium isn’t solely a risk premium, the value premium will decrease. As I asserted earlier in this thread, a DIY SCV fund may give better return than a SCV mutual fund/ETF.
There are extra costs associated with this style of investing. But I haven’t seen research that shows that institutional investors have a cost advantage over individual investor. In fact, costs are a reason why institutional investors have difficulty with small cap stocks. Because institutional investors tend to invest larger amounts of money, the bid ask and price impact costs of trading small cap stocks are greater for them. And the smaller the stocks, the greater the value premium.
About uncompensated risk, a 30 stock portfolio will be more volatile than a DFA fund. But much of the increased volatility is upside deviation; that’s the deviation investors like. And if you have a 5 year holding period, volatility is less of an issue.
Are you trying to justify a 2.15% ER? Seriously? Do you really believe a strategy that you have to pay >2% for is likely to benefit your portfolio? Do you really think that strategy is 2% a year better over the long term than a simple index strategy?
Vanguard does lots of things I (along with Jack Bogle) disagree with. Just because Vanguard jumps offers something doesn’t mean it should be bought.
You question Joel Greenblatt’s credibility, on the basis that he owns and manages a fund with a 2.15% ER.
My response was that Vanguard offered a similar fund with a 1.64% ER. So Vanguard is charging 24% less than Joel Greenblatt. But on average, Vanguard states that it charges 82% less than other fund providers.
AQR (Cliff Asness) has a long short fund with a $5 million minimum for individual investors. At present, it has an ER of 1.36%. But that’s due to a fee waiver of 1.04%, which is set to expire on April 30 of this year.
AQR has another fund, QSPIX, which also uses a long short strategy. It has an ER of 1.50%. But that’s due to an expense cap, which is set to expire on April 30 of this year. The AQR website states that net expenses are 2.61%. Larry Swedroe has spoken favorably about this fund; see the link below.
http://www.advisorperspectives.com/articles/2014/11/18/how-aqr-s-new-fund-adds-value-an-alternative-approach-to-alternatives-investing-with-style
It looks like you question whether the expense of a long short strategy is worth it, and I would tend to agree with you. But others have different opinions.
I don’t find your questioning of Joel Greenblatt’s credibility to be persuasive.
How about this argument for his credibility:
1) Joel Greenblatt encourages investors to try to pick stocks instead of invest in an index fund.
2) Picking stocks instead of investing in an index fund is a losing activity for the vast majority.
3) Therefore, Joel Greenblatt gives bad advice for the vast majority.
But, like I tell the whole life diehards, I don’t have dog in this fight. It really doesn’t bother me if you want to spend your time and money picking stocks. If you love picking stocks and your data shows you are talented at doing so, feel free to continue to do so. Just realize that your talent is so rare you should be managing billions and making 8 figures a year doing so, rather than trying to eke out an extra 50 basis points for your own 6 or 7 figure portfolio.
Joel Greenblatt
“Most people have no business investing in individual stocks on their own!” I agree with that.
“If you want to do as little as possible and you don’t mind doing average, an index fund could be a fine choice” Actually, you’ll end up doing better than the average investor.
“I believe that if you are able to stick with the magic formula strategy through good periods and bad, you will handily beat the market averages over time.”
He doesn’t consider his method as picking stocks, and there’s some truth to that. He’s not proposing a method to pick stocks individually; he’s proposing a method to pick a group of stocks. I would tend to argue that whether you’re picking stocks individually or picking a group of stocks, you’re still engaging in security selection though.
The goal of his method is to obtain the small cap value premium. That’s similar to the goal of DFA, Bridgeway and some of AQR’s funds. In backtests, the small cap value premium results in beating the market. In practice, DFA has shown it can be done. Larry Swedroe has presented data that DFA funds have beaten their Vanguard index counterparts by 1.5% annually on average. Now that doesn’t include the advisor fees and probably higher tax bill of DFA funds. However, it doesn’t take into account the fact that DFA can’t go as small as individual investors can. And the smaller you go, the larger the value premium. Also, it doesn’t take into account that DFA funds are highly diversified. That results in less volatility and enables DFA to have greater capacity. But it also dilutes out the small cap value premium.
What Joel Greenblatt is advocating is a DIY small cap value fund, as opposed to buying a small cap value fund.
Is that a good idea? Investors show a behavioral gap of about 2% in their returns; they tend to buy high and sell low. Those who purchase and sell value funds show a behavioral gap also. So if buying index funds results in buy and hold behavior and the disappearance of the behavior gap, then index funds are preferable.
