Author Topic: Active stock pickers can now beat the market  (Read 12926 times)

growingstaches

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Active stock pickers can now beat the market
« on: November 25, 2013, 08:12:59 PM »
I hope the subject line catches your attention.  The below article with the same title certainly caught my attention in a big way.

http://www.marketwatch.com/story/active-stock-pickers-can-now-beat-the-market-2013-11-13

Background:  Over the last 12 years I've built our families $440k stash using a variety of active managed funds.   Spread across all of our accounts I was using these funds based on my own research.

Fidelity Contra Fund - FCNTX (.74 ER)
Fidelity Value Fund - FDVLX (.68 ER)
Fidelity Low-Priced Stock Fund - FLPSX (.80 ER)
Fidelity New Markets Income Fund - FNMIX (.87 ER)
T. Row Price Small-Cap Stock Fund - OTCFX (.92 ER)
Harbor International Institutional - HAINX (.78 ER)


I feel very fortunate to have the current stash, but I'm trying to get more focused on the finish line of FIRE.   Over the last many months I've been reading a ton of MMM, jcollinsnh, and the madfientist.   I came to realize that I've been investing a significant amount of effort trying to select the "best" active managed funds.   After reading each of these blogs in depth my investing philosophy has fundamentally changed.   I'm now a believer that index funds are the way to go.  In the last month I've migrated all funds to a combination of these.

Vanguard Inst Index Fund Inst Plus - VIIIX (.02 ER)
Vanguard Total Bond Mkt Index Inst - VBTIX (.07 ER)
Fidelity Spartan Extended Market Index Fund - FSEVX (.07 ER)
Fidelity Spartan International Index Fund - FSIVX (.12 ER)

Now back to the MarketWatch article.   It's putting doubt back into my recent thought process of moving to index funds.   Here are some quotes if you don't have time to read the article.

"And yet, the interesting question is what happens once trackers and ETFís dominate the entire market, as they are now starting to do."
"They will be buying big and bigger stakes in businesses that are clearly rubbish."
"There are signs a shift is underway already, and the active fund managers are starting to do better."

I would like to see a discussion of this article.

Are any of the points valid?
Was it a mistake to move to index funds?

Thanks,
growingstaches





the fixer

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Re: Active stock pickers can now beat the market
« Reply #1 on: November 25, 2013, 08:25:34 PM »
Read through to the second page and stopped when he started getting to concrete examples.
Quote
In my case, that is the FTSE-100 index UK:UKX +0.30%  made up of the largest businesses listed in London. There are quite a few companies in there that no one in their right mind would want to own shares in right now.

British Sky Broadcasting UK:BSY +0.42%   and British Telecom BT -0.80%  , for example, are engaged in a suicidal race for sports rights for the pay-TV market that has just seen BT pay £900 million for the rights to show Championís League soccer. Thatís great for the clubs and the players, but terrible for shareholders in both companies.
If BSY and BT are generally thought to be in trouble, their share prices and thus market caps should be declining. If this is the case, index funds holding them will also be reducing their stake. It's also possible the market is wrong, in which case the index funds still holding some as opposed to none would turn out to be a good idea. Remember GM?

The guy has a point that the market cannot be 100% index funds. But all the index funds take to succeed is a certain base level of active trading volume to keep pricing efficient. With Wall Street's greed, I don't see the systems providing that level of efficiency going away any time soon.

Nords

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Re: Active stock pickers can now beat the market
« Reply #2 on: November 25, 2013, 10:07:18 PM »
Now back to the MarketWatch article.   It's putting doubt back into my recent thought process of moving to index funds.
I would like to see a discussion of this article.
Are any of the points valid?
Was it a mistake to move to index funds?
Here's some more thoughts to muddy the waters:
1.  "... and this time it's really different!"

2.  If he's so prescient, then why did he give away the damn secret with his article?  Now everyone will leap back into active funds tomorrow morning, which means that the advantage will shift back to passive index funds.  Oh, wait, the article's over a week old, which means that everyone is already arbitraging that news.  In fact, why is he writing the article at all when he could be making gazillions from his own advice?

3.  Yes, it's possible to achieve higher returns than the benchmarks.  How much harder & longer are you willing to work to achieve that higher return?  Or would you rather get 70% of that return with about 10% of the effort, leaving you with plenty of newfound spare time to enjoy your life?  Or, if you're already enjoying life to the max, perhaps your newfound spare time could be devoted to raising your own personal income (and boosting your savings) instead of reading Marketwatch.

judgemebymyusername

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Re: Active stock pickers can now beat the market
« Reply #3 on: November 26, 2013, 04:10:03 AM »

Vanguard Inst Index Fund Inst Plus - VIIIX (.02 ER)
Fidelity Spartan Extended Market Index Fund - FSEVX (.07 ER)


You can ditch both of these funds and replace them with the Vanguard Total Stock Market Index fund.

Good job converting to index funds, don't worry about what the fear mongerers are trying to get you to buy. If you need justification for staying in these index funds, you can start with the book Boglehead's Guide to Investing. If that's not enough, you can get Bogle's Common Sense on Mutual Funds that has something like 800+ pages of data and analysis that explains how and why index funds are the best route.

I'd welcome you to post this exact same question over on the forum at bogleheads.org as there are some smart guys over there that can help clear you head on this. Unfortunately I'm not as well versed as they. If you'd rather stick to what Mr. Money Mustache has to say, you can search his blog for Vanguard and see that he is only invested in Vanguard Index funds.

