Critical view of index investing

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Northern Flicker
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Re: Critical view of index investing

Post by Northern Flicker »

more than one poster wrote: As long as you invested in 30+ stocks, you got an index.
This is not correct. The best available evidence is that it takes at least about 60 stocks to diversify away idiosyncratic risk and about 100 to be sure of it in the worst case. Generally, when retail investors try to manage their own portfolio of individual stocks, they end up taking on uncompensated risk that they are not aware of. It is not risk that materializes often, but statistically, you are likely to get hit with it at some point if you invest for a long enough period. Exposure to this risk leads to DIY portfolios having a lower expected return than a better diversified portfolio with exposure to the same systematic risk factors as the DIY portfolio.
gougou
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Re: Critical view of index investing

Post by gougou »

Northern Flicker wrote: Mon Jun 21, 2021 5:45 pm
gougou wrote: What I dislike about index investing is that it merely gives you an average return if you have the stomach to hold for a very long time.
You don't have to hold a long time to get the market return. An index fund gives you that every day.
Not everyone has the stomach to hold through a 30%+ crash like what happened in 2020. Probably even fewer people can hold through 2000 to 2010 and still hold strong underwater for 10 years. If investors don’t understand the underlying businesses they are buying, they are unlikely to hold them when they are dirt cheap, and they are likely to chase them when they are expensive. These people won’t even get the long term average market return of 8% to 9% per year.

And last year was the time when many companies were dirt cheap by almost any metrics, so going 100% stocks or even mortgage your house and dump into those stocks was the right thing to do with fairly low risk and high reward. But if you don’t do fundamental analysis I just don’t see how you can judge such opportunities.
The sillier the market’s behavior, the greater the opportunity for the business like investor.
alex_686
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Re: Critical view of index investing

Post by alex_686 »

Northern Flicker wrote: Mon Jun 21, 2021 3:07 pm
alex_686 wrote: In a up market you get the average return. It does not matter if you are passive or active. It is how averages work. It is hard to beat the index in a up market. However, In a down market you also get the average return. It is just as hard to beat the market in a down market. It is not like a magic door opens up in a down market.
You can take more risk than the market, and most often beat the market in an up market, and most often underperform the market in a down market. This is how many actively managed stock mutual funds are managed.

You can take less risk than the market, and most often underperform during an upmarket and most often underperform in a down market. Minimum volatility equity funds are designed to behave like this.

I made a point of saying most often above because there are no guarantees or hard and fast rules.
I am not exactly sure what point you are making, but I think you are missing the mark.

I am going to assume that we are talking about Beta, the portion of return that can be attributed to the market, and Alpha, the portion of return that can be attributed to the portfolio manager's skill.

Do active managers get higher returns by piling on Beta (a.k.a. risk)? Generally no. Investors know that trick. A portfolio manager is paid to produce Alpha. They are not going to pay expensive management fees to a lazy portfolio manager. Performance is adjusted for that, and thus the manager's fees.

Now, onto minimum volatility funds. As an aside, I am a big proponent of this factor. Anyways, for a active manager whose style is minimum volatility, the correct measuring stick is a minimum volatility index. Can a active minimum volatility fund manager beat the index in a up market? Yes, but it is hard to do. Can they beat the minimum volatility index in a down market? Yes, but it is just as hard as beating it in a up market.

Maybe you are referring to minimum volatility as a style, where a manager rotates through various styles such as value, momentum, sectors, etc. Can a active manager bring value this way? Yes, but once again it is hard - both in up and down markets.
gougou wrote: Tue Jun 22, 2021 1:51 am Not everyone has the stomach to hold through a 30%+ crash like what happened in 2020. Probably even fewer people can hold through 2000 to 2010 and still hold strong underwater for 10 years. If investors don’t understand the underlying businesses they are buying, they are unlikely to hold them when they are dirt cheap, and they are likely to chase them when they are expensive. These people won’t even get the long term average market return of 8% to 9% per year.
Gougou, I am kind of picking one of your posts at random. Let me expand on a point I made earlier - the analogy of professional athletes. I can believe a couple of things that may seem contradictory - but are not.

1. All of the athletes, coaches, etc. are highly skilled people. They earn big bucks because of the value that they add. I can say the same about portfolio managers.

2. There are as many winning teams as losing teams. This is true for funds as well.

How can there be so? How can a team with so much expensive talent still lose? Well, it is a highly competitive flat fair playing field. Same for the stock market and funds.

3. People can identify winners. To be specific, that you have wisdom, insight, and skill that is greater than the collective wisdom of the market. I can. Well, not with sports - I am rubbish with that. But I can with stocks and funds. I have had professional training and experience with both. It can be done. It is hard. It is next to impossible to do so consistently.

You can be wrong due to luck or skill. You can select who you think is the greatest quarterback of all time. He could have a career ending injury in the first game. He could just not pan out, not being as good as the hype. You can be right and still be wrong. Great teams still lose. For example, I believe in the premise of minimum volatility funds, as a safer sub-set of equities. It didn't work last year because of the issues specific to the COVID crisis.

I am a modest advocate of stock picking. The stock market is very efficient due to the number of highly skilled players in the market. If you have got the skill then go for it. However, the easy wins you suggest are not there.
gougou wrote: Tue Jun 22, 2021 1:51 am And last year was the time when many companies were dirt cheap by almost any metrics, so going 100% stocks or even mortgage your house and dump into those stocks was the right thing to do with fairly low risk and high reward. But if you don’t do fundamental analysis I just don’t see how you can judge such opportunities.
Going back to the point that even great teams win. I have seen this scenario many times, and the risk is much higher than you think. I have seen people step into the bottom of the market and make a fortune. I have seen people do this and it takes 10 years for the market to recover. I have seen people do this and the market takes another crash.

The issue here is that you need to do so consistently. One bad step and you have underperformed the market for 10 years.

It is why I stick mostly to passive indexing. You should only go active when you have a high conviction of your position and you have self-calibrated yourself for all of the mental traps out there.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
Northern Flicker
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Re: Critical view of index investing

Post by Northern Flicker »

gougou wrote: Not everyone has the stomach to hold through a 30%+ crash like what happened in 2020. Probably even fewer people can hold through 2000 to 2010 and still hold strong underwater for 10 years.
Implementing your own equity portfolio won't protect you from crashes. Investors diversify their equity holdings with bonds if they cannot tolerate a deep drawdown.
Northern Flicker
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Re: Critical view of index investing

Post by Northern Flicker »

alex_686 wrote: Tue Jun 22, 2021 8:55 am
Northern Flicker wrote: Mon Jun 21, 2021 3:07 pm
You can take more risk than the market, and most often beat the market in an up market, and most often underperform the market in a down market. This is how many actively managed stock mutual funds are managed.
I am not exactly sure what point you are making, but I think you are missing the mark.