Also, a DIY small cap value fund requires greater knowledge and work by an individual investor. I can understand if someone says they don’t want to spend the time on a DIY SCV fund. About the knowledge aspect, I have a different opinion. Unless you are one of the few physicians who is getting a good sized pension, you are on your own when it comes to retirement. You may have an advisor, but I still think that you should spend a significant amount of time learning about personal finance. That’s regardless of whether you want to index or buy SCV funds or have a DIY SCV fund.
As all methods of investing do, index investing has its strengths and weaknesses. An example would be at the end of 1989. By market cap, the world stock market consisted of 41% Japanese stocks. At that time, the Japanese stock market had a PE10 of greater than 90. The results of the Japanese stock market since then have been very poor. The problems of stock market bubbles and secular bear markets is why I am no longer an index investor.
About the comment regarding rare talent and managing billions, I think I’ve addressed that issue earlier in the post. An investor who decides to create a SCV fund and make 8 figures a year doing will find that others (DFA, Bridgeway, Vanguard etc.) already are offering SCV funds.
Index investing is a good way to invest. As long as you stick to low cost funds, you will beat the average investor.
I think you’re understating the case for an index investor. Not only will you beat the average investor, you will beat the vast majority.
Designing and running your own SCV fund seems foolish to me. First, what about all the other asset classes out there? Or, are you going to just buy SCV stocks and be dangerously undiversified. Second, what about the value of your time. Let’s say you’ve put 10% of your portfolio into SCV stocks. Let’s say your portfolio is a million bucks. So we’re talking about $100K in SCV stocks. Let’s say by doing this yourself instead of just buying a SCV fund you can boost your returns by 1% even after the additional commissions, spreads, and taxes. So instead of earning $10K, you earn $11K. Now, how many hours have you spent doing this in the previous year. Let’s say 2 hours a week, or 100 hours a year (you took the weeks of Thanksgiving and Christmas off.) Well, that works out to be about $10 an hour. “But I enjoy this so that doesn’t count.” Okay, that’s fine. Have a good time. But advocating that physicians do this, most of whom don’t know the difference between a 529 and a Roth IRA, is a huge stretch in my opinion. Third, even if you run your own fund and pick 20 or 30 stocks for it, you’re still running uncompensated risk compared to the fund.
http://greenbackd.com/2012/05/07/how-to-beat-the-little-book-that-beats-the-market-an-analysis-of-the-magic-formula/
“In Does Joel Greenblatt’s Magic Formula Investing Have Any Alpha? Meena Krishnamsetty finds that the Magic Formula generates annual alpha 4.5 percent:
It doesn’t beat the index funds by 18% per year and generate Warren Buffett like returns, but the excess return is still more than 5% per year. This is better than Eugene Fama’s DFA Small Cap Value Fund. It is also better than Lakonishok’s LSV Value Equity Fund”
Wesley Gray, in his book “Quantitative Value” finds that a simplified version of the Magic Formula (just EV/EBIT) beats the Magic Formula by about 2% yearly.
James Montier also backtested the Magic Formula; the link is given below.
He also finds that the method beats an equally weighted (not market cap weighted) stock universe, and that the simplied version of the Magic Formula (EV/EBIT) was overall better than the Magic Formula.
http://www.poslovni.hr/media/forum-user-upload/files/9a/9a5c2b2f55b461120e8d01095cf09a34.pdf
You’re using the wrong verb tense. When using back-tested data, you should use “beat” rather than “beats.” And that’s really the rub, isn’t it? Is this “formula” simply a reflection of torturing the data until it confesses, was it a worthwhile formula that now won’t work that everyone knows about it, is it a reflection of a value tilt that gives higher returns although at higher risk, or it is something I can really stake my retirement money on? In the words of Dirty Harry-“Do you feel lucky, punk? Do ya?”
About how much SCV should be as part of one’s portfolio, I leave that question unanswered. If a person would like to look into that more, there are MANY threads on the Bogleheads forum about it :-).
As to the amount of time spent and how worthwhile it is, each person answers that question themself. There is a significant amount of time required to learn about this. I wouldn’t just read Joel Greenblatt’s book and start your own SCV fund; there are other books that you should read on the topic. And a DIY SCV fund should only be started after you’ve spent a considerable amount of time learning the basics of personal finance. But once you’ve spent the time on learning, the subsequent amount of time required is much smaller. It’s doesn’t require much effort on a yearly basis. And if your investment horizon is decades, the total amount of time divided by the number of years won’t be large.
