

The best investment advice you'll never get - a5seo
http://www.sanfranmag.com/story/best-investment-advice-youll-never-get

======
weber88
Just a question that popped into my head: what would happen if everyone
followed a passive strategy, ie, no one was active? Isn't some sort of active
strategy required, somewhere, for funds to be directed at all?

Though, I do think on average fund managers probably don't actually make
anything like useful predictions. But perhaps we do need someone, somewhere,
looking for good investment.

My guess is that there is a role in society for some conservative, value based
investing, but at the moment there are more people trying to do this than is
useful, and even more people trying to find good investments by worthless
strategies (like trying to predict future movements from past movements).

~~~
dkarl
The advice against trying to beat the market is based on the fact that there
are tens of thousands of highly intelligent people paid to analyze securities,
and they're all feeding off each other's behavior. To beat the market, you
have to beat a conventional wisdom based on the accumulated expertise of a lot
of people. For instance, if you want to buy stock in a Malaysian steel
company, you have to decide that you understand the current value of this
stock better than a crowd-sourced price generated by the research of a horde
of steel industry specialists, people with intimate knowledge of the Malaysian
economy, business environment, and political environment, people who can
afford to spend all day reading forecasts of economic conditions in the
countries where this company's steel is consumed, and people who have a drink
with a VP from the company and get gossip about the CEO's health and the
competence of his likely successor.

If no one was trying to beat the market, it would be easy to beat the market.
But since so many people are busy trying, it's silly to try to compete unless
you want to take it as seriously as the professionals do and get plugged in
the way they are.

The "random walk" hypothesis says you _can_ beat the professionals. About half
the time. By flipping a coin. But the professionals are insiders, and as well-
regulated as the stock market is, I would assume that an outsider playing
against insiders in a 50/50 game will not quite win his full 50% share.

The hope that a person can price stocks better than the market as a whole
rests on a couple of possibilities:

1\. Beating full-time professional analysts at analysis in your spare time,
because you're just so bad-ass.

2\. Identifying a price that is heavily influenced by ignorant people and
beating them by just being reasonably well-informed -- but this is not an
original idea and hence is a special case of #1.

3\. Finding a niche that you know intimately for some reason, and in which you
have no professional competition. Oh, wait, this is just #2 again. Or maybe
you found a niche small enough that it doesn't get a lot of attention from
professional analysts, and you can make a little bit of money at it. That
might work!

4\. Being the first one to take into account a new idea or source of
information. This one will make you wildly rich, and it's fun to dream, but
while you're looking for that brilliant idea, there's no reason to risk real
money on your ideas-in-progress.

~~~
brisance
Or maybe the "analysts" are just not any good.

For a specific example, look at how the "hobbyists" are beating the
"professional" analysts at predicting Apple's quarterly performance, time and
time again.

[http://tech.fortune.cnn.com/2010/04/20/apples-blow-out-
quart...](http://tech.fortune.cnn.com/2010/04/20/apples-blow-out-quarter-the-
bloggers-called-it-the-street-blew-it/)

~~~
achompas
If there's one company where hobbyists will beat professionals, it's Apple. Do
you have any other examples?

~~~
brisance
There are many objective studies that show that individuals with their own
specific trading/investing strategies can beat the street. But that's not
really the point.

The point is that AAPL is now only second to XOM in terms of market cap, and
is not exactly a tiny blip on the radar. It is a stock that is being watched
by literally millions. If these "professional" analysts have so many resources
at their disposal, have the inside track on confidential information and are
operating at such an uneven playing field as the parent postulates, then why
would they consistently be beaten by the "hobbyists"?

~~~
achompas
Well, the fact that Apple is so large actually serves my point: there is a
_lot_ of information on Apple. The information asymmetry between hobbyists and
analysts is nil for Apple.

In fact, I'd argue the information asymmetry tilts in favor of _individuals_ ,
considering that analysts publish their forecast. I wouldn't be shocked if
these guys use "analyst expectations" as an input.

Anyway, this is bad news for the analyst, because the one resource they
_don't_ have is time to focus on one company. Hobbyists, however, can focus on
Apple all they want. So I'm not surprised that Apple fans nail their earnings
forecast.

------
bravura
“Over a ten-year period commencing on January 1, 2008, and ending on December
31, 2017, the S & P 500 will outperform a portfolio of funds of hedge funds,
when performance is measured on a basis net of fees, costs and expenses.” -
Warren Buffet

<http://www.longbets.org/362>

~~~
jules
> Their opposites, passive investors, will by definition do about average. In
> aggregate their positions will more or less approximate those of an index
> fund. Therefore the balance of the universe—the active investors—must do
> about average as well. However, these investors will incur far greater
> costs. So, on balance, their aggregate results after these costs will be
> worse than those of the passive investors.

This argument is wrong? edit: it's like saying this about strategies of chess
players, one group is using strategy A and another is using strategy B:

Chess players using strategy A are known to perform about average (by the
nature of their strategy). So this new strategy, B, has to perform about
average too.