Integrate

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Re: Active stock pickers can now beat the market
« Reply #4 on: November 26, 2013, 12:27:34 PM »
The market performance is the average of all the individual companies. So by definition, some must be below average and some must be above average.

There exists the possibility that someone could always pick the stocks that were performing above average and thus beat an index. The question you have to ask yourself is "Is it reasonable to assume someone will always be able to beat the market?" If somehow you come up with an answer of yes to that question, ask yourself "Where is this person getting their information?"

The answer to that is of course, it doesn't exist. There is no set of information that tells you what will happen in the future. There are bits of information that may help guess at it, but nothing that has proven to determine future performance. There is always the element of luck.

With an index you know you will get the average, and the average performance has been pretty good for quite a long time now.

KingCoin

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Re: Active stock pickers can now beat the market
« Reply #5 on: November 26, 2013, 01:03:20 PM »
The article is predicated almost entirely on hand waving rather than any evidence that indices are meaningfully skewing prices.  It should have been easy enough to study valuation metrics of index companies vs non-index companies to see if there's a meaningful disconnect (correcting for factors like higher discount factors built into smaller companies). But hey, why bother with evidence when that takes a lot of work to generate and might undermine your thesis?

I get irked when guys like this casually drop a statement like "contrarians...are usually the people who make money in the stock market". Are contrarians the ones who usually make money in the stock market? Any evidence? What makes one a "contrarian"? Does investing in actively managed funds constitute a contrarian position? All of this goes unanswered because answering those questions is extremely hard and are probably at odds with his claim.

The best evidence that he could offer in defense of his thesis was that active managers have done well over the past 5 years in certain regions. Given that the past 5 years have been a one way epic bull market, I don't think it's really a sufficient data set to prove anything other than perhaps managers in some regions are taking more risk relative to the index. He also misquoted the data in the article he referenced, arguing that 44% outperform in the US, when the figure in the study was actually 39%.







steveo

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Re: Active stock pickers can now beat the market
« Reply #6 on: November 26, 2013, 01:16:23 PM »
Now back to the MarketWatch article.   It's putting doubt back into my recent thought process of moving to index funds.
I would like to see a discussion of this article.
Are any of the points valid?
Was it a mistake to move to index funds?
Here's some more thoughts to muddy the waters:
1.  "... and this time it's really different!"

2.  If he's so prescient, then why did he give away the damn secret with his article?  Now everyone will leap back into active funds tomorrow morning, which means that the advantage will shift back to passive index funds.  Oh, wait, the article's over a week old, which means that everyone is already arbitraging that news.  In fact, why is he writing the article at all when he could be making gazillions from his own advice?

3.  Yes, it's possible to achieve higher returns than the benchmarks.  How much harder & longer are you willing to work to achieve that higher return?  Or would you rather get 70% of that return with about 10% of the effort, leaving you with plenty of newfound spare time to enjoy your life?  Or, if you're already enjoying life to the max, perhaps your newfound spare time could be devoted to raising your own personal income (and boosting your savings) instead of reading Marketwatch.

These are all good points. I'm not actually a fan of being an active stock picker. I think the risk and effort to reward ratio isn't good enough for me to bother.

KingCoin

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Re: Active stock pickers can now beat the market
« Reply #7 on: November 26, 2013, 01:29:54 PM »
I'll also add that this author seems to have things totally backwards.  If more and more money is being invested in indices, that seems to be an argument to invest in indices, ride the momentum, and laugh at the active managers getting left in the dust.  Once you see the trend start to slow or reverse, that should be the time to switch gears, not now (at least according to the author's logic).

growingstaches

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Re: Active stock pickers can now beat the market
« Reply #8 on: November 26, 2013, 08:24:36 PM »
steveo, KingCoin, B, Integrate, Nords, fixer:   Thanks for taking the time to reply with your thoughts.  Each of your comments was exactly what I was looking for.  Some serious critical analysis of the article.

Nords:  Your comments about enjoying life, and having more spare time hit home.  I recognize I've invested far too much personal time trying to beat the market.  Partly because I thought I could, and partly because it felt good to "do something".   My new found index philosophy does make sense now.   I just need to start reducing down the amount of market news I was digesting on a daily basis as its not necessary.   I think that will be a New Years resolution.

B:  I'm choosing the VIIIX as the best fund in my 401k, and augmenting with FSEVX in other accounts to give the equivalency of VTSAX.  I could use help though on determining the correct ratio.   See the question I posted here.

http://www.mrmoneymustache.com/forum/investor-alley/what-is-the-ratio-to-build-vtsax-equivalency/

beltim

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Re: Active stock pickers can now beat the market
« Reply #9 on: November 26, 2013, 08:35:45 PM »
I'll also add that this author seems to have things totally backwards.  If more and more money is being invested in indices, that seems to be an argument to invest in indices, ride the momentum, and laugh at the active managers getting left in the dust.  Once you see the trend start to slow or reverse, that should be the time to switch gears, not now (at least according to the author's logic).

This comment doesn't make sense to me.  Index funds definitionally cannot affect the relative valuations of individual stocks within that index.  What momentum are you talking about?

KingCoin

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Re: Active stock pickers can now beat the market
« Reply #10 on: November 26, 2013, 09:49:27 PM »
This comment doesn't make sense to me.  Index funds definitionally cannot affect the relative valuations of individual stocks within that index.  What momentum are you talking about?

The author is making the argument that index funds increase the value of stocks in the index relative to other stocks (outside of the index), regardless of fundamentals. If one held this belief, then the further drift of assets into index funds should exacerbate this trend, pushing index stocks even higher relative to other socks.