About uncompensated risk with a 30 stock portfolio, you are right. That is if you’re using the finance definition of risk, which is volatility. But whether that is the most appropriate definition of risk is debatable. Much of that volatility is upside deviation, which is the kind of volatility investors like. And if you’ve got a longer time horizon (5 years or more), volatility is less of an issue. IMO, a good way to deal with risk is to have more money. Warren Buffett is a very rich person. If he lost 99% of his wealth, he’d still be a very rich person.
Do you have any idea how small the percentage of physicians is that has any idea what you’re talking about? It’s similar to the number who own their own real estate investing company. I mean, this is lots of fun to argue about for you and me, but if you’re going to write a post giving advice to the average physician, even the average physician who reads WCI (who is way ahead of the average physician) are you really going to recommend a DIY SCV fund?
My eyes are glazed over. What is going on here?
Historical small cap value and out performance is largely due to changes in definitions and compositions of indices over several decades time to consolidate exchanges and such. This is artificial and has nothing to do with out performance as a reflection of underlying fundamentals of a business.
You would like the blog called philosophical economics, he goes into eye watering detail about lots of these things. Absolutely excellent recent pieces on momentum and back testing recently.
You have to be careful with back testing, and of course the further you go back the less it applies since accounting, market structure, globalization, trade, taxes, ability to actually pursue strategy (aka actually buy, etc..) and information dissemination start to drift far away from today. Translation, the less likely your back test works going forward.
Its easier and cheaper than ever to short something, and even safer. Sure you could short individual stocks but there are etfs for almost any dumb idea someone has to short sectors, commodities, and indices. Leveraged products can be a disaster in a volatile market, even if you’re directionally right. One neednt pay a 2+% ER to short, and can do so in a “safer” manner.
The other problem is telling the difference between a draw down and your system having the alpha ripped away from it. There were actually a couple new articles showing that indeed academic finance papers do notice factors and shortly thereafter is evidence of investors piling in and obliterating it, which is happening faster than ever given how quickly we get info now.
Interesting stuff.
“You’re using the wrong verb tense. When using back-tested data, you should use “beat” rather than “beats.” And that’s really the rub, isn’t it? Is this “formula” simply a reflection of torturing the data until it confesses, was it a worthwhile formula that now won’t work that everyone knows about it, is it a reflection of a value tilt that gives higher returns although at higher risk, or it is something I can really stake my retirement money on? In the words of Dirty Harry-“Do you feel lucky, punk? Do ya”
You’re making the case that this “formula” is an exercise in data mining. I beg to differ. It’s just another way to access the value premium, and the simplified version of EBIT/EV may be better than price/book , with the latter being used by DFA. See “Quantitative Value” by Wesley Gray, if you want more detail.
Will it work now that everyone knows about it? That’s a very good question, and it applies to anyone using quantitative value methods. If it’s risk based,
the returns will persist. If not, and I tend to think there isn’t a risk component, it will decline. However, I doubt it will disappear. The behavioral problems that result in the value premium will persist IMO. How do you otherwise explain Amazon having a PE ratio of 405? I think the value premium will more likely persist in small and microcaps. Institutional investors have trouble going there, and it can be very difficult to short stocks in that space.
Also the more investors put in index funds, the more likely that the small cap value premium will persist. Index fund investors are going net long on each of large caps, growth stocks and momentum. The more money invested in large caps, growth stocks and momentum stocks, the less will be invested in small cap and value stocks. The less invested in small cap and value stocks, the lower their prices will be and the greater their expected returns.
About whether the value premium is a risk premium or not, I’ve talked about that above. I don’t think it is, although there is a least one Nobel laureate who would disagree with me. I have heard the argument made that it may or may not disappear, but even if it disappears, you won’t lose much by trying to obtain it.