I am going to assume that we are talking about Beta, the portion of return that can be attributed to the market, and Alpha, the portion of return that can be attributed to the portfolio manager's skill.
I wasn't going so far as to say how active managers were taking more risk, but that actively managed mutual funds try to beat the market by more than their fee level. To do so, they typically take more risk. That risk is most often rewarded in an up-market. The risk most often materializes in a down market. My point was nothing more complicated than that.

Minimum volatility funds are actively managed, and would be an obvious exception to the above.
Last edited by Northern Flicker on Tue Jun 22, 2021 3:36 pm, edited 1 time in total.
Normchad
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Re: Critical view of index investing

Post by Normchad »

Northern Flicker wrote: Mon Jun 21, 2021 3:00 pm
gougou wrote: I'm not trying to beat Buffett, I'm just trying to earn something like a 15% return instead of the long term average of 8% to 9% from an index fund. Even if someone do get 15% return per year it will take them 50 years to grow $1M to $1B, so Buffett must have done a lot better than that.
Buffett is the CEO of an auto insurer and reinsurer. The investment portfolio return is just one part of the growth. I've never loojed at the BRK books and balance sheet, so I'm speakibg in general terms, but I believe much of the capital to buy the investments held come from insurance premiums and other business profits.
Buffet is more of a business man than an investor. He didn’t get rich by buying mutual funds. He’s buys entire companies, or substantial portions of companies, and exerts a lot of influence on the businesses. This is very different.

In that same way, I just don’t know if any Billionaire investors who did it by just buying actively managed funds either. Soros, etc are not investors as much as they are businessmen.
Exchme
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Re: Critical view of index investing

Post by Exchme »

gougou wrote: Tue Jun 22, 2021 1:51 am And last year was the time when many companies were dirt cheap by almost any metrics, so going 100% stocks or even mortgage your house and dump into those stocks was the right thing to do with fairly low risk and high reward. But if you don’t do fundamental analysis I just don’t see how you can judge such opportunities.
I think you are minimizing the difficulty of making these market timing moves in the moment when you face the possibility that they might be wrong. For instance, did you do what you suggested, mortgage on your house to buy stocks at the bottom or at least go all into stocks and use leverage and options last year?

I moved a few percent of my portfolio from bonds to stocks on the way down last year, a little at a time as I had no idea where the bottom was, just trying to rebalance a bit. Of course wish I had done more, but in the moment, I find it's never easy to do. I recall headlines like 5+% lethality, asymptomatic spread, PPE shortages even for for hospitals, morgues overflowing in China, supply chain breakdowns and near breakdowns for everything, no vaccine or treatment and none that had ever been developed for any coronavirus before. If not for a lot of courageous front line workers, meat packers, delivery people, brilliant researchers, etc., the world could have been a very bad place indeed and fundamental analysis of the prior value of businesses might have been completely irrelevant.

Same thing in 2008, the world's financial system really did come close to collapsing, many millions lost their jobs and houses and no one knew where the bottom was. Search the BH archives for poster "Sheepdog" to read a fear filled tale of a retiree in his 70's that was little too aggressive on the way up and got caught short of cash and had to sell quite a bit when things were already down 30+% (of course that wasn't the bottom, things went down much further).
HootingSloth
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Re: Critical view of index investing

Post by HootingSloth »

Normchad wrote: Tue Jun 22, 2021 11:48 am
Northern Flicker wrote: Mon Jun 21, 2021 3:00 pm
gougou wrote: I'm not trying to beat Buffett, I'm just trying to earn something like a 15% return instead of the long term average of 8% to 9% from an index fund. Even if someone do get 15% return per year it will take them 50 years to grow $1M to $1B, so Buffett must have done a lot better than that.
Buffett is the CEO of an auto insurer and reinsurer. The investment portfolio return is just one part of the growth. I've never loojed at the BRK books and balance sheet, so I'm speakibg in general terms, but I believe much of the capital to buy the investments held come from insurance premiums and other business profits.
Buffet is more of a business man than an investor. He didn’t get rich by buying mutual funds. He’s buys entire companies, or substantial portions of companies, and exerts a lot of influence on the businesses. This is very different.

In that same way, I just don’t know if any Billionaire investors who did it by just buying actively managed funds either. Soros, etc are not investors as much as they are businessmen.
Bill Hwang might be an example of someone who became a billionaire by being an investor, rather than as an entrepreneur. Not an example of someone who stayed a billionaire though...
Global Market Portfolio + modest tilt towards volatility (80/20->60/40 as approach FI) + modest tilt away from exchange rate risk (80% global+20% U.S. stocks; currency-hedge bonds) + tax optimization
gougou
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Re: Critical view of index investing

Post by gougou »

Exchme wrote: Tue Jun 22, 2021 12:37 pm
gougou wrote: Tue Jun 22, 2021 1:51 am And last year was the time when many companies were dirt cheap by almost any metrics, so going 100% stocks or even mortgage your house and dump into those stocks was the right thing to do with fairly low risk and high reward. But if you don’t do fundamental analysis I just don’t see how you can judge such opportunities.
I think you are minimizing the difficulty of making these market timing moves in the moment when you face the possibility that they might be wrong. For instance, did you do what you suggested, mortgage on your house to buy stocks at the bottom or at least go all into stocks and use leverage and options last year?

I moved a few percent of my portfolio from bonds to stocks on the way down last year, a little at a time as I had no idea where the bottom was, just trying to rebalance a bit. Of course wish I had done more, but in the moment, I find it's never easy to do. I recall headlines like 5+% lethality, asymptomatic spread, PPE shortages even for for hospitals, morgues overflowing in China, supply chain breakdowns and near breakdowns for everything, no vaccine or treatment and none that had ever been developed for any coronavirus before. If not for a lot of courageous front line workers, meat packers, delivery people, brilliant researchers, etc., the world could have been a very bad place indeed and fundamental analysis of the prior value of businesses might have been completely irrelevant.

Same thing in 2008, the world's financial system really did come close to collapsing, many millions lost their jobs and houses and no one knew where the bottom was. Search the BH archives for poster "Sheepdog" to read a fear filled tale of a retiree in his 70's that was little too aggressive on the way up and got caught short of cash and had to sell quite a bit when things were already down 30+% (of course that wasn't the bottom, things went down much further).
Yes I did go all in last year. I'm a real estate investor with under-levered properties so I did a bunch of cash out refinancing last year and dumped the proceeds into REITs and energy MLPs. I also rotated pretty much all my index funds into REITs when it was pretty clear the apocalypse was not going to happen, index mostly recovered and REITs were still cheap. There were some blue chip REITs that traded at 50% NAV throwing out 8%+ dividends. That was much better than buying rental properties directly because you can buy $1 worth of equity at 50c and you get to be completely passive.

