Friday, October 10, 2014

Index Fund Investing Revisited

From the 2006 Berkshire Hathaway (BRKashareholder meeting:

Warren Buffett: If your pipes leak, you should call a plumber. Most professions add value beyond what the average person can do for themselves. But in aggregate, the investment profession does not do this – despite $140 billion in total annual compensation. It's hard to think of another business like that. Can you, Charlie?

Charlie Munger: I can't think of any.

How many years would a novice need to study and practice to be able to perform at a higher level than 80% to 90% of doctors?

I'm guessing most of us would have to study and practice for a very long time just to become reasonably competent (never mind top-tier).

For most other professions the answer will be not be much different.

How many years would a novice have to study and practice to be able to perform at a higher level than 80% to 90% of market participants, including the professionals?

Well, none as long as they stay away from trying to actively trade -- both individual stocks and funds -- and this includes, at least in a lot of cases, relying on others to actively manage their money.

When the pipes are a competent plumber. The expertise is likely to be well worth it.

In contrast...

"The statistical evidence proving that stock index funds outperform between 80% and 90% of actively managed equity funds is so overwhelming that it takes enormously expensive advertising campaigns to obscure the truth from investors." - From The Motley Fool

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value." - Jack Meyer, former head of Harvard's endowment, commenting on investment managers

So what's the right way to fix a portfolio that has underperformed?

Those that buy index funds consistently over time -- and learn to ignore near-term price action -- are in fact likely to perform better long-term than most market participants. There's enough evidence out there to more than suggest that the index fund, with basically little or no skill required, can actually move someone toward top-tier in terms of long-term investment performance. (Top-tier in terms of relative performance but, depending on overall market valuation levels, maybe not absolutely all that great.) It's at least a bit odd that some would consider only matching the market's performance somehow unsatisfactory when that result is better than 80% or 90% of active managers.

Too often investors do end up being their own worst enemy.

Unfortunately, it's the thinking that it's possible to be in and out of positions at the right time -- with the idea of improving investment results, of course -  that gets investors in trouble.

So, while there's realistically no way to perform better than vast majority of doctors (or plumbers) without the appropriate skills, knowledge, and experience, the index fund offers a rather straightforward way to perform better -- or, at least, increase the likelihood of performing better long-term -- than the vast majority of market participants including the professionals.

Yet, despite this reality, too many market participants will still try to beat the markets. One of the reasons for this is that investors tend to overestimate their own performance. A study of investors showed that they overestimated "their returns by more than 11 percentage points per year. The average investor painfully lags an index fund and thinks he's Warren Buffett, basically." 

I'm sure many think that overestimating investment results is what someone else tends to do; that it must be someone else's problem.


Professor Terrance Odean said that even when investors "are not better than average, they pretty much have to believe they are just in order to do what they are doing, to be active investors."

The tough part is remaining aware of what is an "observation bias, where people see themselves differently than they really are."

Some will overestimate their own performance to justify the effort when they could have just bought an index fund and focused their energy on something more productive.

Brett Arends recently offered why index funds often make so much sense for investors. It's certainly not because he thinks the markets are somehow efficient (nor do I). Here's how he explains it:

"I believe the market can be wrong, even wildly wrong, for long periods—and often is. So I don't believe a portfolio of random stocks or index funds is necessarily the best investment solution. But it’s pretty good if done right. It involves low costs, and immunizes you from the emotional challenges of investing. And it's especially good for big institutions, as it avoids most value-destroying limitations and complications."

Most investors will not outperform, for example, the Dow Jones Industrial Average. I bring up this particular index for a reason. It's the use of the word "average". An index fund might merely guarantee that the investor will match the market, but, maybe the word "average" in this context is what helps create the wrong impression. It may be a market average, but it hardly represents an average performance when compared to the results of all participants.

So matching a market average isn't the same as getting an average outcome. In fact, it's probably better to not think of a market index as an average at all. It implies a result that's in the middle of a normal distribution when the actual outcome is much better than that.

"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

The right kind of temperament certainly helps:

"A lot of people with high IQs are terrible investors because they've got terrible temperaments. And that is why we say that having a certain kind of temperament is more important than brains. You need to keep raw irrational emotion under control. You need patience and discipline and an ability to take losses and adversity without going crazy. You need an ability to not be driven crazy by extreme success." - Charlie Munger in Kiplinger's

Outside of investment management there's no "index fund" equivalent that enables a novice to match -- never mind exceed -- the performance of most professionals.

