In A Random Walk Malkiel says he was essentially advocating index funds but there were no index funds back then. He says that "two-thirds of active managers are beaten by the indexes." He believes "even more strongly than I did in 1973 -- that most investors would be much better off having at least the core of their portfolio in a low-cost index fund."
We've had a lot of good debates here about passive investing in terms of what the best definition is and how effective it is or isn't. It is tough to argue against the effectiveness of indexing. If you save properly and have the correct asset allocation you will capture whatever the market does and historically this has been sufficient. Note that saving and allocation issues are major issues from a practical standpoint even if the theory is credible.
There are gaps in the theory and for some the gaps are too formidable to make indexing right for them. The two big issues I have with indexing is that there appears to be no forward looking analysis whatsoever, just faith that whatever worked before will continue to work into the future. This is a big leap of faith in my opinion.
The other issue I would note is that indexing seems to completely ignore the concept of risk adjusted return. Indexing proponents might say that proper asset allocation addresses this but I don't agree with that. To the extent that people are potentially their own biggest obstacle to long term success there is something to be said for defensive strategies and not necessarily needing to capture the full effect of the market even in the good times (this would be a function of a high savings rate and living below your means).
A little later on Malkiel notes that "technical analysis is really useless." That it is useless seems to be easily refuted time and again. I wholeheartedly agree that technical analysis is not infallible. TA is not perfect but then nothing is. Malkiel concedes that with indexing one flaw is that you end up owning too much of the wrong thing at the wrong time (tech in 2000 and financials in 2007)
The last thing to touch on is his comments about why individual investors should stay away from hedge funds and other alternatives because they will "get the worst" of both. He also says that the 2 and 20 pay structure of hedge funds will go away.
I have never been a fan of illiquid investments (ex-real estate that you can afford) for individuals and lately things haven't worked out so well for some of the better known institutions buying illiquid investments either.
I am all for moderate weightings in exchange traded, alternative asset products that help manage volatility as part of a diversified portfolio. Not all of them work as advertised but I do believe the right ones can help. There are several ETFs and at least one ETN that are broadly in this category. IndexIQ seems to be the most committed to this space. They have launched two funds so far, tickers QAI and MCRO, and have another 12 or 13 in registration. The two they have that are actually trading are too new for me to draw any conclusion but small exposure to the space is perfectly valid.
13 comments:
"Benoit Mandelbrot has written at some length about how most of the widely accepted notions of finance as taught in CFA courses and business schools are badly flawed, including CAPM, the efficient market hypothesis, and Black Scholes. Because the main assumptions of finance theory (normal distribution and that market prices are independent of each other) are flawed, all constructs built on them are flawed too. Specifically, they understate risk. They overprice stocks, they underprice options, and they therefore understate the equity financial institutions need to hold to be able to bear market risk."
"Now as far as academic theory is concerned, it says that investors should be diversified by asset class. That greatly reduces risk while only somewhat lowering returns, which in the long run leads to superior performance. But the industry has touted that people should be heavily invested in stocks, 50-80%. Frankly, equities are a lousy promise. Management will pay you dividends if and when they feel like it and can dilute you or announce stupid acquisitions. To make a proper evaluation of an equity holding, you need to have a private equity type relationship: you need to know management's intentions and integrity, understand their strategy and competition. Disclosure is a partial but inadequate solution. A company cannot disclose enough for an investor to make a truly informed decision; they'd be giving too much competitively valuable information away."
But investors have been lulled into complacency and because markets are liquid (most of the time) they have come to accept investing based on inadequate information. IMO, the Harry Browne permanent portfolio is one of the few choices for those looking to follow a strict buy hold rebalance type well diversified strategy. All the rest is noise and no once can use forward looking analysis and outguess all the other experts...
All the rest is noise and no once can use forward looking analysis and outguess all the other experts...
How does correctly owning, say, Brazil require or involve "outguessing" someone else?
Roger,
(1) Owning Brazil in any proportion other than its global market-cap weight is basically trying to "outgess" the market. (Note: owning 0% of Brazil would be one example of trying to outguess the market.)
(2) The risk-adjusted return concept *is* taken into account with CAPM. It says that the global market portfolio offers the highest possible risk-adjusted returns because it's maximally diversified. One adjusts for risk preferences by either deleveraging (i.e., putting some fraction of your money in cash or risk-free bonds) or by leveraging (i.e., buying the market portfolio using borrowed money).
(3) CAPM says that taking "defensive action" when, for example, the S&P falls below the 200 DMA is counter-productive. There's not supposed to be any momentum in stock prices. In other words, the fact that equities have gone down in the recent past doesn't make it any more likely that equities will go down in the near future.