I agree that indexing shouldn't affect relative valuations within the index.

I actually don't think the idea is totally crazy. The Nifty Fifty phenomenon in the 1960's and 1970's could be considered a warning, especially for those who are indexed over a narrow, popular range of stocks. But he didn't provide anything more than fairly anecdotal evidence to support his claims.

beltim

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Re: Active stock pickers can now beat the market
« Reply #11 on: November 26, 2013, 11:33:14 PM »
This comment doesn't make sense to me.  Index funds definitionally cannot affect the relative valuations of individual stocks within that index.  What momentum are you talking about?

The author is making the argument that index funds increase the value of stocks in the index relative to other stocks (outside of the index), regardless of fundamentals. If one held this belief, then the further drift of assets into index funds should exacerbate this trend, pushing index stocks even higher relative to other socks.

I agree that indexing shouldn't affect relative valuations within the index.

I actually don't think the idea is totally crazy. The Nifty Fifty phenomenon in the 1960's and 1970's could be considered a warning, especially for those who are indexed over a narrow, popular range of stocks. But he didn't provide anything more than fairly anecdotal evidence to support his claims.

Interesting, that's not how I read the article.  The author clearly compares different stocks within a UK tracker, and how some he thinks are better investments than others.  Where did you get the idea that he was comparing stocks outside of an index?

I wish the author had provided more citations, but I've read many places that active funds outside of the US have done significantly better than those in the US.  For emerging markets, it's easy to make an argument that those simply aren't as efficient a market.  But in this article, the author notes that 99% of active fund managers in Europe beat the index. This is an astounding result!  It'd be great to see where that data comes from.

mr. T

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Re: Active stock pickers can now beat the market
« Reply #12 on: November 27, 2013, 08:33:31 AM »
But in this article, the author notes that 99% of active fund managers in Europe beat the index.

I can reassure you: that's not the case. If only.

My 2 cents on the original point: I do believe that it is quite possible to beat the index by active stock picking. I do it myself.

The entire point on indexing all rests on the assumption that markets are efficient. If markets are efficient, all shares will be priced correctly all the time, so outperformance is impossible. In such an environment, indexing is the only rational way. But we know markets are not efficient. If markets were efficient, the dot-com bubble would have been impossible. And the very low valuations back in 2008 would also be impossible. Both happened, hence, markets are not efficient. At least not all the time.

Of course some markets are more efficient than others. Markets like government bonds, where the product is almost identical and volumes are high, will be pretty efficient. If you state that trading the US treasury bond market is an exercise in futility for the retail investor, I can only agree. But the market in Dutch smallcaps is horribly inefficient (trust me, I live there). There are many totally worthless shares with valuations based on nothing but speculation, and a small amount of very cheap gems.

I will tell you the secret. That's no problem because it's not a secret at all. The secret is to
1- buy good companies for a reasonable price, and hold them for the long term. And
2- be greedy when the herd is fearful and be fearful when the herd is greedy.

Warren Buffett spelled it all out for us.

The system is not difficult. The hard part is to implement it. The natural tendency of humans is to follow the herd. To buy when everybody is talking shares, out of fear to be left behind. To sell when the final apocalypse seems to be around the corner. Another natural tendency is to "do something". This leads to overtrading. Masterful inactivity is actually a hard thing to achieve.

Another thing: in order to become good at something, you will have to invest time and energy into it. If you want to become a good piano player, you will have to practice a lot. If you want to become a good investor, you will have to put effort into it. There's no shortcut to that. If you don't want to put effort into stockpicking, index.

And one more point: don't expect to beat the index every single year. You won't. The target should be to have a good result most of the time. That's enough. And that's the highest achieveable target. Never try to force it.

The problem I have with indexing is that you know beforehand that you will be putting hard-earned money into predictable stinkers. I wouldn't touch a share like Zynga with a bargepole myself. It wouldn't make me happier if I bought it because it's in some kind of index. Second problem I have with indexing is that it favours shares that already had a runup. They join the index because the shareprice has gone up. They have a large weighting because they are popular. Indexes and ETFs favour shares on high valuations. That's an aspect of it that I don't like.

Which doesn't mean I'm against indexing. It has a very valid function.
1- if you don't want to invest time and effort into investing: index. Buy the broadest and cheapest ETF available. Average over time.
2- if you want to invest in a big, mature, liquid market of which you don't have special knowledge: index. If I want to invest into the US market, I would just buy an ETF. On that market, I don't have the knowledge to make a difference.
3- in small, illiquid markets that require specialist knowledge: don't index. Buy a good managed fund. I would never buy an ETF in emerging markets smallcaps.
4- in markets that you know well, do it yourself.

KingCoin

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Re: Active stock pickers can now beat the market
« Reply #13 on: November 27, 2013, 11:04:33 AM »
Second problem I have with indexing is that it favours shares that already had a runup. They join the index because the shareprice has gone up. They have a large weighting because they are popular. Indexes and ETFs favour shares on high valuations. That's an aspect of it that I don't like.

This implies that you believe shares in indices are overvalued. They're "hot" stocks,"run up" stocks, or "high valuation" stocks as you put it. Any evidence of this? Most accurately, they're HIGH MARKET CAP stocks. Those market caps could be perfectly justified by earnings. So unless you're willing to present evidence that index stocks have excessively high valuations relative to other stocks, you're just hand-waving.

beltim

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Re: Active stock pickers can now beat the market
« Reply #14 on: November 27, 2013, 01:05:12 PM »
Second problem I have with indexing is that it favours shares that already had a runup. They join the index because the shareprice has gone up. They have a large weighting because they are popular. Indexes and ETFs favour shares on high valuations. That's an aspect of it that I don't like.