I have also heard the argument that a SCV tilt may not returns, but it may diversify an index portfolio. VTI, Vanguard’s total US stock market index fund, has 3757 stocks in it. On the surface, it looks much more diversified than an S&P500 index fund. But the diversification of the extra 3257 stocks is an illusion. Returns, correlation and volatility are very similar for the two types of funds. As mentioned previously, an index fund is net long on large caps, growth and momentum. A SCV tilt diversified away from that. Examples where diversification through value investing helped investors include the 1974 and 2000 bear markets. It didn’t help in the 2008 bear market. And it didn’t help in the bear market starting in 1929. However, there was deflation of about 25% in that bear market. Value companies tend to be more highly levered, and such leverage will hurt you in times of deflation and help you when there is inflation. With the adoption of fiat currencies, deflation is not a major risk IMO. And there is evidence that value investing, in the Japanese stock market from 1990 to 2011, resulted in reasonable returns when the whole stock market was tanking. See the link below.
http://greenbackd.com/tag/japan/
One point I forgot to mention is the tax advantage of ETFs. ETFs, despite considerable turnover, often distribute little or not cap gains. That is an advantage over individual investors.
You dont diversify stocks with more stocks. Diversification should include an element of non correlation.
Most of these swings that result in premia in value or small caps is the result of behavioral finance mechanisms where things are tossed, and ignored until they start doing so well that it can no longer be so. These type of events happen all the time. It does not mean that you can consistently skim alpha from it, that is much more difficult than it is in backtests.
You keep saying security selection returns are zero, we’ve all taked about this before, you do in fact mean alpha?
The truth is there are now ETFs running value, small caps, momentum, growth of all sizes, any flavor or way you can think up its being done already in an etf form and doing so yourself is just a costly form of replication. If you’re going to do it, just use the etfs, that at least reduces your uncompensated risk. BTW, risk does not seem to have the return it used to the last few years, the risk premium has contracted so there is no benefit to over reaching.
You never know, now may be values time as growth:value is finally turning, but no guarantees. There will be lots of research in the short coming future about PE>100 type stocks and how to assess them and how theyre out performing as of late.
Everyone talks trash about AMZN, without understanding what theyre doing. Once you look at it, it all makes sense. Bezos is brilliant.
Most who own stocks have no clue how they are doing versus the mkt
It’s good for the economy keeping more brokers employed
Incredulous that anyone thinks they are a buffett
Well, someone is buffett, but everyone else, yeah.
Do you think a mutual fund manager or INDEXER (aka drunken person throwing darts) have MAGICAL ABILITY to buy and sell correct stocks from typical holdings of 300-500 securities in a typical mutual fund???
Afterall they are picking up individual stocks for a mutual fund all the time, right?? Well they put some glorified names large cap, small cap, dividend paying, bonds etc but closer look at mutual fund holdings boils down to one and only one thing, ‘Fund manager team is picking up individual stocks’. Worst part is they do this picking again and again in a single year, still tell public to buy-hold-stay course. Do fund managers actualy stay the course, doubtful. For example : Look at TURNOVER RATIOS of Vanguard funds and you will see why MFs don’t walk the talk….
It is much more worst for active VG funds than Index.
Active and Passive Vanguard funds and Turnover Ratio%
———————————————————————————————
ACTIVE Funds
Convertible Securities VCVSX Balanced 85.40%
STAR VGSTX Balanced 5.80%
Wellesley Income VWINX Balanced 109.00%
Wellington VWELX Balanced 71.30%
Large-cap
Diversified Equity VDEQX Stock – Large-Cap Blend 5.30%
Dividend Growth VDIGX Stock – Large-Cap Blend 18.10%
Equity Income VEIPX Stock – Large-Cap Value 33.40%
Growth and Income VQNPX Stock – Large-Cap Blend 133.20%
Morgan Growth VMRGX Stock – Large-Cap Growth 52.00%
U.S. Growth VWUSX Stock – Large-Cap Growth 36.20%
U.S. Value VUVLX Stock – Large-Cap Value 57.10%
Windsor VWNDX Stock – Large-Cap Value 37.50%
Windsor II VWNFX Stock – Large-Cap Value 26.80%
Mid-cap
