The indexing argument: Note - the below statements are from the perspective of buying individual stocks vs. passive index funds and not between buying passive index funds and actively managed funds. So, I don't mention fees.
- Markets are either completely or mostly efficient. Searching for inefficiencies are very expensive in terms of time and money.
- In the aggregate active investors can't outperform the market average return.
- Investors that hold the index (proxy for the market) benefit off of the hard work of the active investors (esp. the winners).
- A broad market index is by definition diversified. So it is a very convenient way of getting diversification with very little effort.
It is helpful to think about indexing as a momentum strategy since it is market weighted and the stocks with more "momentum" get more of your money. This is in contrast to the value approach to investing.
The Value Argument: 1. The market is not efficient or has a reasonable level of inefficiency to prove an enterprising investor with a bargain opportunity - buying below intrinsic value. 2. Buying companies below intrinsic value creates a margin of safety and limits downside risk. 3. The realization of the intrinsic value by the market is what gives an above average return. Once the security is fairly valued then the expected returns are no longer going to be that high. Value investors diverge in their approach at this point. 4. Early Buffett/Graham/Klarman would discard these companies at this point. Older Buffett/Munger would continue to hold. I don't really want to get into the different approaches to value investing but the crux of the philosophy is exploiting the market inefficiency to find bargain deals. 5. Buying momentum stocks is risky and should be avoided since the company is overvalued. At the worst you will lose a significant amount of capital. At the least you will get a mediocre return.
There is enough literature and data to back both of these approaches. I understand that being a successful value investor is hard and very few possess the skills, intelligence and temperament. So getting the average return by buying the index is the most feasible approach for most people.
There is considerable disparity between well known value investors about these 2 approaches. Here are a few:
Warren Buffett: Warren is the most famous and the most successful value investor. His view has been that buying the index is a very good strategy for most people: http://www.berkshirehathaway.com/letters/2013ltr.pdf "I have good news for these non-professionals: The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal."
Seth Klarman: Value investor that has been praised by Buffet Himself. Sees indexing as a "horrendous idea": https://www.gurufocus.com/news/610303/seth-klarman-on-passive-investing “I still think indexing is a horrendous idea for a number of reasons. That said, the average person who spends a very small amount of time on investing doesn’t have a lot of good choices out there.
A tremendous disservice is perpetrated by the idea that stocks are for the long run, because you have to make sure you are around for the long run, that when you have unexpected pain, as many people did in 2008, you don’t get out and you actually are a buyer. The prevailing view has been that the market will earn a high rate of return if the holding period is long enough, but the entry point is what really matters.
Stocks trade up when they are put in an index. So, index buyers are overpaying just because a stock is included in an index. I am much more inclined to buy a stock that has been kicked out of an index because then it may have value characteristics—it has underperformed. A stock is kicked out of an index because its market cap has shrunk below the top 500 or the top 1,000.
We all know that the evidence shows that when you enter at a low price, you will have good returns, and when you enter at a high valuation, you will have poor returns. That is why we have had 10–12 years of zero returns in the market. And given the recent run-up, I am worried that we will have another 10 years of, if not zero, at least very low returns from today’s valuations. The mentality of “I’ll save transaction costs and management fees by indexing” ignores the fact that the underlying still needs to produce for you. Indexing usually refers to equities, but the attractive asset class a year ago, on a risk-adjusted basis, was clearly debt, not equity.”
And from his book Margin of Safety: "I believe that indexing will turn out to be just another Wall Street fad. When it passes, the prices of securities included in popular indexes will almost certainly decline relative to those that have been excluded. More significantly, as Barron's has pointed out, "A self-reinforcing feedback loop has been created, where the success of indexing has bolstered the performance of the index itself, which, in turn promotes more indexing."" When the market trend reverses, matching the market will not seem so attractive, the selling will then adversely affect the performance of the indexers and further exacerbate the rush for the exits."
Aswath Damodaran: The dean of valuation looks at indexing favorably. It boils down to a personal choice and he likens active investing to an act of faith:
http://aswathdamodaran.blogspot.com/2016/12/active-investing-rest-in-peace-or.html
"In fact, I have made peace with the possibility that at the end of my investing life, I could look back at the returns that I have made over my active investing lifetime and conclude that I could have done as well or better, investing in index funds. If that happens, I will not view the time that I spend analyzing and picking stocks as wasted since I have gained so much joy from the process. In short, if you don’t like markets and don’t enjoy the process of investing, my advice is that you put your money in index funds and spend your time on things that you truly enjoy doing!"
Benjamin Graham: The intellectual father of value investing. It is interesting that although he spent considerable effort writing about value investing for the "defensive" (average) investor he actually was a proponent of index funds.
https://blogs.wsj.com/totalreturn/2015/04/03/would-benjamin-graham-have-hated-index-funds/
"Stockholders as a whole must prosper or suffer with the rise and fall of corporations as a whole....An unabashed cross-section approach appears too simple to be sound, and it reduces the role of security analysis to a minimum. We suggest that the student should not dismiss it too contemptuously. It is by no means certain that the analyst will get better results from the type of selectivity most favored in Wall Street— viz., picking out the industries or individual companies that are likely to make the best comparative showing in the near future.... If we could assume that price of each of the leading issues already reflects the expectable developments of the next year or two, then a random selection should work out as well as one confined to those with the best near-term outlook."
From The Intelligent Investor chapter 14 - Stock Selection for the defensive investor: "In setting up this diversified list he (the defensive investor) has two approaches, The DJIA-type of portfolio and the quantitatively tested portfolio. In the first he acquires a true crossss-section sample the leading issues, which will include both some favored growth companies, whose shares sell at high multipliers, and also less popular and less expensive enterprises."
My own views are that indexing is a no-brainer method to benefit from the compounding of the advances of the American/world economy. Value investing although sound in idea is extremely hard to consistently get right. I do pick individual stocks as well but for a lot of the same reasons as Damodaran with the understanding that they have a good chance to be a headwind to my portfolio in the long run.
Submitted October 02, 2018 at 01:26AM by nowrongturns https://ift.tt/2P2JqxL