This implies that you believe shares in indices are overvalued. They're "hot" stocks,"run up" stocks, or "high valuation" stocks as you put it. Any evidence of this? Most accurately, they're HIGH MARKET CAP stocks. Those market caps could be perfectly justified by earnings. So unless you're willing to present evidence that index stocks have excessively high valuations relative to other stocks, you're just hand-waving.

No, that's not what mr. T is saying. He's saying that there are some stocks in indices that are overvalued, and he doesn't want to invest in those.

Also, you're making an assumption that he's using an index that talks about high market cap stocks.  But he could just as easily be talking about, say, a Russell 2000 index instead of the S&P 500, and his point would still stand.

Finally, there's a fair bit of data to show that so-called fundamental indexing, where companies in an index are weighted by something other than market cap, outperform indices that are market cap weighted.  If I indexed, I would use one of these products - market caps are much worse measures of a company than sales, earnings, or book value.

 Mr. T - that was an impressively long response to my simple request for additional information.  I agree with you, however - individual investors who read and understand Warren Buffett and Ben Graham have all the tools they need to invest for themselves.  Most aren't interested in doing in themselves, and indices are best for them.  But I personally enjoy the process of investing, and therefore am an active stock picker myself.

KingCoin

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Re: Active stock pickers can now beat the market
« Reply #15 on: November 27, 2013, 01:42:45 PM »
No, that's not what mr. T is saying. He's saying that there are some stocks in indices that are overvalued, and he doesn't want to invest in those.

He is saying that in addition to what I quoted him as saying.

The problem with arguing that some stocks in the index are overvalued is that it implies you know better than the market. Yet we know that almost no one knows better (with the exception of the oft-sighted Mr. Buffet). The track record of professional investors simply does not bear out the notion that it's plainly obvious that some companies are overvalued and others undervalued. It's not enough to chalk it up to a lack of discipline. I mean really, there aren't a few more disciplined guys out there other than Warren Buffet?

market caps are much worse measures of a company than sales, earnings, or book value.

Perhaps. Care to offer a citation? This again implies that some simplistic measures of value are smarter than the collective "wisdom" of the market. I suspect such indices would outperform during bust periods and underperform during growth periods.

I could have written a much longer response to Mr T, but he touched on about ten major concepts and we'd quickly get into a debate about things like different forms of the efficient market hypothesis, which I have little interest in hashing out.

I'll broadly agree with Mr T that the best opportunity for individual investors to beat the market is to do in-depth research on small, illiquid, inefficient financial instruments where you're not going head-to-head with major institutional investors. This is, in fact, more or what I do for a living. However, even this takes a fair amount of financial acumen that goes beyond looking at simple metrics like P/E ratios and book value.


daverobev

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Re: Active stock pickers can now beat the market
« Reply #16 on: November 27, 2013, 08:32:22 PM »
Ugh.. no-one would want to own shares of BT or BSkyB? Why do their shares trade at roughly 14x price to earnings then?

Article is garbage - premise is just wrong.

mr. T

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Re: Active stock pickers can now beat the market
« Reply #17 on: November 28, 2013, 08:43:42 AM »
Second problem I have with indexing is that it favours shares that already had a runup. They join the index because the shareprice has gone up. They have a large weighting because they are popular. Indexes and ETFs favour shares on high valuations. That's an aspect of it that I don't like.

This implies that you believe shares in indices are overvalued. They're "hot" stocks,"run up" stocks, or "high valuation" stocks as you put it. Any evidence of this? Most accurately, they're HIGH MARKET CAP stocks. Those market caps could be perfectly justified by earnings. So unless you're willing to present evidence that index stocks have excessively high valuations relative to other stocks, you're just hand-waving.

Not exactly. What I mean is that if a share is overvalued, that drives up the market cap and by proxy it drives up the index weighting of the stock. The consequence is that overvalued shares are relatively overweight in indices. So Beltim explained correctly what I meant.

Edit: let me elaborate on that.
I live in Holland. Here, the stock market is tiny compared to the US market. The number of true large caps is very small. So, inefficiencies are quite visible. Besides, the Dutch stock market index is weighted by market cap and trading volume. So hot stocks are favoured double.

Holland is no Silicon Valley. But back in the good old days of the dot-com boom, the Dutch index was dominated by anything that comes close to dot-com. Telecom, cable companies, internet providers, that kind of stuff. Because the shares were very expensive, these companies had (temporarily) high market caps. Because they were red-hot, they had huge trading volume. So their index weighting was out of all proportion. Buying an AEX ETF in those days came close to financial suicide. The index is still at only 57% of its peak value.
« Last Edit: November 28, 2013, 08:53:28 AM by mr. T »

daverobev

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Re: Active stock pickers can now beat the market
« Reply #18 on: November 28, 2013, 10:20:59 AM »
Second problem I have with indexing is that it favours shares that already had a runup. They join the index because the shareprice has gone up. They have a large weighting because they are popular. Indexes and ETFs favour shares on high valuations. That's an aspect of it that I don't like.

This implies that you believe shares in indices are overvalued. They're "hot" stocks,"run up" stocks, or "high valuation" stocks as you put it. Any evidence of this? Most accurately, they're HIGH MARKET CAP stocks. Those market caps could be perfectly justified by earnings. So unless you're willing to present evidence that index stocks have excessively high valuations relative to other stocks, you're just hand-waving.

