Time for a Reality Check !

Dan Solin is a graduate of John Hopkins University and the University of Pennsylvania Law School.

He has written a wonderful book The Smartest Investment Book You’ll Ever Read and is a financial columnist with The Huffington Post

Enclosed is a link to his write-up titled Time for a Reality Check dated 26^th October 2010. 

The important lesson is that ‘predictions and forecasts’ in financial markets are very difficult-even for professionals.  Active investing involves all kinds of future predictions and forecasts-great stocks, managers, time to be in and out of the market and so on.

Dan Solin is a strong advocate of passive indexing!

The futility about some of these forecasts reminds me of terrific stuff that I had read in the book Black Swan

“What is surprising is not the magnitude of our forecast errors, but our absence of awareness of it.”

And

“Thomas Watson, the founder of IBM, once predicted that there would be no need for more than just a handful of computers.”

http://www.huffingtonpost.com/dan-solin/time-for-a-reality-check_b_772954.html

The investor's 'dream team'

Charles Ellis is among the greatest investors of the 20^th century and author of the perennial investment classic Winning the Loser’s Game.

He was associated with the giant Yale Endowment Fund and his firm Greenwich Associates is an advisor to giant institutional investors.

In Winning the Loser’s Game he poses a question...what would an investor’s dream team comprise of?

In other words if a typical investor was given a choice of choosing his ‘dream team’ to manage money-who would he select? Which individuals would he choose to manage his money?

Ellis goes on to answer the question...the team would clearly comprise of Warren Buffett-his partner Charlie Munger, Peter Lynch and George Soros...these guys are obvious choices! It’s a no-brainier.

Further says Ellis-the investor’s dream team would also comprise of all the hedge fund managers-since they too have expertise, insights, knowledge and information...Ellis doesn’t stop...he says why not even have all the best analysts from the best Wall Street banks, from all those brokerages and all those research outfits...!

In short...a typical dream team would certainly comprise of all the finest professionals in the business-if we as investors had a choice wouldn’t we want such a ‘star-studded’ team manage our money? And what if we could hire all of them at a low cost?

Let me reproduce the sage advice of Charles Ellis-how each and every investor can permanently have a dream team comprising of the best professionals work for him !

In fact, you can have all the best professionals working for you all the time. All you have to do us agree to accept all their best thinking without asking questions. (Most of us do the same sort of thing every time we fly: We know that our pilots are trained for and committed to safety. Boring as it may seem, we relax in our seats and leave the flying to the experts.)

To get the combined expertise of all these top professionals, all you do is index-because an index fund replicates the market, and today’s professional-dominated stock market reflects all the accumulated expertise of all those diligent experts making their best current judgments all the time.

And as they learn more, they will quickly update their judgment, which means that you will always have the most up-to-date consensus when you index.

...the ‘market portfolio’ or index fund is actually the result of all the hard work being done every day by the investor’s dream team.

Passive or index investing is seldom given anything like the respect it deserves. But it will, over time, achieve better results than most mutual funds-and far better results than most individual investors achieve.

Conceptually, the timeless and seminal advice of Charles Ellis is also applicable to Indian investors...it always was, it is right now and will be applicable till eternity!

Indian investors can buy cap-weighted broad market index funds / ETFs-including (cap-weighted) Total Market Index fund-they are akin to buying the market or the combined expertise of all professional active managers who participate in Indian markets.

A short list would include all MF managers, insurance managers, all PMS Managers, treasuries managers-corporate & bank, all analysts, all institutional investors, broker-advisors, family offices and so on and so forth.

The combined expertise / thinking of all professionals, at any given point in time, is reflected in the market prices-and therefore in the market capitalization of individual companies...therefore when an investor buys broad market cap-weighted index funds / ETFs he is in effect hiring the combined expertise of all professionals (at a very low cost)-the proverbial ‘dream team.’

How Power Blinds Us to Our Flaws...!

Enclosed is link to another superb article dated 16^th October 2010 by Jason Zweig,

“What Conflict of Interest? How Power Blinds Us to Our Flaws”

It is about how dozens of powerful people on Capitol Hill actively traded during the financial crisis.

