My hypothesis on why it is hard to beat the index...

[blainehodder]

It is mostly hard to beat the index because the majority of index gains come from very few stocks. Most stocks lose money.  If you are actively selecting stocks it is likely you will miss those winners.

 

If you closet index you will likely select the winners but have high fees.

 

Therefore it makes sense that few outperform the index. It is not the case that 50% of people should outperform and 50% should underperform with random concentrated stock selection given the distribution of stock gains is waited heavily to a small subsection of the index. In that scenario most should underperform with some really massive winning fund managers.

 

The momo effect of indexing also ensures you cut losses on nearly all stocks that go to zero and are invested in all stocks that compound value by default.

 

 

[Gregmal]

Also, perhaps getting a little too much into a philosophical angle here, but who's to say that the entire "its impossible to beat the market" campaign thats been growing the past few years isnt some wonderfully orchestrated marketing campaign promoted by companies like Vangard? Meant to discourage investors from even trying and just toss the money into an index fund?

 

Honestly I don't even know why "beating the market" is even that important to people. To me, I couldn't care less. It is utterly irrelevant how my investments perform compared to the market. As long as I am intimately familiar with what I am invested in and comfortable enough with what I own, I don't care about all the other noise. Its kind of even comparable to the market timing approach. You think Buffett really said "I'm banking on a turnaround at BofA" in 2011? Or do you think he simply found himself a great deal and was comfortable making the investment? I'd compare it to trying to hit a home run in baseball. Typically when you try to hit it out of the park, you grip the bat too tight and swing at bad pitches. Whereas when you just relax and pick your spots, life is a lot easier. I consider trying to beat the market just another unnecessary distraction that complicates one's decision making and adds unneeded stress.

This is very much true as well. Beating the index is a very popular topic on CoBF. In real life not so much. People don't really care if their investments beat the index. Mostly they just want their money to be safe and earn a decent/good return. You really find out how much people don't care about beating indexes the moment when you see a client and you tell him that he's down 15% but he should be happy because he's beat the index by 500 basis points. If people's overarching goal in investing is to beat the S&P500 or whatever then no one would buy any bonds.

 

It's also true that investors obsessed with beating indexes will probably fail to do so. Just go out there, do your best, do good work and stop worrying about the index so much.

 

Unless you have no opportunity cost to your time or derive independent enjoyment from the act of investment research, it makes sense to care about whether you are likely to beat an index.  If you can't, why bother to do "good work" on investments?  Wouldn't it be better to do no work, put your money in an index fund, and spend you're time on something else?

 

I don't really view spending time on evaluating investments to be a burden or lost cost. I enjoy reading, consider investing a partial hobby as well as a job; it's something I like. But regardless, I sift through things all the time. Often trying to find reasons not to make the investment. I will occasionally drive around nearby areas looking at potential properties. May a year goes by where I don't do a deal, I couldn't imagine thinking of that as a waste of time or sunken cost. Last year I did one deal and the current yield is about 13.5%. At the time I couldn't predict what the index would do. I didn't care what it did. Instead I viewed this along with several other factors as a risk adjusted return I would be content with. Whether the S&P does 25%, I just don't care.

 

Which brings me to the next point. I really don't think anybody is capable of fully knowing what they own with an index fund. They are told what it is supposed to be, but it's impossible to really understand every component of it. I remember TVIX was supposed to be a 2-3x correlation to the VIX. And one day(I want to say in 2012), when the VIX was up modestly, this index proxy lost something like 60% in a day for no reason at all. It's definitely possible to beat the index over time, however right now we seem to be at the apex of index mania because we have deviated so far from historical norms in so many different areas of the market/investing and many of the experts have been chasing their tails. Owning an index has been and will continue to be en vogue as long as the bull rages on in a straight line up and monetary policy allows most asset classes to have high correlations. But this IMO is not something that is sustainable in the long run, and the second these conditions should cease to continue, being in an index may not seem like such a no brainer.