And it just turned out that I beat the market. But even if I didn't, I would be happy to keep buying those REITs as long as they are cheap. I honestly don't think I took a lot of risk buying REITs in the S&P 500 that traded for 50c to 60c on the dollar. And if you don't care about fundamental analysis, you probably won't notice those companies were cheap.

Even now I still see a lot of opportunities in the market that probably will give me a 15% annual return under some reasonable assumptions. I just believe it's better to put my money there vs buying the index that's been dominated by some overvalued big tech companies.
The sillier the market’s behavior, the greater the opportunity for the business like investor.
gougou
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Re: Critical view of index investing

Post by gougou »

alex_686 wrote: Tue Jun 22, 2021 8:55 am
gougou wrote: Tue Jun 22, 2021 1:51 am Not everyone has the stomach to hold through a 30%+ crash like what happened in 2020. Probably even fewer people can hold through 2000 to 2010 and still hold strong underwater for 10 years. If investors don’t understand the underlying businesses they are buying, they are unlikely to hold them when they are dirt cheap, and they are likely to chase them when they are expensive. These people won’t even get the long term average market return of 8% to 9% per year.
Gougou, I am kind of picking one of your posts at random. Let me expand on a point I made earlier - the analogy of professional athletes. I can believe a couple of things that may seem contradictory - but are not.

1. All of the athletes, coaches, etc. are highly skilled people. They earn big bucks because of the value that they add. I can say the same about portfolio managers.

2. There are as many winning teams as losing teams. This is true for funds as well.

How can there be so? How can a team with so much expensive talent still lose? Well, it is a highly competitive flat fair playing field. Same for the stock market and funds.

3. People can identify winners. To be specific, that you have wisdom, insight, and skill that is greater than the collective wisdom of the market. I can. Well, not with sports - I am rubbish with that. But I can with stocks and funds. I have had professional training and experience with both. It can be done. It is hard. It is next to impossible to do so consistently.

You can be wrong due to luck or skill. You can select who you think is the greatest quarterback of all time. He could have a career ending injury in the first game. He could just not pan out, not being as good as the hype. You can be right and still be wrong. Great teams still lose. For example, I believe in the premise of minimum volatility funds, as a safer sub-set of equities. It didn't work last year because of the issues specific to the COVID crisis.

I am a modest advocate of stock picking. The stock market is very efficient due to the number of highly skilled players in the market. If you have got the skill then go for it. However, the easy wins you suggest are not there.
The big question is, is there skill in the game of picking companies, or is it all pure luck? If there is skill involved, shouldn't the average investor also try to learn the game?

My critical view of index investing is that it doesn't expose you to the real game. The advocates don't care about a company making X dollar of profit, returned Y dollar to shareholders, and reinvested Z dollar into the business for growth. The index fund advocates actually say it's useless to even care about the game, and you should just buy the index and you are golden.

I actually think it's much better for a newbie investor to just buy BRK.B and read its financial statements and annual shareholder letters. They will learn the game because it's a real business and someone is teaching the game.
The sillier the market’s behavior, the greater the opportunity for the business like investor.
alex_686
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Re: Critical view of index investing

Post by alex_686 »

gougou wrote: Tue Jun 22, 2021 2:04 pm The big question is, is there skill in the game of picking companies, or is it all pure luck? If there is skill involved, shouldn't the average investor also try to learn the game?
It is a combination of skill and luck. It is sometimes hard to disentangle the 2.

And no, the average investor should not try to learn the game. NFL players make big bucks. Should the average person strive to be to a NFL players?

On a more realistic note, should one try to become a professional poker player? It requires less time to gain the skills and requires less time and capital to be successful. Of course, you still have to have more skill and luck than the other skillful players on your table.

That is one of the reasons why passive investing works so well. You get decent returns for zero skill and zero work.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
fwellimort
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Re: Critical view of index investing

Post by fwellimort »

gougou wrote: Tue Jun 22, 2021 2:04 pm The big question is, is there skill in the game of picking companies, or is it all pure luck? If there is skill involved, shouldn't the average investor also try to learn the game?
There's been research papers in the past which evidenced that the average professional has greater skill than the average retail investor when it comes to investing in the stock market.
Unfortunately, the hurdle to beat the market is so high that the average professional do not possess the skill to reliably beat the market long term.
So to your question, there is skill (and luck) involved to picking companies. Unfortunately, stock market is like a winner take all game so being slightly better than your neighbor might not be that helpful.
You need to be substantially better than the average professional to have a chance at beating the market (assuming you consider your finite time researching as 0 fees).
And you need a lot of luck. Investing in stocks is a game of probabilities. Uncertainties that are outside your controls exist (a global pandemic, 9/11, etc).

I think people investing in the stock market should learn how stocks were traditionally valued (at least a basic idea).
Knowledge can be of great help. Many people today think 'stocks go up cause it goes up'.
In fact, I don't even think the average person investing in index funds even understand what bond, stocks, preferred stocks, etc. are.
After all, ignorance can prove to be detrimental during extended market downturns.
Plus, I believe learning how the stock/bond market works helps one better appreciate investing in low cost index funds for the long run.
Northern Flicker
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Re: Critical view of index investing

Post by Northern Flicker »

gougou wrote: Tue Jun 22, 2021 1:27 pm
Exchme wrote: Tue Jun 22, 2021 12:37 pm
gougou wrote: Tue Jun 22, 2021 1:51 am And last year was the time when many companies were dirt cheap by almost any metrics, so going 100% stocks or even mortgage your house and dump into those stocks was the right thing to do with fairly low risk and high reward. But if you don’t do fundamental analysis I just don’t see how you can judge such opportunities.
I think you are minimizing the difficulty of making these market timing moves in the moment when you face the possibility that they might be wrong. For instance, did you do what you suggested, mortgage on your house to buy stocks at the bottom or at least go all into stocks and use leverage and options last year?

I moved a few percent of my portfolio from bonds to stocks on the way down last year, a little at a time as I had no idea where the bottom was, just trying to rebalance a bit. Of course wish I had done more, but in the moment, I find it's never easy to do. I recall headlines like 5+% lethality, asymptomatic spread, PPE shortages even for for hospitals, morgues overflowing in China, supply chain breakdowns and near breakdowns for everything, no vaccine or treatment and none that had ever been developed for any coronavirus before. If not for a lot of courageous front line workers, meat packers, delivery people, brilliant researchers, etc., the world could have been a very bad place indeed and fundamental analysis of the prior value of businesses might have been completely irrelevant.