Capital Value VCVLX Stock – Mid-Cap Value 90.10%
Mid-Cap Growth VMGRX Stock – Mid-Cap Growth 82.40%
Selected Value VASVX Stock – Mid-Cap Value 18.40%
Strategic Equity VSEQX Stock – Mid-Cap Blend 60.10%
Small-cap
Explorer VEXPX Stock – Small-Cap Growth 66.40%
Explorer Value VEVFX Stock – Small-Cap Value 35.90%
Strategic Small-Cap Equity VSTCX Stock – Small-Cap Blend 63.60%
International funds Info
International
Emerging Markets Select Stock VMMSX International 53.70%
International Explorer VINEX International 38.80%
International Growth VWIGX International 20.60%
International Value VTRIX International 37.00%
Global
Global Equity VHGEX International 44.60%
Global Minimum Volatility VMVFX International 49.10%
Sector & specialty funds Info
Energy VGENX Stock – Sector 17.20%
Health Care VGHCX Stock – Sector 20.70%
Precious Metals and Mining VGPMX Stock – Sector 34.20%
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INDEX funds
Large-cap
500 Index Admiral Shares VFIAX Stock – Large-Cap Blend 3.40%
Dividend Appreciation Index Admiral Shares VDADX Stock – Large-Cap Blend 3.20%
FTSE Social Index VFTSX Stock – Large-Cap Growth 14.00%
Growth Index Admiral Shares VIGAX Stock – Large-Cap Growth 32.30%
High Dividend Yield Index VHDYX Stock – Large-Cap Value 11.70%
Large-Cap Index Admiral Shares VLCAX Stock – Large-Cap Blend 8.80%
Tax-Managed Capital Appreciation Admiral Shares VTCLX Stock – Large-Cap Blend 3.90%
Total Stock Market Index Admiral Shares VTSAX Stock – Large-Cap Blend 4.30%
Value Index Admiral Shares VVIAX Stock – Large-Cap Value 24.80%
Mid-cap
Extended Market Index Admiral Shares VEXAX Stock – Mid-Cap Blend 10.90%
Mid-Cap Growth Index Admiral VMGMX Stock – Mid-Cap Growth 63.70%
Mid-Cap Index Admiral Shares VIMAX Stock – Mid-Cap Blend 31.60%
Mid-Cap Value Index Admiral VMVAX Stock – Mid-Cap Value 45.90%
Small-cap
Small-Cap Growth Index Admiral VSGAX Stock – Small-Cap Growth 50.00%
Small-Cap Index Admiral Shares VSMAX Stock – Small-Cap Blend 29.20%
Small-Cap Value Index Admiral VSIAX Stock – Small-Cap Value 47.20%
Tax-Managed Small-Cap Admiral Shares VTMSX Stock – Small-Cap Blend 31.00%
International
Developed Markets Index Admiral Shares VTMGX International 13.00%
Emerging Markets Government Bond Index Admiral Shares VGAVX International 180.90%
Emerging Markets Stock Index Admiral Shares VEMAX International 8.50%
European Stock Index Admiral Shares VEUSX International 6.90%
FTSE All-World ex-US Index Admiral VFWAX International 4.20%
FTSE All-World ex-US Small-Cap Index VFSVX International 13.10%
Global ex-U.S. Real Estate Index Admiral Shares VGRLX International 7.50%
Pacific Stock Index Admiral Shares VPADX International 4.90%
Total International Bond Index Admiral Shares VTABX International 80.70%
Total International Stock Index Admiral Shares VTIAX International 2.70%
Global
Total World Stock Index VTWSX International 7.30%
Sector & specialty funds Info
REIT Index Admiral Shares VGSLX Stock – Sector 10.90%
If you’re arguing that actively managed mutual funds are a bad strategy you’re preaching to the choir. Let me reiterate for those who aren’t clear where I stand (and these are general rules of thumb)
Low-cost, passive/index mutual funds good
High-cost, actively managed mutual funds bad
Picking individual stocks bad
Do you REALLY equate the S&P 500 index with a drunken person throwing darts?
What is the basis of creating SP 500 index from universe of 5000 US stocks? other than market cap of a company?
can anyone explain why market cap of a company is the best Metric to create an index supposed to reflet market. The indexer is just picking red marbles over blue ones. There is no financial rationality/logic involved in that or other cap based indices.
No rationality? I disagree. There are two valid reasons to use market cap.
#1 The market is market capped. If you want the market return, then it is by definition cap weighted.
#2 Cap weighting is very inexpensive and costs matter.
That said, I prefer a Total Stock Market index over a 500 Index for various reasons.
Market cap make not at first glance, but let me tell you it absolutely does if you just give it a second.
VTI-385 billion in assets
SPY-175 billion inassets
VTSAX-385 billion in assets
VOO-200 billion in assets
Thats just a couple of index funds, and there are 503 companies in the sp. Most cover the great majority of the same stocks meaning there is trillions in the sp index funds. The smallest stock is Diamond Offshore Drilling company with a market cap of 16.x million dollars. Lets just say there are 2 trillion dollars worth of funds in SP 500 products for illustrations sake.