[NeverLoseMoney]

My question is: what is "the index" exactly? Which assumptions are you baking into your decision by investing in a particular index or by measuring your performance against it? Is the S&P 500 the right benchmark for your portfolio and why?

 

For example: I think Asian countries are likely to grow faster than the US and European countries over the next few decades. Should I therefore seek out investments in Asian companies and compare my performance against an index that also has a substantial exposure to Asia? Am I making a mistake by focusing too much on companies listed in the US, just because they've had a good century?

 

Charlie Munger mentioned at the latest DJCO meeting how he made a bunch of money on a particular stock / security and then gave it to Li Lu who turned it into, I believe, five times that amount by investing in Chinese companies. Munger didn't put that money into US stocks or an S&P index fund, he gave it to someone he saw as highly talented and who probably had a lot of knowledge about a much faster growing part of the world. Should we perhaps be looking at that part of the world a bit harder as well? Are we partly investing in the things we are investing in, because it feels most comfortable given the historical results, or because it is part of the standard offering of our brokers and therefore easiest?

 

I think the question of what your index / benchmark is exactly, is complex and you can't help but make certain assumptions and macro judgments in answering it. I don't think I even believe in the whole concept of "passive investing". You're always making a judgment call at some level when you're investing. For one thing, most people have a huge home country bias. Someone from the US might think that "beating the index" means beating the S&P 500, while someone from the Netherlands might think that it means doing better than their national index (the AEX).

[KJP]

 

Unless you have no opportunity cost to your time or derive independent enjoyment from the act of investment research, it makes sense to care about whether you are likely to beat an index.  If you can't, why bother to do "good work" on investments?  Wouldn't it be better to do no work, put your money in an index fund, and spend you're time on something else?

 

I don't really view spending time on evaluating investments to be a burden or lost cost. I enjoy reading, consider investing a partial hobby as well as a job; it's something I like.

Because you derive independent enjoyment from investing, it makes sense that forming a belief about whether you can beat the market is less relevant to you.

 

Which brings me to the next point. I really don't think anybody is capable of fully knowing what they own with an index fund. They are told what it is supposed to be, but it's impossible to really understand every component of it.

 

For people who do not believe they can be the market, this would be either irrelevant or a good thing.  By hypothesis, their security selection and portfolio weighting decisions (i.e., deviations from the index) destroy value rather than create it, so gaining knowledge likely won't help them.

 

But if your point is that you cannot avoid some active decision-making because you must pick an index, I would suggest the broadest, most vanilla equity or bond index fund you can find, rather than any exotic index.

 

 

[KJP]

I think the question of what your index / benchmark is exactly, is complex and you can't help but make certain assumptions and macro judgments in answering it. I don't think I even believe in the whole concept of "passive investing". You're always making a judgment call at some level when you're investing. For one thing, most people have a huge home country bias. Someone from the US might think that "beating the index" means beating the S&P 500, while someone from the Netherlands might think that it means doing better than their national index (the AEX).

 

You are correct that some active decision must be made.  But if you believe your decision-making with respect to equity investments is poor and destroys value, one reasonable approach would be to attempt to minimize your decision-making as much possible by selecting a very broad, vanilla index fund to capture as much of the benefits of diversification as possible and a purely mechanical method of adding and selling, e.g., 10% of paycheck each month goes into XYZ Global Index Fund.  No further decision-making; no attempt to assess valuation or anything else.

[Gregmal]

 

Unless you have no opportunity cost to your time or derive independent enjoyment from the act of investment research, it makes sense to care about whether you are likely to beat an index.  If you can't, why bother to do "good work" on investments?  Wouldn't it be better to do no work, put your money in an index fund, and spend you're time on something else?

 

I don't really view spending time on evaluating investments to be a burden or lost cost. I enjoy reading, consider investing a partial hobby as well as a job; it's something I like.

Because you derive independent enjoyment from investing, it makes sense that forming a belief about whether you can beat the market is less relevant to you.

