Sounds great, it makes sense on paper.
But I would love to find a 'Sophisticated Investor' in the wild that has beaten the market in the long term. (And they cannot be selling something .....)
I think it's possible, but I guess anything is. My questions if we find one are:
- How much effort/time does it take? (I am a family man, and while you could compute a $/hr. that was spectacular, there are only so many hours in the day as I am still working.)
- How many have tried and failed for each one we find? This question we will never be able to answer, by default they will be harder to find.
ScroogeMcDutch (love the name). I am curious, when this year alone 85% of fund managers failed to beat the market (and long term the results are lower) .... what leads you to say:
I do believe I will be able to pick stocks that are good deals with proper analysis, that will beat the market on the long term (10+ years) or match it with a lower risk.
I am not trying to argue here or pick a fight at all, I am honestly curious, thanks for your feedback!
Thanks Re: Name :D
TL;DR:
I think it may be possible to defeat the index, but don't know if I have the skill and/or information. The same is true for any average investor and is best served with index funds.This is going to get into a stock-picking vs indexing discussion quickly. I was very careful in my wording as I know this might be considered heresy on this forum, and I do think you need to be very diligent in picking your stocks as well as . There are different types of trying to beat the market. There is a day-trading and derivatives-trading market. That one is, in my opinion, for an individual investor impossible to beat. Anything that's remotely interesting is snagged off the market before you see it on your screen. Then there is the long-term stock market, which is what we are interested in here on MMM. When talking "the index" in the next part, just read S&P 500 as that will do for the index.
I have a business background, so I should be able to read and understand financial statements. I should also be able to advise for a business direction, as part of the work I do professionally. I currently do not have the skills to take these financial statements, look at global developments, and determine if a price asked for a stock is a good valuation of the underlying company - these I would have to develop if I have any hope of beating the index through choosing a different portfolio of companies than the index provides.
The index has as a goal to best measure US stock market performance, and decides to pick 500 (arbitrary?) largest capitalization companies on the US stock market, and weights them using market capitalization/float. Induction and removal from the index passes a committee, is what I quickly read up on wikipedia.
1) Time for some theoreticic blablaBasically, let's say the following. A stock in the index has an certain expected and unknown return Ri and volatility Vi. Stocks outside of the index have a certain expected and unknown return Ro and volatility Vo.
Ri=RoIf it would be impossible to beat the index in terms of return, then Ri = Ro and it wouldn't matter if I picked stocks inside or outside the index in terms of return on investment. That would leave a difference in the amount of volatility experienced and risk ran.
If Vi = Vo as well, then picking more stocks rather than less would be the better choice. The amount of volatility experienced from the sum of stocks with the same underlying volatility is reduced with each addition of an extra stock. Basically the reason why one would not pick one stock, and picks 500 based on S&P 500 at the moment.
If Vi > Vo, then obviously adding lower volatile stocks would be better.
If Vi < Vo, then addition might still reduce overall risk, but may also increase it. This would basically mean we get higher volatility as companies have a lower capitalisation. [This is an effect we actually see in the market, small cap is more volatile/risky than large and megacap, so this is the more interesting hypothesis]. This would mean there is a negative correlation between capitalisation and volatility. The larger they are, the less volatile they would tend to be. If this is the case, then that correlation would have to be 0 for all the stocks inside the index (all 500 equally volatile), and then suddenly lower than 0 for stocks outside the index for it to be true that one cannot beat the index on either return or risk.
Ri < RoSimple to beat the index in this case, pick stocks outside of the index in order to have a higher expected return.
Ri > RoIn this case, it is comparable to the Vi < Vo when Ri=Ro above. There is apparently a relationship between size of capitalisation and the expected return of the stock. This correlation would have to be 0 for all 500 inside the index, and negative outside for it to be true that one cannot beat the index on return.
Note that if Ri and Vi are also equal between the companies inside the index, then the weighting doesn't matter at all. If it is not the same, then you could start a same type of argument for the weighting method.
2) Stocks in the S&P 500 are in higher demandAs shown by all the index funds and mutual funds trying to mimic the S&P500 and other indexes and the people here on the forum. As soon as a stock hits the S&P500 index, then demand for those stocks spikes. The following paper talks a bit about this effect:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1152224 - a stock will increase in price between 2.7% and 5.4% after announcement to the index. This effect doesn't work the other way, leaving the index doesn't seem to have a permanent price impact (if the companies exist longer time after the deletion). These effects point to Ro > Ri. Only if the returns of the other companies that stay outside of the S&P500 are much below Ri then it could compensate back to Ri >= Ro.
3) Valuations don't matter / reversion to the meanThis falls under the market timing category. If valuations and other fundamental values do not matter as per most of the index proponents here, then any form of market timing is impossible. If the stock market rises 10% tomorrow, then we expect still the same result per dollar invested, compared to if the stock market drops 10% tomorrow. The phrase here is "the stock market might crash tomorrow, but you don't know when it will crash and you will lose out on too much in terms of return by sitting at the sideline". Yet the same people will be the ones screaming "stock market is on sale" when prices do drop. By the same reasoning, it can never be on sale, as you expect the same return per dollar invested (and by the same reasoning, you just lost a crapload of time to FIRE)? Those two contradict each other and not many who scream both seem to understand that.
First conclusionBased on all of the above, I cannot believe the statement "One cannot beat the index on return and volatility" to be true theoretically. Whether practically that one can beat it, is another statement itself, and one that I am not yet thoroughly convinced of, and that doubt is mostly caused by potential transaction costs. However, I do think it is possible to do what Scandium stated as a fallacy: "This is the same fallacy we see in every discussion about stock, that somehow a person reading enough financial statements will somehow predict the (uncertain) future better than someone else reading the exact same financial statements!". This is mostly true for companies that have a massive amount of speculative value, such as amazon, facebook etc and I would agree with that statement for those. For companies that are mostly 'done' such as for example Coca Cola, it becomes about evaluating the financial statements to other companies in a similar situation, and deciding where you get the best value for money. You also do this when buying something, and you compare quality and value of the item you are going to purchase.
Now to read the 16 other replies ;)
Joshua Kennon is in my list of blogs to follow/read, along with jhcollinsnh and MMM - lot's of wisdom there and coming from a similar angle.
TL;DR:
I think it may be possible to defeat the index, but don't know if I have the skill and/or information. The same is true for any average investor and is best served with index funds.