2 trillion/503=3.9 billion
An equal weighting index would have 3.9 billion in each company which should be now plainly absurd for not only the smaller companies but the companies that generate that kind of profit every quarter. How would a tiny company absorb that kind of cash? It makes zero sense. Also, this is obviously a lot less money than is in the total US market meaning the issues with allocation are actually worse. market weighting makes sense.
I can’t believe a blog post encouraging physicians (the target audience) to index instead of buying individual stocks is getting such vigorous opposition. Shocking really. I also love the numerous statements of “I bought TYG and SWX and it was obvious I was going to make money”. Funny how no one ever remembers the losers they bought.
what about the Motley Fool Supernova? they have consistently beaten the market in the last 10-15 yrs
The SuperNova service at Motley Fool was started in 2012. Any data prior to that must be backtested. I can backtest some pretty awesome data too.
I stumbled across this blog when doing some research on the rational given for index and smart beta investing. I am an asset manager who manages money for HNW individuals and primarily utilize individual securities. My background is equity and credit analysis, as well as portfolio management. I thought that I would share this so that my bias is clear.
I push back on the growing conventional wisdom that HNW individuals should simply invest passively in market oriented low-cost asset allocation models for the following reasons: 1) Low-cost is misleading because even if your ETF’s or Mutual Funds have expense ratios of 0.10% to 0.40%, most investors utilize a financial adviser who charges between 0.90% and 1.25% to “manage” the allocation. Therefore, utilizing a good and experienced portfolio manager to construct and manage an individual security portfolio can actually be less expense due to the fact that individual securities do not have expense ratios. 2) Along the same vein as the low-cost mirage of passive investing is that fact that most widely diversified passive ETF’s and Mutual Funds do not generate dividend and interest income yields that can compare to such yields generated by a portfolio of individual securities. 3) I contend that it is much more challenging to value “the stock market” than it is to value an individual company. 4) From a behavior finance standpoint, I find that most individual investors’ fear and anxiety about investing lies with the frustration of attempting to understand “the market” and the feeling that it is completely out of there control and random. 5) Along the same lines, I find that most HNW individual investors that I work with gain comfort in their portfolio from having the transparency of knowing what they own, being able to have their holding valued, and understanding security by security, if necessary, what the underlies value creation, such as competitive advantage, growth opportunities, and proven ability to generate superior returns on invested capital. 6) Lastly, the author of this blog throws out stats regarding catastrophic losses associated with individual stocks over time. I have certain experienced such catastrophic losses infrequently over time having managed money through the tech bubble, 9/11, and the financial crisis/Great Recession. However, this is where portfolio management comes into play. One does not need to own the market (3000-5000) equities in order to control stock specific risks. Owning 30-50 equities limits the downside associated with the infrequent permanent impairment that can happen unexpectedly to an individual stock to 2% to 4% of the portfolio. This type of loss is easily compensated for by the higher income yields and higher long-term returns associated with a purpose built individual security portfolio.
I will end by saying that most financial advisers and brokers in business today are not trained and experienced in security analysis and portfolio management and this is at the root of the popularity of commoditized passive or semi-passive product driven investment solutions. One cannot expect thousands of advisers to concede the fees associated with the investment management needs of clients to the small number of professionals who actually manage investments, thus the advent of investment products and model portfolios. The rub is that the adviser fees have not declined over time as those investment professionals managing money for HNW individuals went from managing money to shuffling investment products around in the name of asset allocation. The narrative that caused individual investors to buy into this is that individual investors have been told that they need to try to capture as much “market return” as possible and this set-up the straw man argument that the best way to do this is to simply invest directly in the markets. The fact is that following the markets means following the herd over the cliff every 7 to 10 years, which leads to individuals being scared out of their investments at the worst time and then being shell-shocked and not getting back in until well after the recovery, thus this equates to utter failure and frustration in achieving their desired results.
I find your arguments for taking on the uncompensated risk and additional hassle of individual securities to be weak and self-serving. Your firm charges a wrap fee starting at 2.75% or an AUM fee of 2.5%, which is ridiculously high. As Upton Sinclar said,
I find it very difficult to believe that you can pick securities well enough to overcome those types of fees in the long run on a risk adjusted basis when compared to using low-cost index funds (even when combined with a low cost advisor-not an average advisor charging 1%), and the data would agree with me. Perhaps you’re the next Warren Buffett, but it seems unlikely.