According to me, power enforces the illusion that one is larger and more brilliant than the market.

The author quotes Meir Statman, of the Santa Clara University,

 If you passed a law saying that [members of Congress and their staffs] can only invest in index funds, on the whole you would do them a great favor, for two reasons," says Meir Statman, a finance professor at Santa Clara University. "First, they won't be reading news coverage about themselves that they and their constituents don't like. And two, they're more likely to make more money on index funds than by trying to outsmart the market."

http://online.wsj.com/article/SB10001424052748704049904575554224110186824.html

I don't know and I don't care...!

Jason Zweig is an eminent personal finance columnist in the US and has written famous books such as “Your Money & Your Brain.” He edited the revised edition of Ben Graham’s perennial classic “The Intelligent Investor.”

I am posting a link to an excellent article titled I don’t know and I don’t care written for the media in 2001.

He narrates his experiences about ‘picking’ hot funds and ‘star’ managers...finally he realizes that it would be more logical to invest in broad market index funds.

Indexing give you the freedom to say I don’t know and I don’t care...because you do away with the need to forecast and identify the next hot stock or manager. 

Individual stocks and managers represent additional risks (over and above the market risk) and these often remain uncompensated!

Indian investors & investment advisors should also try and understand the logic of indexing as explained by Jason Zweig.

http://money.cnn.com/2001/08/29/investing/Zweig/

Two great investment strategies !

Enclosed link to a great media write-up titled Two Great Investment Strategies which was done a couple of years back by Dr Ajay Shah.

He gives a superb explanation of survivorship bias in fund evaluation.

Except for the CRISIL SPIVA Scorecard, I don’t recollect seeing any comparisons of active and passive in India which make adjustments for this important factor.

As a result outperforming active funds (from a given sample) appear much better than they actually are!

In principle, correction for survivorship bias is valid for all managed portfolios present in the market.

http://www.mayin.org/ajayshah/MEDIA/1998/two-strategies.html

Common misconceptions and misplaced beliefs about indexing...some answers

In the following blog I have attempted to answer and address some common misconceptions as well as misplaced beliefs about indexing...some of these may be of more relevance to Indian investors.

Myth-1: The index is typically comprised of a smaller number of stocks whereas the fund manager or stock picker can pick and choose from the entire market.

Reality-1:  The number of stocks, in an index is not relevant, what is important is how much or what percentage of market capitalization the index captures or maps.

Therefore indexes when used as (cash market) investment vehicles in index funds or ETFs try to capture the various sources of risk so that investors can hope to earn the resultant expected returns.

Hence, for example, a total market index is designed to mimic the behaviour of the market as a whole and thereby capture its characteristics and peculiarities i.e. equities as an asset class.

Similarly other indices such as large-cap or mid-cap indices or narrower sector indices-help capture the behaviour and peculiarities of the respective sub-segments of the market or sub-asset categories.

An individual stock (or even a handful) cannot hope to capture a market’s behaviour nor the characteristics of any of its sub-segments-and this also true for portfolios managed by individual managers / advisors.

In other words individual stocks (and managed portfolios) will have a wide range of outcomes or returns (at random)-relative to the market.

Myth-2:  A cap-weighted index generally tends to ‘overweight’ large and growth companies and ‘underweight’ smaller and / or ‘value’ ones.

Reality-2:  Nothing really is known about ‘fair value’ of a security and therefore any stock (regardless of its capitalization) is just as likely to be ‘over or undervalued.’

In other words the presumption that large-caps are overvalued is rather ‘subjective’ and a result of individual opinion...therefore it can never be the ‘absolute’ opinion.

Further, due to the beauty of the cap-weighted ranking method-if the price of a big company falls for some reason-its aggregate market cap will also fall-and as a result the security will reduce in weight and ‘rebalance’ automatically / instantly in the portfolio.