- AAG
Brazil is outguessing the market?
yes but the comment said outguessing all the other experts.
active management involves what i might think of as out-maneuvering the market but other would say out guessing which is fine but where to the other experts come in?
Malkiel is usually worth reading and arguing with his points is an excellent clarification exercise. It should be remembered though that the random walk he is talking about is not the same thing as a random market and it doesn't necessarily rely upon the validity of CAPM; he is referring to systematic research supporting the observation that when you map out the results of everyone investing in the market, the pattern looks virtually the same as a pattern generated by a series of random throws; there is no way to know in advance who the winners or losers are going to be.
Most fundamental and quantitative analyses and virtually all forms of technical analysis tested as a strict set of investing rules do not change that pattern to any significant degree and this is true even though many individuals may profitably use an analytic model involving one or more of these approaches. In part this is probably because their success is offset by those using a less effective approach or by those who simply lack ability but it also may be because even the most successful techniques can blow up eventually, causing very large losses (and we've had more than one discussion about what that can do to long term results).
Generally speaking if an investor does not have a fairly strong reason such as predictable profit to believe they possess investing acumen they should probably consider employing some form of indexing using an allocation and re-balancing model that makes sense to them. Active portfolio management covers an awful lot of territory and I suspect even a complete devotee to indexing would admit there is more than one model or conceptual framework available; e.g., capital weighting is only one way to judge appropriate sector allocation.
And even those convinced they have the requisite talent would probably be wise to sequester assets in some manner, possibly using a permanent portfolio approach, on the chance they might actually be more lucky than clever.
Well said RW.
"...on the chance they might actually be more lucky than clever." To me, this statement alone is reason enough to follow a passive indexing strategy. Having read a little about behavioral finance and the numerous cognitive and emotional biases investors (and advisors) are burdened with it is plain for me to see the wisdom in indexing.
I for one would like to see posters (and even Roger) who propose exploring a theme, sector, strategy etc. to ask themselves in their post "...and what if I'm wrong, what can happen?" I have always found exploring that question a useful exercise.
Mebane Faber recently mentioned "The Fundamental Index" by Arnott and Hsu as far excceding his expectations. Anyone here have an opinion on it?
Thanks much.
From my following Roger the past several years, his whole strategy is based on "what if I'm wrong?". I always enjoy reading RW's comments, they make me slow down and read each word. Interesting discussion.
Sam
To change the subject, Roger, you have mentioned that you are underweight in equities so I am assume overweight in cash (or bonds?), I don't recall reading your position on this. Question where are you stashing your cash? Money Markets are so low I am wondering the risk of spreading some cash to internet banks' savings accounts paying 2 to 3%. Thoughts?
America needs a new political party.
The Republicans are a criminal gang mafia, no longer even a representative political party.
I don't think we can wait until Jesus returns.
Anon 7:09 - Just like the Democrats. We should fire them all and start over. We ahve way to much government.
Perhaps a revolution, similiar to what happened in Iran recently, is needed in this country to overthrow the "regime" (meaning our current form of government).
I never would have thought this possible, but I now believe anything is possible.
What we have seen in this country over the last 10-15 years, and the severe manipulations by business and government, a change is needed.
A strong middle class is what propelled America to its' heights and now this weakening is pulling America down.
I do not subscribe to the theory that prices are random. There's a pretty well defined business cycle, and it is not vodoo (TA)to watch for where money is moving in or out. Why be IN an index if it is clear that money is moving out of it and the trend is turning unfavorable? I'll never understand that.
Index investing IS the most easily accessible investment strategy, which I think makes it popular. I don't care to be lumped in the same boat as money managers who lost 25-30% (or more)by staying fully invested.
"Bubbles only clear in hindsight?" BM's comment strikes me as naive and failing to take into account speculative excesses that are pretty well documented.
I no longer subscribe to the 'smart money' theory either. Smart money has proven to be anything but. RAther, I'd start a new theory on Quiet Money. It's the really smart money that works quietly behind the scenes putting brains ahead of ego. It finds the opportunities and quietly builds a position at favorable prices.
Everyone watches the indexes, so it is hard to game those so much. I still prefer individual stocks or sectors rather than a glommed together index.
I'm just a nobody, but I've beat the indices handily watching the quiet money. I agree that asking the "What if I am wrong" (or a turn...."How/when do I know that I'm wrong?" questions are critical.
In index investing, there is no wrong, which makes that investment modality seem, well, wrong.
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