The White Coat Investor,
With all due respect, you mis-represent my firm’s fees. If you are pulling them from the B-D that I operate through from their SEC Brochure, this is a catch-all fee schedule and represents the highest fees permitted by advisers who are associated with the firm. My firm is independent and maintains its own unique fee schedule where HNW investors pay an average annual fee of approximately .90%. I do apologize for a few typos in my post above, however I took the time to post my comments as a counter to, not only your passive investment argument, but to the general tendency of investors today to believe that passive investing is a panacea. I have been managing individual client portfolio using individual securities for 18 years and my comments are based upon that experience that spans two major market bubbles, a major terrorist attack and the deepest economic contraction since the Great Depression. I attribute the ownership of individual securities versus broad market investments as the reason all of my clients were able to stick with their long-term investment plan.
I think that’s a weak argument for owning individual securities. To me that makes little logical sense that someone can stay the course with individual securities but not with a broadly diversified index fund. Individual stocks can and do go to zero, while the market does not (except for a few notable historical examples like Russia in the Soviet revolution and Egypt.) I don’t expect you to agree with me.
Passive investing is a panacea in that it eliminates a number of risks that simply don’t need to be run at all. Like manager risk and individual stock risk.
I am, however, glad to hear you don’t charge clients 2%+. That must be embarrassing to be associated with a firm that does.
The fee schedule that you got your information from is a requirement of regulators who make you post a fee schedule of the highest fees that might be charged. I know of no one associated with this B-D that charges anything like that. If someone tried to do such a thing I would not expect them to have too many clients. Also, please do not try to attack my ethics or character, you do not know me and I choose to operate as a pure fiduciary for my clients, thus not utilizing high cost financial products to make my life easier or selling commissioned investments of any kind.
By the way, I agree with you that occasionally an individual security will go to zero, however that infrequent risk can be easily compensated for by limited the size of an individual security position in the portfolio to less than 4-5%. The other side of the coin is that individual stocks can and do double, triple and quadruple over the relative short spans of time and the broad market does not. I have experienced many more instances of individual stocks rising 200% to 300% during the time that they are owned versus those who go to zero over the last 18 years.
Yes, I’m aware individual stocks go up. I own them all. If it’s publicly traded, I own it.
Don’t give me that garbage about “regulators make us state our fees are 2%+.” I’ve read dozens of ADV2s. There are plenty of them that don’t list a fee higher than 1%.
If you can pick stocks well enough to beat the market on a risk-adjusted basis, why are you working for chump change instead of managing billions? Serious question. Either you have that skill, or you don’t. If you do, you shouldn’t be managing a few million bucks for a few people. If you don’t, you shouldn’t be trying to pick stocks.
Your tone is very antagonistic. The ADV Brochure that you pulled that fee schedule from was created by a B-D/RIA that has hundreds of independent adviser across the country operating under its supervision. It is not practical to put hundred’s of unique fee schedules in the ADV reporting, therefore the SEC advises the organization to simply include a fee schedule that shows maximum fees, not actual fees. Regarding why I don’t manage billions of dollars through a mutual fund, hedge fund or institutional investor, I have been in that world working for a mutual fund as an equity analyst and portfolio manager early in my career and some parts of that work was very rewarding, however I was uncomfortable managing money for thousands of individual investors who I have no personal relationship with. I am much more comfortable and satisfied with a business model where I work directly with investors in order to customize portfolios to meet their unique investment objectives and risk tolerances. I have been told many times that I could make a lot more money managing one portfolio and having it sold to a broad audience. Having done that early in my career, I have decided to put professional satisfaction ahead of maximizing my earning power. My business grows significantly every year, so maybe I will be able to have my cake and eat it to. All the best to you.
I am antagonistic toward ideas I think are dumb. Dumb ideas include trying to beat the market by purchasing individual stocks and paying someone else to try to beat the market by purchasing individual stocks, especially when that person is charging ridiculous AUM fees.
Good luck to you and your clients. I hope you can beat the market after your fees, for their sake.
I will repeat again, I do not even attempt to “beat the market”. My clients have personal benchmarks and I manage to those personal benchmarks, as they are far more relevant to an individual investor than simply resigning one’s self to accept what the broad market has to offer or trying to beat the the arbitrary and unpredictable returns of the market.