Same thing in 2008, the world's financial system really did come close to collapsing, many millions lost their jobs and houses and no one knew where the bottom was. Search the BH archives for poster "Sheepdog" to read a fear filled tale of a retiree in his 70's that was little too aggressive on the way up and got caught short of cash and had to sell quite a bit when things were already down 30+% (of course that wasn't the bottom, things went down much further).
Yes I did go all in last year. I'm a real estate investor with under-levered properties so I did a bunch of cash out refinancing last year and dumped the proceeds into REITs and energy MLPs. I also rotated pretty much all my index funds into REITs when it was pretty clear the apocalypse was not going to happen, index mostly recovered and REITs were still cheap. There were some blue chip REITs that traded at 50% NAV throwing out 8%+ dividends. That was much better than buying rental properties directly because you can buy $1 worth of equity at 50c and you get to be completely passive.

And it just turned out that I beat the market. But even if I didn't, I would be happy to keep buying those REITs as long as they are cheap. I honestly don't think I took a lot of risk buying REITs in the S&P 500 that traded for 50c to 60c on the dollar. And if you don't care about fundamental analysis, you probably won't notice those companies were cheap.

Even now I still see a lot of opportunities in the market that probably will give me a 15% annual return under some reasonable assumptions. I just believe it's better to put my money there vs buying the index that's been dominated by some overvalued big tech companies.
I take it that the fact that sector risk is uncompensated by a priori expected return was not a consideration.
alex_686
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Re: Critical view of index investing

Post by alex_686 »

Northern Flicker wrote: Tue Jun 22, 2021 11:35 am I wasn't going so far as to say how active managers were taking more risk, but that actively managed mutual funds try to beat the market by more than their fee level. To do so, they typically take more risk. That risk is most often rewarded in an up-market. The risk most often materializes in a down market. My point was nothing more complicated than that.

Minimum volatility funds are actively managed, and would be an obvious exception to the above.
To restate, this is specifically how it is not done. There are a couple of different ways of stating risk, but this stuff gets spelled out beforehand. When evaluating a fund or the management you do not reward them for taking more risk. It is lazy. It encourages dangerous behavior. I am going to keep things simple and stick with a single risk parameter - Beta.

Let us walk through some examples. You are viewing a minimum volatility fund (MVF) which had a 12% annual return last year.

Case #1: The Broad Market Index (BMI) was up 8% but MVF was up 12%. Did the portfolio manager add any value? Unknown. You are comparing apples to oranges. And we certainly are not going to give credit to the portfolio manager. We picked the asset class, minimum volatility - not the portfolio manager.

We have to use a Minimum Volatility Index (MVI) as the yardstick. There is nothing magical about a MVI that says it has to have a lower return or a lower volatility than the BMI. Stocks that have lower volatility in the past tend to have lower volatility in the future. Stocks that have lower volatility tend to have lower returns than the BMI. but not always.

Case #2: BMI market up by 8%, the MVI is up by 10%, and the fund by 12%. Was value added? Maybe.

Note, the Beta of MVI is 1, by definition. Beta is a relative value. You are comparing a stock or a fund to the relevant market. The relevant market in this case is the universe of low volatile stocks. We can't use BMI - it would give us garbage results.

We are going to assume that the risk free rate is 0%. It makes the math easier.

Case #3: The fund manager buys stocks in the MVI with a Beta of 1.2. After all, in the sub-set of the MVI's universe of stocks some are going to be relatively more volatility than others. MVI is up 10%, MVF is up 12%? Did the manager add any value? Nope. 10% market return * 1.2 Beta = 12%. They got the extra return by loading up on risk. We are going to fail both the fund and the manager. We reward skill, not risk.

Case #4. The fund manager buys stocks in the MVI with a Beta of 1.0. MVF is up 12%? Did the manager add any value? Maybe. 1 period could just be luck. We are going to see more periods to see.

There are many mangers that fall into the last category. We can tell that these are high skilled players. The problem for the investors is that while these managers gross returns regularly beat the market the net returns don't. The managers know that they are highly skilled and charge according.

So, let us talk about other risk factors. We have kind of covered volatility and Beta. Are there other types of risk you want to cover?

Active fund managers need to be different than the underlying index if they want to generate Alpha. So you are going to get "tracking error risk" and "mismatch risk". But is that risk? You are getting different returns and risks, not necessarily higher or lower.

To play devil's advocate, lets look at the extreme case of Michael Burry. He ran a hedge fund. Insurance companies hired him to invest in small cap US companies. He invested in credit default swaps instead in 2008. Significant mismatch risk and tracking error. But it paid off big, returning 489.34% net. See "The Big Short" for more details.
Former brokerage operations & mutual fund accountant. I hate risk, which is why I study and embrace it.
Northern Flicker
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Re: Critical view of index investing

Post by Northern Flicker »

alex_686 wrote: When evaluating a fund or the management you do not reward them for taking more risk. It is lazy.
Right. You are talking about professional institutional investment teams doing detailed analyses of investment opportunities. I'm referring to actively managed retail mutual funds. There are a few good active managers in the retail space-- T. Rowe Price, Vanguard active funds, Dodge & Cox, no doubt some others, but many are not delivering value for their effort. Their excess return is explainable by additional risk they took, which is not just beta exposure, and exposure to the same risk factors would have been available more cheaply to the investor.
Northern Flicker
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Re: Critical view of index investing

Post by Northern Flicker »

gougou wrote: My critical view of index investing is that it doesn't expose you to the real game. The advocates don't care about a company making X dollar of profit, returned Y dollar to shareholders, and reinvested Z dollar into the business for growth. The index fund advocates actually say it's useless to even care about the game, and you should just buy the index and you are golden.
Not so. Index fund investors care about the collective profits of the companies in the index. The real game sometimes involves swimming with piranhas and sharks. Index funds avoid that.

But why would a real estate investor want to take on the correlated risk of concentrating equities in REITs?
alex_686
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Re: Critical view of index investing

Post by alex_686 »

Northern Flicker wrote: Tue Jun 22, 2021 10:58 pm
alex_686 wrote: When evaluating a fund or the management you do not reward them for taking more risk. It is lazy.
Right. You are talking about professional institutional investment teams doing detailed analyses of investment opportunities. I'm referring to actively managed retail mutual funds. There are a few good active managers in the retail space-- T. Rowe Price, Vanguard active funds, Dodge & Cox, no doubt some others, but many are not delivering value for their effort. Their excess return is explainable by additional risk they took, which is not just beta exposure, and exposure to the same risk factors would have been available more cheaply to the investor.
This has not been my experience. This is one the very basic fundamental questions that is asked. How are you getting return, what risks are you taking. There have just been too many scandals in this area. Let me expand.

There is a sub-industry for performance attribution. Beta and Duration are basic introductory stuff. Lots of packages out there. Lots of "big investors" are using this stuff, like the people setting up 401ks, model portfolios, and the like.