Not exactly. What I mean is that if a share is overvalued, that drives up the market cap and by proxy it drives up the index weighting of the stock. The consequence is that overvalued shares are relatively overweight in indices. So Beltim explained correctly what I meant.

Edit: let me elaborate on that.
I live in Holland. Here, the stock market is tiny compared to the US market. The number of true large caps is very small. So, inefficiencies are quite visible. Besides, the Dutch stock market index is weighted by market cap and trading volume. So hot stocks are favoured double.

Holland is no Silicon Valley. But back in the good old days of the dot-com boom, the Dutch index was dominated by anything that comes close to dot-com. Telecom, cable companies, internet providers, that kind of stuff. Because the shares were very expensive, these companies had (temporarily) high market caps. Because they were red-hot, they had huge trading volume. So their index weighting was out of all proportion. Buying an AEX ETF in those days came close to financial suicide. The index is still at only 57% of its peak value.

Ok, so in other words, don't invest in a shit/poorly diversified index as your only thing!

You can get away with investing in just the FTSE All Share (the UK's biggest 350) because there are multi-nationals, bakers, milk producers, etc in there - as your only 'stock' index. You wouldn't want to do the same with the Canadian TSX 60 because it's dominated by banks, miners, and oil - there is little else.

But the Dutch index + the UK All Share + some bonds + some real estate and you'd be fine. It's about diversity. Indices with 25 stocks are not great. It's one thing in favour of the S&P 500, the FTSE all share, or just making sure you have large AND mid cap stuff going on.

That's about asset allocation, not picking winners - IMO.

Now, I'm not saying that value investing is bad - it's great - and it is/should be pretty obvious what sectors are out and which are hot (commodities, miners, oilers going down at the moment I guess, service/consumer discretionary on the way up?) - but I'm not smart enough to stick to that. I dabble, and I fail - I'm better off just buying the incredible VXUS (I'm lucky in that Canadian brokerages have access to the US, and tax free in retirement funds, very cheaply).

mr. T

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Re: Active stock pickers can now beat the market
« Reply #19 on: November 29, 2013, 03:37:38 AM »
No, that's not what mr. T is saying. He's saying that there are some stocks in indices that are overvalued, and he doesn't want to invest in those.

He is saying that in addition to what I quoted him as saying.

The problem with arguing that some stocks in the index are overvalued is that it implies you know better than the market. Yet we know that almost no one knows better (with the exception of the oft-sighted Mr. Buffet). The track record of professional investors simply does not bear out the notion that it's plainly obvious that some companies are overvalued and others undervalued. It's not enough to chalk it up to a lack of discipline. I mean really, there aren't a few more disciplined guys out there other than Warren Buffet?

market caps are much worse measures of a company than sales, earnings, or book value.

Perhaps. Care to offer a citation? This again implies that some simplistic measures of value are smarter than the collective "wisdom" of the market. I suspect such indices would outperform during bust periods and underperform during growth periods.

I could have written a much longer response to Mr T, but he touched on about ten major concepts and we'd quickly get into a debate about things like different forms of the efficient market hypothesis, which I have little interest in hashing out.

I'll broadly agree with Mr T that the best opportunity for individual investors to beat the market is to do in-depth research on small, illiquid, inefficient financial instruments where you're not going head-to-head with major institutional investors. This is, in fact, more or what I do for a living. However, even this takes a fair amount of financial acumen that goes beyond looking at simple metrics like P/E ratios and book value.

There is one thing on this board that I think is odd. On the one hand there's a very strong DIY mentality. The Mustache Man himself does some pretty advanced car maintenance based on watching a couple of youtube videos. I would be terrified to drive a car that I have been mucking around with after watching youtube. There's a tendency to claim that you can be badass at almost anything just by reading a book from the library, watching youtube videos and putting some effort into it. But with one exception: stock market investing. On this one single subject the Mustache Man makes a 180: you shouldn't even try, just buy a Vanguard tracker and forget about it. I think that's strange. Or maybe not as strange: maybe it's just a subject that this guy is not interested in. Maybe he's interested in building houses and reparing cars, but not in picking stocks. Fair enough. But the fact that the Mustache Man isn't into stock picking doesn't mean that no-one can do it properly.

You guys assume the big majority of the population sucks at almost anything: they can't run their personal finances properly, they eat too much and too unhealthy, they pay people to walk their dog, they have clown-like car habits. But at the same time, in stock market investing, the wisdom of the crowd is supposed to be invincible. Again: strange.

Let me use an analogy: there's a huge number of people playing the piano. The vast majority is crap at it. Only a very small percentage can make a living out of playing the piano. Those people have a natural talent and beside that, they put a lot of effort into it. But no-one would claim that putting effort into playing the piano is useless because "most people suck at it". Of course, the odds that you're the next Horowitz are small, but no-one would claim it's impossible. For some reason stock market investing is supposed to be different.

Of course there is something different about stock market investing: it's possible to get mediocre results without any effort. And that service is cheap. That's amazing. If someone would invent a service that would guarantee anyone to be able to play the piano at a mediocre level without any effort, this service would be a scam or very expensive (or both). But with investing it's dirt cheap. That's why I say: if you don't feel like it, just buy an ETF. If you want to do better, that's possible (I didn't say it's easy), but you will have to put some effort into it.