This neglects that there are other strategies than A and B. The whole world is
not either passive investors or hedge funds.

And he's saying something even stronger: there is no _subset_ of B players
that is better than average.

So while he may well be correct in his prediction, he makes it sound like he
has a mathematically tight argument for why he is correct. But the conclusion
of his argument (that active investors will perform about average) is not the
prediction of his bet (that hedge funds will perform about average, and
because they have higher operating cost they will lose).

~~~
drblast
He's making the (correct) assumption that the speculative stock market where
active investors expect to make their money is a zero-sum game. For there to
be winners in "buy low, sell high" there have to be an equal amount of losers.

So, if there are going to be winners, there have to be an equal amount of
losers. It's difficult to siphon money off of someone passively invested in an
index fund, so the active investors are competing against themselves.

Because active investment has a much higher cost than passive, as a group they
will be significantly worse off compared to passive investors. This is so
self-evident as to be not even worth betting against.

Note that this isn't to say that there won't be big active winners
individually. But in a chess tournament, if the top players use strategy A
that wins 90% of the time, and others use strategy B that wins 51% of the
time, that guarantees the existence of some other strategy that performs below
average.

The stock market isn't necessarily a zero-sum game like chess because
companies pay dividends, but that's rare and small enough to be insignificant
compared to the amount of money gained and lost through speculation.

~~~
eru
Dividends aren't what makes the speculative stock market fixed-sum.

Players that are getting utility out of things other than direct monetary
value, say reduced risk or improved liquidity, make it a non-zero-sum game.

I am agreeing with both of you to some extent.

------
philfreo
Interesting comment on that article:

 _Index investing (applied to extremely wide market indexes) makes an
assumption that there will be a continuous and infinite increase in the total
market capitalization of that index. As time marches forward I beleive we will
experience a deceleration of worldwide market cap increase._

Anyone have thoughts on this?

~~~
akg_67
I have several concerns with index fund/ETF investing:

1\. How much of the underlying stocks, that make up the Index, are really
owned by the Index fund/ETF? I doubt that such funds/ETF actually own 100% of
the required underlying stocks, may be using some sort of option/hedge
strategy.

2\. In what scenario, not owning the actual underlying stocks can be
detrimental to index fund/ETF? I am looking for what may cause failure of such
funds/ETF and who may lose.

3\. Is index fund/ETF investing artificially inflating price for underlying
stocks compared to price of the rest of the non-index stocks in the market?

4\. Can index investing cause Index "Bubble"?

~~~
sebilasse
For European ETF:

1.) Depends on the ETF. There is

a) Full Replication. All stocks are 1 to 1 in the ETF.

b) Swap based. EU swap ETFs can have up to 10% (but not more) in swap (what
you mean by option/hedge), the rest is stocks. Oftentimes ETF issuers have an
insurance on those swaps. If the swap counterparty goes bankrupt you loose
that 10%.

c) optimized sampling. You have different stocks (or not all of that index) in
your ETF. The idea is to find stocks that corelate closely to those in the
index.

2.) By buying the ETF you "own" the stocks. ETF are regulated like mutual
funds (at least in EU).

3.) ETF are only a small fraction of the worldwide trade. But obviously if
your company gets into a popular index (s&p 500) you can be quite happy.

4.) If everybody would only invest in indices, the market won't play anymore
and it would be smarter to buy individual stocks again. This is the index
investing paradox. But very unlikely to happen.

~~~
eru
About 4: Active investor could get a better performance than passive
investors, if that situation would arise.

------
jeffmiller
It should be mentioned that this article is from December 2006, when index
funds were less widely adopted than they are today.

~~~
jasonkester
???

Index funds were as widely adopted as you could ask for back in 1996 when I
first started investing in them. And it was common knowledge even then that
the S&P 500 tended to outperform 70%+ of managed mutual funds.

If that's the message this article is trying to convey, it certainly has the
wrong title.

------
adamjernst
A well-written article, but really? Investing in a low-cost broad index fund
is the /only/ investment advice I get nowadays.

~~~
jerf
Having also read this a lot, it makes me wonder how the clever financial world
will find a way to take a lot of people owning index funds and somehow fleece
them.

I also find myself pondering the macroeconomic effects of a lot of the market
simply being in index funds, though I'm sure we're a long ways from that.

My personal rule-of-thumb "By the time you've heard of it, it's too late to
get in on it" is also triggering, though I have to admit for the life of me I
really can't imagine how to exploit this tendency. But I am anything but a
financial wizard.

~~~
WildUtah
_take a lot of people owning index funds and somehow fleece them_

There are strategies to do this now, but they're hard to execute. One example
is to target stocks that are likely to enter or drop off indicies. Index funds
will be looking to buy or sell them soon.