A mutual fund is a independent corporation with a independent board that negotiates the fees that are paid to the portfolio manager, including performance bonus. We can debate the effectiveness and vigor of this "independent" board, but this is a very low bar to hop over. It would think it would be gross negligence if they didn't. We did this type of analysis at the 2nd rate mutual fund that I worked at.

You know the hedge funds that charge 2 and 20? (They don't actually charge 2 and 20, but that is a different story). That 20% of return that the fund gets? That is what they get on the excess performance against the benchmark. It is standard to adjust this benchmark for Beta, volatility, semi-var etc. depending on what the fund is doing. 2 Nobody pays 2 and 20 for managers to load up on hot stocks. That lesson was learned 20, 30 years ago.

I could go on.
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Re: Critical view of index investing

Post by Northern Flicker »

Many consultants choosing fund products for 401K plans cannot even be bothered to look past the names of the Vanguard Midcap index fund to see that it tracks a CRSP index with a different size taxonomy and mostly holds S&P500 member stocks, or that the Vanguard Small-Cap index fund is a small and midcap fund. Instead they just include the S&P 500 Fund, Midcap Index Fund, and Small-cap Index Fund without a correct explanation. Not only does this lead to significant overlaps or gaps if trying to cover the total market, but it confuses plan participants.

So, I would not trust that active funds included in 401K plans are vetted properly or thoroughly for delivering alpha in risk-adjusted terms.

The mutual fund industry is filled with actively managed retail mutual fund products that achieve their excess return by taking more risk. If they truly were generating risk-adjusted alpha, the SPIVA scorecards would be more favorable.

Another game played is to have a fund that tilts away from one benchmark and towards another. An international fund holds 90% DM and 10% EM. When DM overperforms EM, they beat the total int'l index benchmark. When DM underperforms EM, they beat the DM index benchmark. The fund is equidistant from both benchmarks.
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Re: Critical view of index investing

Post by gougou »

Northern Flicker wrote: Tue Jun 22, 2021 11:59 pm
gougou wrote: My critical view of index investing is that it doesn't expose you to the real game. The advocates don't care about a company making X dollar of profit, returned Y dollar to shareholders, and reinvested Z dollar into the business for growth. The index fund advocates actually say it's useless to even care about the game, and you should just buy the index and you are golden.
Not so. Index fund investors care about the collective profits of the companies in the index. The real game sometimes involves swimming with piranhas and sharks. Index funds avoid that.

But why would a real estate investor want to take on the correlated risk of concentrating equities in REITs?
That's a business which is very easy to understand. They just own a bunch of properties and collect some rents. I don't think anyone has a significant edge over me in evaluating the approximate value of those properties. And then when such stocks trade at massive discount to the underlying business it made a lot of sense for me to buy.

On the other hand, I have no idea how to analyze say, Apple's business, and I think some very smart people, group of people could have a strong edge over me in analyzing all those tech companies. So there's no reason for me to do an outsized bet on all those tech companies via an SP500 index fund.
The sillier the market’s behavior, the greater the opportunity for the business like investor.
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Re: Critical view of index investing

Post by Northern Flicker »

The point of a market index fund is that you don't have to understand the idiosyncracies of each company's business. You get the return of the market. Idiosyncratic return and risk of individual companies is diversified away.

You may also want to consider the principles of modern portfolio theory, which are that by holding a mix of less than fully correlated risky assets, you can earn the long-term return of each with an overall portfolio that is less risky than its individual components.

Directly held residential rental income property has moderately low correlation with the broad stock market. Although there are no guarantees, combining them provides a portfolio that typically has less drawdown than either asset class by itself during a bear market. You are not compensated for taking much more risk by giving up this type of diversification opportunity to hold stock concentrated in the same sector.

If you want to hold assets concentrated in one sector, that is your choice. But please don't try to convince us that an asset mix slathered in uncompensated sector concentration risk is evidence of purported flaws of broad market index funds, which diversify away uncompensated sector concentration risk.
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Re: Critical view of index investing

Post by gougou »

Northern Flicker wrote: Wed Jun 23, 2021 2:52 pm The point of a market index fund is that you don't have to understand the idiosyncracies of each company's business. You get the return of the market. Idiosyncratic return and risk of individual companies is diversified away.
Sure, if the majority of the index components are attractively valued, I can see myself buying into an index fund.
Northern Flicker wrote: Wed Jun 23, 2021 2:52 pm Directly held residential rental income property has moderately low correlation with the broad stock market. Although there are no guarantees, combining them provides a portfolio that typically has less drawdown than either asset class by itself during a bear market. You are not compensated for taking much more risk by giving up this type of diversification opportunity to hold stock concentrated in the same sector.
The drawdown of the REITs was an opportunity to buy real estate at half the price. The risk of REITs going to 0 is the same as privately held real estate going to 0. The risk of REITs not able to collect rent is the same as privately held real estate not able to collect rent. So it's clearly not more risky than privately held real estate. REITs can't trade at 50% forever because they would sell properties and buy back their stocks overtime. If REITs trade at par or at premium to the underlying business then I don't see myself making a concentrated bet on them.
Northern Flicker wrote: Wed Jun 23, 2021 2:52 pm If you want to hold assets concentrated in one sector, that is your choice. But please don't try to convince us that an asset mix slathered in uncompensated sector concentration risk is evidence of purported flaws of broad market index funds, which diversify away uncompensated sector concentration risk.
I am diversified into different sectors and multiple stocks, most are out of favor with low multiples, and now no sector takes up 30% of my stock portfolio. I don't think SP500 is well diversified because it's about 40% in large cap tech stocks. So buying SP500 is equivalent to making a concentrated bet in some most overvalued sectors and stocks.
The sillier the market’s behavior, the greater the opportunity for the business like investor.
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Re: Critical view of index investing

Post by alex_686 »

gougou wrote: Wed Jun 23, 2021 3:45 pm Sure, if the majority of the index components are attractively valued, I can see myself buying into an index fund.
Well, yes, the devil's in the details.
gougou wrote: Wed Jun 23, 2021 3:45 pm The drawdown of the REITs was an opportunity to buy real estate at half the price.
O.k., here is the question. I have seen lots of investments at 1/2 off, only to drop another 50%.

How do you know if this trade was a good trade? You can't look if you made money or not.

Was the return due to skill or luck? This is hard to disentangle.

What benchmark are you using? Lets say the S&P 500. It is a popular one. Lets say you outperformed the S&P 500 - so what? You are moving money from one asset class to a risker asset class. Higher volatility, lower Sharpe. Maybe there is skill. Maybe you just piled on risk and lucked out.