I will obviously not change your preference for passive investing and that is OK. However, you might at least give me the benefit of opening up your mind to the fact that HNW investors do not have to chase the markets to achieve their unique investment objectives. They have many other options to generate both income and growth and it does not always make a lot of sense for a HNW investor to resign themselves to utilizing passive market instruments which are available to the broad public whether you have $2,500 or $2,500,000. If you have $2,500,000 you have access to strategies and investments that can significantly reduce your correlation to the volatility and uncertainty of the broad markets.
One other thing that the advocates of index investing should contemplate is the cumulative effect of passive investing. The capital markets primary function is to operate as a capital funding source for corporate entities thought IPO’s and secondary offerings. The price per share that a company can sell its stock for is determined by public investors who set the price based upon ongoing price discovery informed by company and industry specific factors. When index investing began an index was a way to easily capture the performance of a market that was a market of stocks. Today, with an ever greater share a company’s share float owned and traded by passive vehicles, price discovery on a security by security basis is being adversely affected. The transmission mechanism that had always existed between fundamentally driven investors and price discovery is not working as it traditionally had. Instead when a passive investor puts his or her money into an index vehicle there is no assessment being made in regard to which underlying securities deserve to be bid higher or bid lower, they all proportionally get bid higher or lower with each buy or sale of the entire basket.
The only reason that I bring this up is to stimulate thought on the subject. Investing passively in broad market baskets is not underpinned by fundamental price discovery, but instead relies upon that price discovery being done by others. However, according to the staunch advocates of passive investing, everyone should invest passively. If that were to happen the market would cease because there would not be any investors left to perform the necessary price discovery, instead markets would be bought and sold with no regard for the fundamental tenants of investing.
I find that to be a weak argument against passive investing as well. What percentage of investment purchasers need to be active to maintain a reasonably efficiently priced market? Probably less than 10%. What percentage of assets are owned by passively traded funds? Far less than 90%. It’s just not an issue. I fully admit passive investors are piggybacking on the efforts of active investors, but it is still the right move for an individual. The market will never be 100% passive investors, give me a break.
I did not say that the market will be 100% passive, I simply mentioned the extreme situation in order to illustrate that a greater and greater amount of passive investing can lead to a counter-production outcome where price discovery is rendered ineffective. From recent articles that I have read, it appears that of all funds and ETF’s, around 40% are classified as passive. We all know that many “active” funds are indeed closet index funds, as they must not deviate too much from their stated benchmark (one of the reasons why statistically active mutual funds as whole compare so poorly to low-cost index funds). I do not think that it is a stretch to say that at least 50% of equity float is captured by pure passive or closet passive strategies. As a manager of individual securities over the last 18 years I can see the effect that this trend is having on security price movement. The market is much more near-sited than it used to be. In other words the market is not incrementally discounting the constantly evolving mosaic of information and extrapolating future earning and cash flow assumptions into the current price of the security. Instead prices now move much more abruptly up or down based upon real-time information flow. In my opinion this is now what it takes to trigger a large influx of active managers to act in concert to move the stock in a market awash in passive, algorithmic and high frequency trading volume. You see fundamentally oriented active managers do not turnover positions often, thus fundamentally driven active managers cannot, under normal circumstances, compete with all of the non-fundamental actors on a daily basis.
Like I said, I don’t expect to convince you. If I did, it would require a career change and perhaps even closing your business. You’re not likely to do that after an interaction on the internet. But I think your defense of individual stock picking is pretty weak.
They are as risky as you want to see them. Many traders fail to do the fundamental analysis to make sure they are not trading or investing into a company that has a chance of dropping 40%. Yes mid caps stocks are more volatile but thats what you need in the markets. If you are a retail trader or investor and want to go buy few shares here and there from big companies you are in the wrong game because you must be well funded $$$ or commissions and taxes will eat your profits away. Retail traders only stand a chance in swing trading mid to some big companies.You must do your fundamental analysis to make sure is a real company with some solid earnings , low debt, ok to good return on investment and a solid product or service that has been growing and won’t crash on you. If you are shorting you must look it at the other side of the coins and hedge your self with some options if in case the company was to bounce back and gets you off guard . Also yo must have an exit plan before you get in and more important you need to be ready to cut your loses short and don’t hesitate to get out of a position that is giving you trouble.
Uhhh…okay. Are suggesting that buying individual stocks instead of an index fund is a good idea or that trading stocks instead of buying and holding them is a good idea.