E.g. some big banks in US indices fell in ranking in the broad market indices (due to fall in price) as the sub-prime problem broke out-and they automatically moved (rebalanced) to a lower slot as (simultaneously) other companies from different sectors moved up in weighting.

In the cap-weighted index-all these adjustments happen instantly and automatically as events unfold.

On the other hand-in actively managed portfolios the investor or portfolio manager has to take a view i.e. remove some of those companies or instead buy more? In an actively managed portfolio one has to decide whether to increase the weight or reduce the weight of individual components-as events unfold rapidly.

Myth-3:  Fund management experts are better placed (relative to the market) in arriving at ‘correct valuations’ or right price of a security-and therefore indexing is on a weaker ground because there is no expert taking calls on valuations.

Reality-3:   What is the definition of right price? It is the ‘price’ at which a ‘buyer and seller’ enter into a voluntary exchange of goods and services! This happens all the time in a free market.

This makes the ‘market price’ as closest to the fair value of a security because numerous buyers & sellers are entering into voluntary exchanges-based on their choices and perceptions.

The market price of a security is the best estimate of what numerous market participants (all those buyers and sellers including numerous professional managers / analysts) are thinking at any given point in time.

Some individuals (typically active investors) can keep arguing about the definition of ‘right price’ because each of them has a subjective valuation process-to use an analogy e.g. different buyers of an apartment will (each) have different criteria for arriving at the right price or valuation of the same apartment. 

Some will dispute with the price or ‘value’ of the apartment (for a number of reasons) saying it is ‘overpriced’ while several others will define the ‘price’ as ‘right’ because of proximity to school, or railway station or overlooking a garden and so on.

The right price is therefore the agreed price between the apartment buyer and seller. When both enter voluntarily into a transaction-it becomes the market price or fair price.

An analyst can spend days and days (working on a spreadsheet) making arguments why the ‘agreed price’ of the apartment was incorrect...but value finally lies on the eye of the beholder and no amount of expert analysis (done independent of the market process) can change this reality.

‘Market Price’ of a security aggregates dispersed knowledge of numerous market participants.

Hence when an individual active investor is attempting to ‘beat’ or ‘outguess’ that price (through commonly known tools / methods of analysis in active investing) it is the equivalent of playing ‘chess’ against thousands of invisible opponents.

Myth-4:   Companies or stocks (usually) get into an index after the run up happens hence those stocks are already overpriced-by the time find a berth into an index.

Reality-4:     The presumption over here is that there exists some authority (an individual expert) who knew the right valuation (of the stock) in the first place.

But for a moment let us assume that some active investors did manage to spot some great companies in their infancy i.e. before they got into the index and hence managed to capture a good deal of returns in infancy. However, those smart active investors also ended with some lousy stock picks-this happens all the time!

Let us assume that the lousy picks (the negative outcomes) were a case of ‘bad luck’...it would then imply that the great picks (done in infancy before those stocks got into the index) were ‘good luck.’ Some financial economists would call stock picking outcomes as the equivalent of throwing darts-mostly luck!

In a highly competitive and efficient market it implies that the ‘absolute skills’ of individual portfolio managers is intact...but their skills relative to the market are on the decline.

The market is nothing but an entity comprised of numerous equally brilliant active managers / stock pickers-all trying to outperform each other and by that definition- the market.

Myth-5:   Index components are decided (periodically) by the index committee-hence there is a stock selection process involved-similar to active management.

Reality-5:    There is a major difference: the index committee is not paid to beat the market. In direct contrast the objective of an active manager is to outperform the relevant market (index) and the manager is paid to do so. 

Therefore the criteria of an index committee are to formulate a portfolio that is at best a representative sample of the characteristics and behaviour of a market and by definition this should map the market (or its sub-segments) in terms of value or capitalization.

Moreover, once security ABC or XYZ gets into an index-its subsequent change in fortunes (i.e.  Its weight in the index) are left to the market forces. The index committee goes out of the picture.

On the other hand the same security in an actively managed portfolio will be regularly monitored by the portfolio manager who will take (active) decisions based on various criteria-such as profits, brand, competitiveness, ROCE, new projects, change in management, FII positions and so on and so forth, fund inflows and outflows into his scheme, trading calls, his own insights, gut, market information and so on.