Investment management is unique in this way.

Far too many who could benefit from this reality end up not doing so.

The bad news is that market valuations have become a whole lot higher in recent years. So that naturally means it's tougher to buy with a sufficient margin of safety. Unfortunately, some will get interested in buying stocks (or a fund) just when they're not nearly as attractive to buy. Successfully timing the market is easier said than done. That reality doesn't make understanding how prevailing market prices compares to per share intrinsic value irrelevant. Attempting to time the market is a waste of energy. Attempting to understand how price compares to value is not. For those who don't feel comfortable with judging value, consistently buying an index over time ends up being more than a reasonable alternative. Unfortunately, history suggests the pattern will often end up being increased buying during the good times (i.e. when stocks are usually more expensive) and selling during the not so good times (i.e. when stocks are usually cheap).

That's a tough way to get results.

At a minimum, considering the current valuations of many stocks, the expectations of future returns need to be much reduced. At least that's the case until the next bear market. 

In other words, the next inevitable bear market should be thought of as the long-term investors best ally.

"You make most of your money in a bear market, you just don't realize it at the time." - Shelby Davis

Ben Graham long ago said that investors should consider themselves "enviably fortunate" the next time a long bear market occurs. For someone with a long time horizon -- let's say 20 years or longer -- lower market prices in the near-term are a very good thing. Buybacks become more effective. More shares can be accumulated at a bigger discount over time. A severely down market is only a bad thing when someone has put money at risk in the equity markets and needs the money now.* 

Well, short-term money shouldn't be in the equity markets in the first place.

Attempting to predict when the next bear market will occur is folly. Just remember that bear markets are not at all a bad thing if the investment time horizon is long enough.

Of course, there are many capable individual investors who buy individual stocks and perform very well.

It's just that an investor with the right temperament and an awareness of limits can do just fine lacking the necessary investment skills, knowledge, and experience using index funds. This just doesn't exist for other professions. To me, it's not just the novice investor who should carefully give this consideration. More than a few investment professionals, at least based upon the number who underperform, would be wise to do the same.
(Even if, realistically, justifying and earning fees is a big factor.)

Many will no doubt continue to invest (or, worse yet, actively trade) in individual stocks in an attempt to outperform the markets. The temptation will prove irresistible for some and will likely be, at least for most of them, not necessarily very fattening in a financial sense. Naturally, some are and will be very successful buying individual stocks. Yet, with so many underperforming the market as a whole, more obviously think they are good at balancing investment risk and reward than actually are good at it.

This is why temperament and a realistic assessment of one's own limits comes into play.

Overconfidence is very expensive.


Long position in BRKb established at much lower than recent prices

Related posts:
Charlie Munger on Complexity, Hedge Funds, and Pension Funds
Why Do So Many Investors Underperform?
When Mutual Funds Outperform Their Investors
John Bogle's "Relentless Rules of Humble Arithmetic"
Investor Overconfidence Revisited
Newton's Fourth Law
Investor Overconfidence
Charlie Munger: Focus Investing and Fuzzy Concepts
Chasing "Rearview-Mirror Performance"
Index Fund Investing
Investors Are Often Their Own Worst Enemies, Part II
Investors Are Often Their Own Worst Enemies
The Illusion of Skill
Buffett's Bet Against Hedge Funds, Part II
Buffett's Bet Against Hedge Funds
The Illusion of Control
Buffett, Bogle, and the "Invisible Foot" Revisited
If Buffett Were Paid Like a Hedge Fund Manager - Part II
If Buffett Were Paid Like a Hedge Fund Manager
Buffett, Bogle, and the Invisible Foot
Charlie Munger on LTCM & Overconfidence
"Nothing But Costs"
Bogle: History and the Classics
When Genius Failed...Again

* Unfortunately, since market prices have risen a bunch in recent years, that means expectations of forward returns for the market is necessarily much reduced. Less margin of safety (if any) and less potential reward. Those with a long-term investing horizon shouldn't be cheering as the market goes higher. They should be hoping that market prices relative to per share intrinsic values becomes more favorable again. That's why bear markets are a good thing for those with a long investment horizon. So, essentially, indexes are likely to do relatively better than most active participants but it seems wise to assume that the absolute results from these current levels won't end up being all that wonderful. Losses, even if only temporary, are much more likely near current valuations. The market can, of course, go on to become even more expensive but the risks will be increasing. Things seem more risky during a bear market but that's simply not the case. Price can be the great regulator of risk.
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