 

Which brings me to the next point. I really don't think anybody is capable of fully knowing what they own with an index fund. They are told what it is supposed to be, but it's impossible to really understand every component of it.

 

For people who do not believe they can be the market, this would be either irrelevant or a good thing.  By hypothesis, their security selection and portfolio weighting decisions (i.e., deviations from the index) destroy value rather than create it, so gaining knowledge likely won't help them.

 

But if your point is that you cannot avoid some active decision-making because you must pick an index, I would suggest the broadest, most vanilla equity or bond index fund you can find, rather than any exotic index.

 

Funny but I actually hadn't thought of it like that. Essentially, telling somebody you are deficient, and they for better off not trying. The more you try the more you'll just screw up. Knowledge is not power for you. Which again, for the average person probably is somewhat if not entirely true. I've met some very well educated and highly accomplished people who have blown me away with their ignorance when it comes to investing.

 

In my own case, I own one ETF(index/etf to me are basically the same). CIBR. My reasoning is the I am highly confident in my ability to forecast the runway for cyber security. However I am fine acknowledging that I have next to no ability to analyze companies trading at 100x sales with any degree of confidence. Nor do I have any confidence in my ability to learn how to get comfortable with companies that carry such staggering valuations. But I do want exposure so I found two ETF's, CIBR and HACK and did some work running through the various differences in terms of portfolio holdings and weighting of the components. It's probably the only investment I have where I literally have no deeper knowledge or understanding of the vehicle or instrument, and as such despite it doing well, will never be a major component of my portfolio. How some could get comfortable having a major allocation to an index, even say SPY, is crazy to me(someone just dumping money into XZY Global Index fund after a while will have a very high concentration). After all, especially with broader market index funds, you are entirely at the mercy or macro trends. Which is definitely something one can analyze and make efforts to be aware of. And if you're doing that work, then you might as well do it for individual companies.

[eclecticvalue]

MAYBE, no one is holding their stocks for the long term.

[Guest longinvestor]

MAYBE, no one is holding their stocks for the long term.

 

You don't say!

[rb]

There are some very valid points raised against indexes on here. I'll try to add a bit more colour.

 

1. What you actually own while holding and index. A point was raised that you don't actually know what's in it - which is fair in the context of the poster. A lot of other times is because you know what's in it. A lot of investors really do not want to hold certain companies. From my experience a lot of times it's tobacco and weapons. But the industries really run the spectrum. And people REALLY have strong feelings about what they don't want to own.

 

1.1 A particular case of what can go wrong with indexes. This is from memory so figures may be a bit off here and there but not my much. In late 90s Canada Nortel rose to be over 1/3 of the whole index. Its market cap got to about $400 Bn. It was worth a multiple of the 5 big Canadian banks put together. I can't remember if the multiple was 3 or 5, but i think it was 5. Today the big 5 are worth $488 Bn and Nortel is no longer with us. Everyone beat the index if they didn't own Nortel.

 

1.2 I'm sure there are similar stories elsewhere in the world.

 

2. What actually is an index? If you're Warren Buffett you'd say S&P 500. But index investing really is pleading ignorance to business, finance, really everything. So if one is truly ignorant ignorant, one would say I'd want a piece of everything. That is a global index market weight by geography and all. Based in that decision you would have relatively done very well during the 2000s but not so well during the 2010s. Relative to what is the big question. It really shouldn't be a question. You did average by definition. But I'm willing to bet a steak dinner that people in the global fund were feeling pretty smug during the 2000s but kinda crappy during the 2010s. So much for ignorance.

 

3. Largely the index mentality (striving for mediocrity) is absent from the real world. The wealthy segment of western societies is mainly made up by business owners. These people's wealth is concentrated in equity and they are woefully undiversified. And they do not care about that one bit. You never see a meeting of business owners where someone comes and explains indexing to them. You're more likely than not to underperfom the index so you should shut down/sell your business and put your capital in an index fund. You don't see that because you can measure with an egg timer the time before that speaker is laughed out of the room.