This is why I am skeptical of retail investors saying that they can beat the market. Most who say that they have did not. They had a lucky home run which they attribute to their skill, discount the impact of a rising market, and forget all of their mediocre and poor trades. The psychology of these cognitive, emotional, and behavioral failings are strong. This is even true with people with strong investment skills.

So, moral of the story, always keep a skeptical eye on yourself. Remember to self calibrate your perceptions of realty.
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Re: Critical view of index investing

Post by Northern Flicker »

If you are concentrated in a sector that is down 70%, being able to buy more is fine but the assets you have to do that are still down 70%. There is no evidence that investors can actively manage sector exposure by timing which sectors are primed for outperformance. In fact, if they could, they would do so and the opportunity would be arbitraged away by the activity. If the big institutional investors are not treating a sector as undervalued, what do you know that they don't?

But you are focusing on predicting future outperformance, not how much additional risk is being taken in the hope your prediction turns out to be correct.
Last edited by Northern Flicker on Wed Jun 23, 2021 8:55 pm, edited 1 time in total.
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Re: Critical view of index investing

Post by gougou »

alex_686 wrote: Wed Jun 23, 2021 4:25 pm
gougou wrote: Wed Jun 23, 2021 3:45 pm The drawdown of the REITs was an opportunity to buy real estate at half the price.
O.k., here is the question. I have seen lots of investments at 1/2 off, only to drop another 50%.

How do you know if this trade was a good trade? You can't look if you made money or not.

Was the return due to skill or luck? This is hard to disentangle.

What benchmark are you using? Lets say the S&P 500. It is a popular one. Lets say you outperformed the S&P 500 - so what? You are moving money from one asset class to a risker asset class. Higher volatility, lower Sharpe. Maybe there is skill. Maybe you just piled on risk and lucked out.

This is why I am skeptical of retail investors saying that they can beat the market. Most who say that they have did not. They had a lucky home run which they attribute to their skill, discount the impact of a rising market, and forget all of their mediocre and poor trades. The psychology of these cognitive, emotional, and behavioral failings are strong. This is even true with people with strong investment skills.

So, moral of the story, always keep a skeptical eye on yourself. Remember to self calibrate your perceptions of realty.
I know it was a much better trade than buying rental properties directly. Those REITs were going to pay me an 8% annual dividend plus annual growth plus stock buybacks. That was more than adequate return if I can hold a few years for a recovery.

I don't care about beating the performance of TSLA, Bitcoin, QQQ or SP500. But it just turned out I beat SP500 by a wide margin. There's no guarantee that my rental properties or stock portfolio will ever outperform the SP500. It's strange that index investors require others to prove they can beat the index, because almost nobody can prove nothing in investing. Can you prove your index is going to consistently outperform a diversified portfolio of value stocks?

My benchmark is just that I made an adequate return per year owning stocks that I understand. A stock that gives me a 5% cash yield and expected to grow at 10% would probably be an adequate return. A stock that gives me an 8% cash yield and growing its business by 15% a year would probably be something I want to double down on. I don't see why I want to compete against an abstract index. I don't like the index because most of its components seem overvalued, and even if they drop 50% they still don't quite fit my investing criteria (so I believe they are extremely risky).
The sillier the market’s behavior, the greater the opportunity for the business like investor.
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Re: Critical view of index investing

Post by alex_686 »

For context, I have spent most of working career in risk. I suspect that my temperament is 180 degrees off from yours. Cautious, analytical, evidence based. I think I have known people like you. Some have down very well, others have blown up. So, don't take my posts as being overly critical, rather insights from a different direction.
gougou wrote: Wed Jun 23, 2021 5:14 pmThose REITs were going to pay me an 8% annual dividend plus annual growth plus stock buybacks.
I am not sure where to start picking apart that statement other than to say it has not been born out historically. Dividend payments are fairly erratic, and REITs are especially so.

I have seen more than one fund blow up on this assumption. And when did REITs start doing buy-backs? Because REITs have to pay out all of their earnings they tend to be starved for capital. They tend to issue new shares. Or at least they did back in my day.

I may be mixing up the order here. So a couple of points.
gougou wrote: Wed Jun 23, 2021 5:14 pmI don't care about beating the performance of TSLA, Bitcoin, QQQ or SP500. ... My benchmark is just that I made an adequate return per year owning stocks that I understand
I am not hearing any mention of risks. Why hazard your capital, spend time and blood, and take great risks to get sub-part results? "owning stocks that I understand" is a classic yellow flag for the cognitive errors of overconfidence and self-attribution. I can't tell you how many people I had to liquidate after they said those magical words.

Also, in my experience, it is the portfolios that earn a decent constant return that tend to blow up and go to zero. It is the calm waters that hid the big sea monsters.
gougou wrote: Wed Jun 23, 2021 5:14 pmCan you prove your index is going to consistently outperform a diversified portfolio of value stocks? ... There's no guarantee that my rental properties or stock portfolio will ever outperform the SP500.
So, which is better - a apple or a orange? Or is it a false question? SP500, value stocks, rental properties all have different risk and return profiles. These profiles change over time. The relationships change over time. They are exposed to different drivers and factors. So what?

You are a active investors. Don't you want to know if the choices you are making are good choices? Humans are very good at lying to themselves, justifying their actions post hoc, etc. In both life and investing you need to self calibrate. For that you need a measuring stick.

For a more direct answer, you want to pick the asset classes with the risk / return profile that is most likely to meet your goals. Now, I used to have to answer the above question about S&P v real estate, etc. It tended to be nuanced and complex, but at the heart was how these assets got their returns and what where the risks, because that tended to drive the answer on what was the best way to mix them.
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Re: Critical view of index investing

Post by Northern Flicker »

gougou wrote: I am diversified into different sectors and multiple stocks, most are out of favor with low multiples, and now no sector takes up 30% of my stock portfolio. I don't think SP500 is well diversified because it's about 40% in large cap tech stocks. So buying SP500 is equivalent to making a concentrated bet in some most overvalued sectors and stocks.
You shouldn't start by picking funds, but by designing an asset allocation that has a good chance of meeting your goals and manages risk. Then an implementation for each asset class in the asset allocation would be selected. If large-cap US stocks is one of the asset classes, a large cap index fund such as an S&P500 fund held at the allocation weight is an excellent implementation of the asset class.

This is top-down portfolio management, and it enables managing overall portfokio risk.