Mostly these strategies depend on your ability to set up a very high speed
link to the computers that clear trades and interpret the algorithms that
index funds use to establish their samples of the market. If you can get in
just ahead of the index funds and their monster volume, you can shave a few
tenths of pennies from the investors.

You can make millions with those strategies but it's a drop in the index fund
bucket. Quite a lot of "quant" trading activity is about ripping off ordinary
people by unnoticed fractions by getting in ahead of them. Much more innocuous
than the large scale bribery and fraud that makes up so much of the financial
industry.

~~~
nradov
This was covered in a WSJ article yesterday.
[http://online.wsj.com/article/SB1000142405274870400870457563...](http://online.wsj.com/article/SB10001424052748704008704575638583030174768.html?KEYWORDS=index+fund)
"Over the long run, sharp traders getting out in front of these forced
portfolio changes have poached at least 0.38 percentage point of annual return
away from Russell 2000 index funds, estimates a new study in the Journal of
Empirical Finance."

~~~
amh
Not all index methodologies are created equal, the way that Russell handles
periodic reconstitution is particularly susceptible to front running. Other
indexing methods are not as bad.

------
sram
I got a wake up call about 4 years ago when my broker tried to convince me to
buy into a hedge fund. Buried in the prospectus was an entry load of 8%. Fired
him, and have been in index funds since.

------
kevinburke
Along the same lines here's an interview with a guy who's essentially shaped
my investment philosophy: <http://www.kirkreport.info/2009/03/qa-with-less-
antman.html>

------
antareus
I'm 28, and I don't want to end up like Liz Lemon ("well I have $12,000 in
checking"). What's a good primer on investing? I don't have a ton of money but
I'd like to get into it.

~~~
wrs
I recommend Andrew Tobias's classic _The Only Investment Guide You'll Ever
Need_. Very sensible, and very readable.
<http://www.andrewtobias.com/theonly.html>

~~~
antareus
Will take a look, thanks.

------
JSig
One way to beat index funds is through piggyback investing on those who can
beat them.

Check out <http://alphaclone.com/>

You have to pay for a membership but the site is top notch. They parse
investment fund's sec filings and allow you to backtest strategies to see how
well they would have performed over a given time frame. You will find
strategies that crush any index fund.

I am not affiliated with alphaclone.com.

~~~
eru
In retrospect there will always be strategies that will beat any index fund.
But can you identify such a strategy beforehand?

------
jteo
2 words: Renaissance Technologies

<http://en.wikipedia.org/wiki/Renaissance_Technologies>

~~~
jedc
Agree, but:

1) They're a huge, huge outlier

2) Any of Renaissance's funds are not nearly as scalable as a passive index
fund

3) As a hedge fund will still take a big chunk out of returns as fees

------
GFischer
I always thought of the stock market as a form of gambling, and this quote
hints at that:

"a list of advantages of active management, which essentially boiled down to
the fact that it’s more fun"

also:

"There is an innate cultural imperative in this country to beat the odds"

and the stock market is viewed as better than casinos for this kind of
gambling.

------
by
Index funds seem to me to work by reducing churn - the percentage of your
stock that is sold and bought each year - because every time you sell then buy
you lose a lot of money. I am not yet convinced you have to follow an index.

If you had a fund that did not sell anything and bought a random stock from an
index as funds came in would this beat an index fund?

~~~
hnhg
Think of the index fund as reducing the risk of depending on any one stock for
your gains. I don't know what the distribution of gains is like on an index
fund but an answer to your question would likely come from an examination of
one.

~~~
by
My theoretical fund would have a wide range of stocks. It does not seem to be
related to spreading gains or risks.

I have not seen any comparative table of stock churn rates for different
funds, but my guess is that index funds do well because they reduce the sell-
buy transaction costs, partly by eliminating the cost of human stock pickers,
but primarily by reducing the percentage of stocks in the fund that are sold
then bought every year. Maybe this is wrong?

My understanding is that an index fund sells and buys stocks to balance the
proportions held in the fund as the market capitalisation of the companies
changes inside the index. This imposes an apparently unnecessary cost on the
fund. If we removed this cost by not selling and buying stocks to keep it
equal to the index would the fund become more profitable? I am considering it
to be a fund where people invest incrementally over a long period so there
would be constant random aquisition of new stocks from the index.

Maybe that doesn't make sense for some reason.

~~~
Benjo
Balancing portfolios is basically a universally recommended practice. If you
manage your own portfolio, won't you have a similar "churn rate" to the index
fund?

~~~
by
"Balancing portfolios is basically a universally recommended practice."

The 'balancing' is against a stock market index which will seriously over-
represent a particular geography, industry sector, business size, asset class
etc. Why choose that index? Because the stock market tells us to?

"If you manage your own portfolio,"

I was considering how to make a 'passive' index fund even more passive.

"won't you have a similar "churn rate" to the index fund?"

An index fund would have a higher churn rate and therefore higher costs than
my theoretical fund, but I do not know how much money an index fund spends on
index-following sell-buy transactions.