Yes, I do imply that it is possible to know better than the market. Now you state that "professional investors" do not have a good track record of doing that. I will tell you why.
1- There are quite a few of them that do. Only that's a minority. Just like with any profession, there's a small high-end that's really good and a big low-end that essentially consists of salaried office workers who are just good enough not to be fired.
2- Professionals have a fixed cost basis that they have to recover before they start making money: there's their own salary (and salaries tend to be pretty high in this industry), there's corporate overhead, an office building, a Bloomberg subscription etc. For a private investor, the fixed cost base can be close to zero. That's a huge advantage.
3- Professionals are chased by their bosses to produce results on a quarterly basis. This induces short-termism that's very harmful on the long run.
4- Many funds have captive customers. There's huge amounts of money in funds that are tied to mortgages, life insurance policies, pensions and the like. Situations where the customers are bound by long-term contracts and getting out is prohibitively expensive. Not a very strong incentive to invest your socks off for an optimal result. But a very strong incentive for the company to just let some junior grunt do the investing for minimal costs.
5- Many funds are marketing-driven. When internet and tech were hot, every house started an internet and tech fund. When BRIC was hot, everyone started a BRIC fund. Do all houses have the specialised knowledge to get it right? Of course not. But they start such a fund anyway, just to get a piece of the pie.
6- Professionals get sucked into crazes too. It took a person with the stature of Warren Buffett to resist the internet craze. And even he was considered to have "lost it" because he didn't invest in tech back then. What if you are Mike, fund manager of a generalist equity fund at a medium sized bank in a medium sized state? Even if Mike didn't want to, he would be forced to be sucked in. Because he would be instantly fired if he didn't invest in tech. And because Mike has a mortgage, wife and children in college, he doesn't want to be fired. So he does what his boss expects of him and he goes with the flow.
7- The customers of the professional investors are lazy and the investment houses know this. A large amount of private investors just take the standard funds that their bank offers them. Of course, those are the funds that are good for the bank, not necessarily the funds that are good for the customer.

All these factors drag down the average performance of professional investors as a group.

And I didn't say that "some simplistic measures of value" are enough. If a company has a low p/e, there's a very good chance that there's a good reason for that. But there's also a good chance there isn't. To tell the difference, you have to dig deeper. It's easy to artificially pump those simplistic measures. So you always have to investigate where that fantastic growth is coming from. And why this company is so profitable.

A simple example. For fast growing companies, it's easy to pump growth by stuffing the sales channel. In the past, there was a company that sold their product to partly-owned distributors and booked it as sales. Easy peasy. Until the system broke down of course. But anyone could have detected that, by looking at the debtors in the yearly report, that ran up just as fast as sales. But most investors just looked at the headline growth figure and fell for it. Wisdom of the crowd. Yeah right.

Another example. Big oil companies essentially pump money out of the ground. They're very profitable, and have been consistently so for a very long time. Still, their shares are cheap. If you ask why, you will get a long treatise about Middle East politics, peak oil theories, troubles in Nigeria and many more things. But all that shit has been around for decades and still those companies are cash-fountains. I don't think there is a very good reason to assume that will end soon. So I just cash an easy 5% dividend. Again with thanks to the wisdom of the crowd.

Left

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Re: Active stock pickers can now beat the market
« Reply #20 on: November 29, 2013, 04:26:52 AM »
hm I'm leaning index myself because a few reasons but I pick a few myself.
reasons I like the index ones are because 1) I don't WANT to work at it. If being retired but actively picking stocks, you're not really retired. You are just working from home... 2) if I buy a managed fund, while returns are better, the fees are also higher so to me the investor, I come out about even... 3) is that I don't mind not netting 1-2% extra profit by actively picking... I don't HAVE to maximize my returns to get a GOOD return. I just need one on the profit side that's above inflation...

And it isn't just MMM saying buy index... such as http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2013/press.html

mr. T

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Re: Active stock pickers can now beat the market
« Reply #21 on: November 29, 2013, 06:06:47 AM »
@DaveRobev:

I cite the Dutch market for two reasons:
1- I know it well
2- it's tiny and a shit index to follow with an ETF

The second reason makes the processes very visible: the index is always very much overweight on the present hot sector. And gets slaughtered when everyone is queueing up at the exit. Of course the same processes work at bigger, better and more diversified sectors, only the consequences are not as bad because of diversification. That's why diversification is important.

And you're right. If you invest in some broad, well diversified indices, throw in some bonds and a little cash, you will be fine. I was not denying that. I just say that it's possible to do better.

In a market like the Dutch, it's not that difficult: avoid the basket cases and you will outperform by default. In the FTSE 350, it will be harder, because the basket cases are diluted down by diversification. Like I said, some markets are more efficient than others.

the fixer

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Re: Active stock pickers can now beat the market
« Reply #22 on: November 29, 2013, 11:43:42 AM »
There is one thing on this board that I think is odd. On the one hand there's a very strong DIY mentality. The Mustache Man himself does some pretty advanced car maintenance based on watching a couple of youtube videos. I would be terrified to drive a car that I have been mucking around with after watching youtube. There's a tendency to claim that you can be badass at almost anything just by reading a book from the library, watching youtube videos and putting some effort into it. But with one exception: stock market investing. On this one single subject the Mustache Man makes a 180: you shouldn't even try, just buy a Vanguard tracker and forget about it. I think that's strange.
There's a big difference between replacing your car's sealed-bearing hub and stock picking: for the former, a YouTube video or blog post can describe an EXACT PROCESS for performing the task, and if you follow it exactly, your chances of success are extremely high. If stock picking were simple someone would post a basic guide of how to do it (look for companies with X, Y and Z and buy them; avoid companies with A, B, and C). Of course, if someone were to do this and it caught on, all companies with X/Y/Z would no longer be undervalued because everyone was looking for those characteristics. The reverse would be true of A/B/C companies. One could argue that this is not just a hypothetical and people are constantly writing books, etc. about new ways to get rich in stocks. So strike #1: it's not possible to document a consistent success strategy.