You are discussing a bottom-up approach of starting by selecting individual investments. This is a problematic approach. If the individual investments are diversified index funds, it does mitigate some of the risk, but it is still a problematic approach. Individuals who choose their own individual investments usually do not have any awareness for how much more risk they are taking, usually without increasing expected return beyond that of a market index.
Last edited by Northern Flicker on Thu Jun 24, 2021 12:31 am, edited 1 time in total.
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Re: Critical view of index investing

Post by gougou »

alex_686 wrote: Wed Jun 23, 2021 5:59 pm
gougou wrote: Wed Jun 23, 2021 5:14 pmI don't care about beating the performance of TSLA, Bitcoin, QQQ or SP500. ... My benchmark is just that I made an adequate return per year owning stocks that I understand
I am not hearing any mention of risks. Why hazard your capital, spend time and blood, and take great risks to get sub-part results?
Well I didn't get subpar return. I doubled all my money invested in those REITs. I guess the risk is we have a real estate market crash worse than 2008 then maybe I'll lose 50% of those invested money?
alex_686 wrote: Wed Jun 23, 2021 5:59 pm
gougou wrote: Wed Jun 23, 2021 5:14 pmCan you prove your index is going to consistently outperform a diversified portfolio of value stocks? ... There's no guarantee that my rental properties or stock portfolio will ever outperform the SP500.
So, which is better - a apple or a orange? Or is it a false question? SP500, value stocks, rental properties all have different risk and return profiles. These profiles change over time. The relationships change over time. They are exposed to different drivers and factors. So what?

You are a active investors. Don't you want to know if the choices you are making are good choices? Humans are very good at lying to themselves, justifying their actions post hoc, etc. In both life and investing you need to self calibrate. For that you need a measuring stick.
My investment thesis was that buying a $100 quality REIT that owned $200 worth of real estate equity was a good investment, which would beat the performance of the underlying real estate. And that turned out to be very true because REITs bought around the bottom outperformed real estate prices, which I guess is the measuring stick in this case.

However, if someone invested in Bitcoin and says his investment is the best, and ask you to prove how your SP500 would beat Bitcoin consistently, how would you do that? Even if your investment strategy is guaranteed to lose money, it's still pretty hard for anyone to prove they can consistently beat your strategy.

So how do you convince yourself that you are making a good choice, that your index is a good investment, especially at today's valuations?
The sillier the market’s behavior, the greater the opportunity for the business like investor.
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Re: Critical view of index investing

Post by alex_686 »

gougou wrote: Wed Jun 23, 2021 9:45 pm Well I didn't get subpar return. I doubled all my money invested in those REITs. I guess the risk is we have a real estate market crash worse than 2008 then maybe I'll lose 50% of those invested money?
You go to a roulette table in a casino. You put all of your money on black. You double your money. Did you take a risk? Was your return due to skill? The answer to this question is obvious. The answer to yours is not. Sigh. Such is life.
gougou wrote: Wed Jun 23, 2021 9:45 pm My investment thesis was that buying a $100 quality REIT that owned $200 worth of real estate equity was a good investment, which would beat the performance of the underlying real estate. And that turned out to be very true because REITs bought around the bottom outperformed real estate prices, which I guess is the measuring stick in this case.
So, how do you know that the REITs were worth $100? For context, I know a person who thinks they can will a roulette ball to black. In a single case like this there is a whole host of cognitive and behavioral issues at play. What you want to do is find people who can consistently predict what is going to happen. What is your success ratio? How accurate have your predictions have been? If REITs had been trading at $200 and you thought they were only worth $100 would you short the REIT? Not being facetious, these are questions that my team used to ask portfolio managers.
gougou wrote: Wed Jun 23, 2021 9:45 pm However, if someone invested in Bitcoin and says his investment is the best, and ask you to prove how your SP500 would beat Bitcoin consistently, how would you do that? Even if your investment strategy is guaranteed to lose money, it's still pretty hard for anyone to prove they can consistently beat your strategy.
Kind of a good question, kind of a bad question.

Bitcoin is a horrible example in my opinion. The fact that it has done well means nothing. Water under the bridge. The question is why it will have returns in the future. The answers I have gotten are unsatisfactory.

What drives the cash flow for a rental property, a company in the S&P 500, or the index in aggregate. Cash flow, interests rates, risk. I can model those. I have theory that I can test against historical data. We can understand what is happening. We can change growth, interests rates, or inflation and see the impact.
gougou wrote: Wed Jun 23, 2021 9:45 pm So how do you convince yourself that you are making a good choice, that your index is a good investment, especially at today's valuations?

Not exactly sure how to answer this question. Are you familiar with the Equity Risk Premium (ERP)? It is the extra yield that investors ask to hold risky stocks over the long-term risk-free Treasury bond. It is a staring point. You start with a risk free rate. Are you willing to take risk X to gain return Y over the risk free rate?
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Re: Critical view of index investing

Post by gougou »

alex_686 wrote: Wed Jun 23, 2021 10:13 pm
So, how do you know that the REITs were worth $100? For context, I know a person who thinks they can will a roulette ball to black. In a single case like this there is a whole host of cognitive and behavioral issues at play. What you want to do is find people who can consistently predict what is going to happen. What is your success ratio? How accurate have your predictions have been? If REITs had been trading at $200 and you thought they were only worth $100 would you short the REIT? Not being facetious, these are questions that my team used to ask portfolio managers.
The REIT was trading at $100. It owned $200 worth of real estate. The value of the real estate can be estimated by dividing the net operating income by a prevailing cap rate, or you can estimate it using total number of units or square footages.

Let me put it this way, most REITs were about fairly valued before 2020. Most REITs crashed like 40%+ in 2020 and took months to recover. Did the housing market crash 40% in 2020? No it didn't, in fact it went up. So obviously there were times when REITs were significantly cheaper than the underlying properties they owned.

And unfortunately I don't get to buy real estate for 50 cents on the buck every day. It probably only happens every 10 years. So even if I can seize such opportunities every single time, there are still very few data points for anyone to prove I can do this consistently. But common sense tells me I can do well if I can buy $100 bills for $50.
alex_686 wrote: Wed Jun 23, 2021 10:13 pm
gougou wrote: Wed Jun 23, 2021 9:45 pm However, if someone invested in Bitcoin and says his investment is the best, and ask you to prove how your SP500 would beat Bitcoin consistently, how would you do that? Even if your investment strategy is guaranteed to lose money, it's still pretty hard for anyone to prove they can consistently beat your strategy.
Bitcoin is a horrible example in my opinion. The fact that it has done well means nothing. Water under the bridge. The question is why it will have returns in the future. The answers I have gotten are unsatisfactory.