 

3.1 This is neither here nor there. But I find it paradoxical that people that people that hate the grind of investing and are great believers in indexing spend time on a value investing board. One would think that their money is in index funds and they would peruse more pleasurable activities such as chasing after a girl, hammering the wife, reading a book, or checking out that nice new restaurant down the street. I'd add watching a good movie but there aren't that many of those anymore.

[frommi]

It is mostly hard to beat the index because the majority of index gains come from very few stocks. Most stocks lose money.  If you are actively selecting stocks it is likely you will miss those winners.

 

If you closet index you will likely select the winners but have high fees.

 

Therefore it makes sense that few outperform the index. It is not the case that 50% of people should outperform and 50% should underperform with random concentrated stock selection given the distribution of stock gains is waited heavily to a small subsection of the index. In that scenario most should underperform with some really massive winning fund managers.

 

The momo effect of indexing also ensures you cut losses on nearly all stocks that go to zero and are invested in all stocks that compound value by default.

 

I just read that in the past 5 years only 13 of 500 stocks in the S&P500 outperformed the index. My conclusion is that you either have to go hunting outside the index (microcaps etc.) or you have to increase your turnover to outperform. Going the microcap route is the easiest route to outperform with small AUM and at the same time the hardest thing for people to do because it is viewed as risky by most investors.

[rb]

I just read that in the past 5 years only 13 of 500 stocks in the S&P500 outperformed the index. My conclusion is that you either have to go hunting outside the index (microcaps etc.) or you have to increase your turnover to outperform. Going the microcap route is the easiest route to outperform with small AUM and at the same time the hardest thing for people to do because it is viewed as risky by most investors.

I'm not sure that is correct, but i don't have the data right now so I can't contradict you. But what you say is true then less than 13 companies were responsible for all the out performance. Since the index is market weighted I don't see how the conclusion you draw is that you should go low market cap since the out performance was driven by high market cap companies.

[Hielko]

I just read that in the past 5 years only 13 of 500 stocks in the S&P500 outperformed the index. My conclusion is that you either have to go hunting outside the index (microcaps etc.) or you have to increase your turnover to outperform. Going the microcap route is the easiest route to outperform with small AUM and at the same time the hardest thing for people to do because it is viewed as risky by most investors.

I'm not sure that is correct, but i don't have the data right now so I can't contradict you. But what you say is true then less than 13 companies were responsible for all the out performance. Since the index is market weighted I don't see how the conclusion you draw is that you should go low market cap since the out performance was driven by high market cap companies.

Micro-caps are not part of the index, so the fact that in the index the outperformance was driven by a few high market cap companies doesn't say anything about the potential performance of very small market cap companies.

[SharperDingaan]

The majority of people invest in an index because they have better things to do with their time.

The index investment is expected to return either a reasonably reliable cash flow (interest or dividend), or earn only marginally less that could be made on a direct 'widows and orphans' investment. For most people if you want to be more 'hands-on' in your investment approach, you invest in rental property rather than 'widows and orphans' shares - and collected rents versus dividends and interest. No fund trading, and an index sector review maybe once/year - if that. 

 

Horrifying from an industry perspective.

Capital flows to main street (rental property) versus wall street (stocks/bonds), there is heavy bias to not 'trading' (no commissions), fees are highly visible, and value-for-money isn't. More telling, is that this was pretty much the norm prior to the major wall street firms becoming public companies. Hence - anything other than this is essentially marketing, to generate commission.   

 

There have always been a small number people who outperform; but it's just that - small.

Making the pool of people bigger doesn't create more out performers, it just makes it harder to out perform; returning us back to that very small number. Education is a very good analogy: There was a time when an MBA was very hard to get; hence the people who had one were very good, & paid accordingly. Today pretty much everyone has one, but most of the folks who have it ? not so good.

 

In the real world we live on Main Street.

Get a life, & enjoy it!

 

SD