The second problem is replication of success across individuals. You could make the counterargument that, even if it's impossible to provide an exact process, stock picking is still something anyone can learn by developing their own style, or something. This is refuted with the evidence: on average, even professional financial advisors and money managers cannot beat the market cost-effectively. Why would the MMM community be any different? Maybe one of us would be phenomenally successful at stock picking, but at the expense of 5-10 others trying and failing. Everything else on the blog is advice that doesn't work this way: if you take the time to figure out how to do it right, your odds of success are reasonably high. So stock picking doesn't fit.

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Re: Active stock pickers can now beat the market
« Reply #23 on: November 30, 2013, 05:06:47 AM »
just saw this article that is opposite of the original on this thread
http://www.cbsnews.com/news/with-active-managers-is-alpha-really-just-beta/

another article from cbs, http://www.cbsnews.com/news/why-not-just-buy-stock-in-berkshire-hathaway/ about how even being as good as he is, buffet's company stock doesn't always beat the index
« Last Edit: November 30, 2013, 05:37:33 AM by eyem »

KingCoin

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Re: Active stock pickers can now beat the market
« Reply #24 on: November 30, 2013, 11:48:17 AM »
There is one thing on this board that I think is odd. On the one hand there's a very strong DIY mentality. The Mustache Man himself does some pretty advanced car maintenance based on watching a couple of youtube videos. I would be terrified to drive a car that I have been mucking around with after watching youtube. There's a tendency to claim that you can be badass at almost anything just by reading a book from the library, watching youtube videos and putting some effort into it. But with one exception: stock market investing. On this one single subject the Mustache Man makes a 180: you shouldn't even try, just buy a Vanguard tracker and forget about it. I think that's strange. Or maybe not as strange: maybe it's just a subject that this guy is not interested in. Maybe he's interested in building houses and reparing cars, but not in picking stocks. Fair enough. But the fact that the Mustache Man isn't into stock picking doesn't mean that no-one can do it properly.

The problem is that unlike fixing a car or playing the piano, investing is a competitive enterprise. It's a 0 sum game around the average. So while changing your own oil might be a good idea, going up against a professional pit crew probably isn't. While learning a Mozart Sonata may be pleasant, competing for stage time against Horowitz would be a life dominating endeavor.

While many of your points about professional investors are valid, the most important one that you neglect to mention is the massive economy of scale that professional investors have over retail hobbyists. Running $10 billion vs $1 million allows you to access an on-demand team of professional analysts, up-to-the-second data, achieve the best borrowing rates, along with countless other advantages. The retail investor will have to dedicate an enormous amount of their free time in order to compete with these investors. Just building a model to value a single corporation could take of weeks worth of free time and may not lead to a single trade (you might even feel obliged to do a bad or mediocre trade just because you put in the work).

I've traded at some of the biggest banks and hedge funds in the world, as well as on my own so I've seen all sides. If you have the know-how, you can beat the market, especially if you're looking at securities that have less than $50mm notional outstanding. Most institutional investors don't bother looking at these securities because they're not big enough to move the needle for them. They often trade sloppily since liquidity is poor. The biggest advantage that a retail investor has is that he can ride out some volatility without having to face redemption or other liquidity events. The long term approach can give them an enormous advantage.

KingCoin

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Re: Active stock pickers can now beat the market
« Reply #25 on: November 30, 2013, 11:56:55 AM »
Not exactly. What I mean is that if a share is overvalued, that drives up the market cap and by proxy it drives up the index weighting of the stock. The consequence is that overvalued shares are relatively overweight in indices. So Beltim explained correctly what I meant.

This might introduce timing risk more than anything. In theory, the index is buying the "hot stock" as it is rising, and selling it as it's falling. This should more or less end up as a wash for a long term holder. If you bought early, you would have benefited from the market cap weight approach. If you bought late, it would have cost you. I'm not sure if this is better or worse than a equal weighted approach. Each has its advocates and detractors. It would be interesting to see some research pieces comparing and contrasting different indexing methods.

brewer12345

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Re: Active stock pickers can now beat the market
« Reply #26 on: November 30, 2013, 02:50:43 PM »
I'd guess the more liquid and widely traded the market, the harder it is to beat it.  When you start trying to beat the market you must also take into account the additional risk you are taking by coloring outside the lines.  Is any additional return you generate sufficient compensation for the extra risk you run?  That becomes a difficult question to answer sometimes.

Since I have about won the race and am ERing in January, I have been moving more and more of my portfolio to index investments.  Whie I was in accumulation mode I was willing to run the risks and didn't care.  Not so much any more.

On market I think is not difficult to beat is the junk bond market.  This is a market that regularly blows up and has many forced sellers when that happens (they literally are not allowed to keep holding the bonds even if they are money good).  All you have to do is stay out of the market until it blows up and then go in and carefully buy the better names/bonds.  Sit and wait until the bonds are called or mature once the market recovers.  If the bonds you own trade up to the call price, it is time to sell so you can wait for the next implosion.