What drives the cash flow for a rental property, a company in the S&P 500, or the index in aggregate. Cash flow, interests rates, risk. I can model those. I have theory that I can test against historical data. We can understand what is happening. We can change growth, interests rates, or inflation and see the impact.
I intentionally chose a terrible investment and hope you can prove your SP500 is somehow consistently better. Because to me, an index fund is not much better than randomly picking a bunch of stocks. And when the universe of stocks that you pick from are mostly bad investments, you get a bad return. Yet even then, it's hard for anyone to prove they can consistently beat your collection of bubble stocks, just like you can't prove you can consistently beat Bitcoin (or insert any bad investment here).
The sillier the market’s behavior, the greater the opportunity for the business like investor.
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Re: Critical view of index investing

Post by gtrplayer »

gougou wrote: Thu Jun 24, 2021 1:46 am
alex_686 wrote: Wed Jun 23, 2021 10:13 pm
So, how do you know that the REITs were worth $100? For context, I know a person who thinks they can will a roulette ball to black. In a single case like this there is a whole host of cognitive and behavioral issues at play. What you want to do is find people who can consistently predict what is going to happen. What is your success ratio? How accurate have your predictions have been? If REITs had been trading at $200 and you thought they were only worth $100 would you short the REIT? Not being facetious, these are questions that my team used to ask portfolio managers.
The REIT was trading at $100. It owned $200 worth of real estate. The value of the real estate can be estimated by dividing the net operating income by a prevailing cap rate, or you can estimate it using total number of units or square footages.

Let me put it this way, most REITs were about fairly valued before 2020. Most REITs crashed like 40%+ in 2020 and took months to recover. Did the housing market crash 40% in 2020? No it didn't, in fact it went up. So obviously there were times when REITs were significantly cheaper than the underlying properties they owned.

And unfortunately I don't get to buy real estate for 50 cents on the buck every day. It probably only happens every 10 years. So even if I can seize such opportunities every single time, there are still very few data points for anyone to prove I can do this consistently. But common sense tells me I can do well if I can buy $100 bills for $50.
alex_686 wrote: Wed Jun 23, 2021 10:13 pm
gougou wrote: Wed Jun 23, 2021 9:45 pm However, if someone invested in Bitcoin and says his investment is the best, and ask you to prove how your SP500 would beat Bitcoin consistently, how would you do that? Even if your investment strategy is guaranteed to lose money, it's still pretty hard for anyone to prove they can consistently beat your strategy.
Bitcoin is a horrible example in my opinion. The fact that it has done well means nothing. Water under the bridge. The question is why it will have returns in the future. The answers I have gotten are unsatisfactory.

What drives the cash flow for a rental property, a company in the S&P 500, or the index in aggregate. Cash flow, interests rates, risk. I can model those. I have theory that I can test against historical data. We can understand what is happening. We can change growth, interests rates, or inflation and see the impact.
I intentionally chose a terrible investment and hope you can prove your SP500 is somehow consistently better. Because to me, an index fund is not much better than randomly picking a bunch of stocks. And when the universe of stocks that you pick from are mostly bad investments, you get a bad return. Yet even then, it's hard for anyone to prove they can consistently beat your collection of bubble stocks, just like you can't prove you can consistently beat Bitcoin (or insert any bad investment here).
I understand what you’re saying and I appreciate different viewpoints on here… but taking a strong opinion against indexing seems like the very essence of anti-Boglehead…

Indexing is not random - an index is providing the selections made by the market - essentially the average of what the active investors are doing when they’re buying and selling. Bogle’s theory was that most investors aren’t going to beat the market but indexing gives them the average of the market, and he suggested buying the whole market.

It sounds like you’re trying to convince people to become active investors. Most Bogleheads tried that at some point and determined they’d rather get the average than underperform trying to beat professional traders (who themselves often underperform the market in the long term). I doubt your argument will win over very many people here.
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Re: Critical view of index investing

Post by Northern Flicker »

I don't know where you get your info that the S&P500 is a bad investment. If you look at the SPIVA reports, you will see that 60% of active large-cap funds failed to beat the S&P500 in the last year, 70% over the last 3 years, 75% over the last 5 years. Professional active portfolio managers struggle mightily to beat the S&P500 by taking their best shot at picking large cap stocks.

If large cap US stocks are an asset class in your asset allocation, an S&P500 fund is an excellent implementation to get the asset class market return without worrying about a portfolio manager stock picker screwing it up or holding other stocks outside the asset class.

Many other asset classes you may include have index fund implementations. By implementing asset classes in an asset allocation that way, you can manage portfolio risk without worrying about other sources of risk creeping in.
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Re: Critical view of index investing

Post by gougou »

I believe the SP500 and most of its components are bad investment right now. I also believe long term bonds that yield 2% are bad investments. I also believe Bitcoin is a bad investment. I'm not sure how anyone can prove something is a bad investment without looking at the underlying business. In the case of Bitcoin, there's no underlying business. But if you look at its historical performance, it probably beat 99% of any investment you can come up with.

And my point is that it seems index investors don't care about underlying businesses. They care about historical performance, competition with other assets, various theories/hypothesis that are much harder to understand than some simple businesses. They require others to prove they can consistently beat the index, while it is almost impossible for anyone to prove consistency against anything in the world of investing. And when there are some glaring examples of investors who significantly outperformed the market, that is attributed to luck, or extra risk.

And sure the index probably outperformed most active investors. But I guess the index also outperformed most index investors, because people like to chase bubbles and sell at bottom. And if you had the temperament to hold on to the index when the sky was falling, you are probably better than most investors already, but you are still missing the tool that tells you this is a great investment that you should double down on, and you are still just getting the average return.
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Re: Critical view of index investing

Post by Northern Flicker »

You don't need to look at each underlying business when investing in a market index fund because the revenue driving return comes from the entire economy.

I would say that you seriously overestimate your ability to decide which index components are overvalued. If it were as easy as you seem to think it is, professional active managers would have little trouble beating the index, but they do not.

You can evaluate individual businesses until the cows come home. This does not protect you from future risk driven by future events. Some of that risk is specific to an individual company. Because this can be diversified away, the market does not discount in a risk premium to compensate for it. The price you pay for any individual stock is too high if you do not diversify away the risk specific to that stock.

Most individual investors lack the asset level and analytic resources to build a portfolio of individual stocks that diversifies away idiosyncratic risk. Investing in an index fund like a total market index fund solves that problem. Some stocks in the index may be overvalued, but some are undervalued, poised for explosive growth, but not yet on the radar screen of amateur investors. An index fund ensures you are holding those. Their return generally more than offsets the mediocre return of the index components that turn out to be overvalued. If you held a total market index fund, you would have acquired stocks like Tesla and Google when they were cheap. Those types of outcomes offset the fact that Exxon-Mobil was the largest stock in the index 15 years ago but has shrunk considerably.

There also is no evidence that professional money managers can time the market successfully. Thus, an index fund investor is content to earn market returns, whatever that turns out to be, by staying the course through thick and thin.

If you want to double down on stocks with low valuations that you believe are primed for a turnaround, include a size and value tilt in your asset allocation by including some small-cap value in the allocation. This could be implemented with an index fund like VIOV or a more active fund like AVUV.

The point is to manage exposure at the asset class level in your asset allocation rather than by bottom-up stock picking.
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