KingCoin

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Re: Active stock pickers can now beat the market
« Reply #27 on: November 30, 2013, 04:01:25 PM »
I'd guess the more liquid and widely traded the market, the harder it is to beat it.  When you start trying to beat the market you must also take into account the additional risk you are taking by coloring outside the lines.  Is any additional return you generate sufficient compensation for the extra risk you run?  That becomes a difficult question to answer sometimes.

Since I have about won the race and am ERing in January, I have been moving more and more of my portfolio to index investments.  Whie I was in accumulation mode I was willing to run the risks and didn't care.  Not so much any more.

On market I think is not difficult to beat is the junk bond market.  This is a market that regularly blows up and has many forced sellers when that happens (they literally are not allowed to keep holding the bonds even if they are money good).  All you have to do is stay out of the market until it blows up and then go in and carefully buy the better names/bonds.  Sit and wait until the bonds are called or mature once the market recovers.  If the bonds you own trade up to the call price, it is time to sell so you can wait for the next implosion.

I agree with all this. Illiquid securities trade at a higher yield/cheaper valuation than liquid securities. If you're a long term investor and able to ride out the intermittent storms, it makes a ton of sense to clip the illiquidity premium. This is almost never discussed by financial writers or advisors, I think in part because it's not obvious what securities to recommend on the back of this advice (go buy some random 10mm stub issue from XYZ insurance group doesn't really help), people have to do their own work.

I think a good strategy is to stick to higher quality, liquid instruments when the market is booming, and switch to illiquid/sloppy instruments when the market s*&#s the bed.  I remember in the depth of the crisis seeing practically risk free bonds (IG, 5y CDS @ 40bps) trading at 18%YTM. Of course, chasing yield when things are booming is everyone's natural inclination, which usually ends in tears.

Playing technicals in junk bonds can be interesting, but the question is where to keep your money in the meantime. Stocks usually underperform during a market puke, and then outperform on the come-back, so selling stocks to buy junk bonds is a tricky business. Rotating a treasury position is probably the right play (treasuries rally in crisis).

brewer12345

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Re: Active stock pickers can now beat the market
« Reply #28 on: November 30, 2013, 04:40:08 PM »
KingCoin, I remember very well.  Investment grade, 5 year maturities at double digit yields; a high quality preferred issue with qualified dividend treatment of the coupons and a 14% yield; 5 year junk that was obviously money good at 20% yield even after I got skinned buying a retail lot.  Definitely turns my crank.

I run about 65% equities these days, increasingly well diversified, and that number will come down as I get farther ahead of what I really need to sustain FIRE.  When the junk market next blows up I will be using the proceeds from high quality bonds, CDs, cash, and merger arbitrage funds to buy individual junk bonds I like.  Last time around I was caught out by the crash and had to supplement the cash I could raise by a draw on my HELOC to go chase those juicy opportunities.  Not planning on doing that again.

abliviax

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Re: Active stock pickers can now beat the market
« Reply #29 on: December 06, 2013, 08:59:04 PM »
To OP --

There are definitely people who can consistently beat the U.S. market.  There are many examples.  I have in 5 of my 7 years of investing (the last five), and mostly learned from two other people who have consistently beat the market for 15+ years each.

So how does this affect your ETF vs. Mutual Fund choice?:  Probably not at all.  Unless, you think you can evaluate managers' strategies and/or performance (don't think I can, but I do trust myself to pick a basket of stocks for myself with some help from experienced people who have reason to increase stock-picking performance).

One of the main problems with active management is that investment firms' bottom lines subtract from yours.  Expense ratios, fees, etc. -- and these costs are reported much more clearly than they used to be.

I would switch to ETFs to lower expenses, and consider leaving some in active funds if you have strong reason to have confidence in a few particular managers.




Cooperd0g

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Re: Active stock pickers can now beat the market
« Reply #30 on: December 07, 2013, 10:31:38 AM »
People will always be able to beat indexes by picking individual funds or stocks. The problem lies with you. Can YOU do it? Can you do it for one year? How about 2, or 3 or 4 or 5 ... in a row? Not likely. What about the pros? Same thing. Historical data has shown that less than 10% of of mutual funds can beat the market 3 years in a row. So you have a less than 1 in 10 shot of picking a pro who can do it for only three years. I think the percent that can do it for 10 years is like less than 1. So in the long run choosing index funds is vastly better than actively managed funds, especially when you take costs into account.

RobertBirnie

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Re: Active stock pickers can now beat the market
« Reply #31 on: December 09, 2013, 09:10:15 PM »
Two points I think I can add,

1. MarketWatch makes money via advertisement which is driven by page views. MarketWatch really wants you to be a day trader because then you'd probably view a hundred pages a day. If you were an index investor you might view less than one.

2. Also, valuations are based on all available knowledge of the stock, not trade volumes. So even if there were fewer active traders, they'd still be able to hit a fair valuation. Plus I think most of the trade volumes are by active or algorithmic traders anyways, they do a lot more volume than you or I ever will and also have a larger effect on prices. There is actually a stock picking scheme called the "odd-lotter" which most of us would be in when we actively trade stocks http://en.wikipedia.org/wiki/Odd_lotter.

I would be very interested not in how "active traders beat indexes" but rather in how the increase of index funds and the decrease of active traders has changed the volatility of stock prices. With fewer traders making active bets on price movements I'm guessing volatility would rise as well. I doubt you would be able to tease this out of the data though because over the same time period as index funds came about, the speed of information has also increased by leaps and bounds which I think also increases volatility.