Myth-6:   Outperformance in the ‘efficient’ US market maybe difficult-agreed! However, in emerging markets (like India) experts can (as yet) locate mispricing with relative ease and hence consistently beat the market (index)

Reality-6:   First of all let us understand-the composition of the modern Indian stock market- we have numerous MF managers, FII managers, hedge fund managers, PMS managers, insurance companies, treasury managers-bank and corporate, pension managers, analysts, family offices, broker-advisors and many other professional active managers-all of whom are attempting to beat the market and are paid to do so. Financial media adds to the information flow in the market.

Therefore publicly available information in a competitive market like India-is essentially ‘broadband’ or a commodity.

This competition results in efficiency.

In other words-alphas is a reality in any efficient market-but they are random, transient and known in hindsight. Therefore there are no ‘free-lunches’ or proverbial diamonds (mispricing) lying scattered on a heavily populated road just waiting for the fortunate few to pick them up! Even if ‘mispricing’ anomalies exist-they are kind of randomly scattered and it is rather tedious to capitalize on them consistently.

One can outperform only by exploiting the mistakes of others-but in a market that is increasingly dominated by professionals-it is difficult (for individual managers) to locate victims i.e. consistently.

Even if the market is presumed to be ‘informationally’ inefficient-for every alpha in the zero-sum game (of outperformance) there will be an ‘anti-alpha’ or underperformance. Hence for every out performing manager or active investor there will be an underperforming counterpart somewhere in the system.

Points to Remember: 

A cap-weighted index portfolio is a representation of the entire market (or its segments) and therefore at any given point in time the index is a reflection of the way the world (investors in the aggregate) values its assets.

Any active deviation from market weights-is an individual judgement and no subjective valuation (done independent of the market process) can ever be sacrosanct. 

Therefore any active deviation from market weights can lead to out and under performances-which will be random, transient and known in hindsight.

Some thoughts on the inherent limitations in trying to outguess or beat the market

Active investing has a lot to do with all types of ‘predictions & forecasts’-especially when the objective is to beat the market (index).

For example stock pickers have to ‘predict’ and therefore identify a couple of stocks with higher future rates of return...this has to be done from among the large number of companies typically listed on a stock exchange...and do this in competition with numerous contemporaries attempting a similar exercise.

Similarly manager pickers have to predict (from a large pool) the few managers who they believe will pick stocks with a higher rate of return-and in the process beat the market and other managers (also) attempting a similar exercise.

Predictions can extend to attempting market timing i.e. a great time to enter the market and then exit it.

Forecasts in active investing normally also extend to macro-economic domain such as predicting interest rates, government action affecting an economy, oil prices, and global cues and so on and so forth.

This narrows down the debate to understanding the difference between ‘physical / natural’ sciences and ‘social’ sciences.

Natural sciences such as physics, astronomy, medicine, engineering, chemistry etc deal with the natural phenomena found in our universe. On the other hand social sciences are the study of human interaction as individuals and as groups-for example their choices, preferences and so on.

‘Prediction’ is easier in natural sciences, e.g. an engineer can use a mathematical model to predict the stresses in a concrete structure such as a dam or a bridge or a skyscraper...similarly an aeronautical engineer can predict the impact of natural forces on an aircraft in flight via simulations in a wind tunnel or on a computer.

Likewise, medical sciences such as cardiology are moving towards ‘predicting’ heart attacks before they can occur in (otherwise) perfectly healthy people. For example, huge advances in cardiac imaging technology can pick up heart blockages in infancy and with a high level of accuracy-thereby the risk of a future stroke can be ‘actively predicted’ beforehand and necessary lifestyle changes be suggested to a possible future victim i.e. ‘in advance.’

Prediction is therefore easier with physical phenomena because they work according to a predictable past pattern and in accordance with natural laws.

Such ‘prediction’ luxuries may not be available to social sciences e.g. economics and investments.

This is because it involves human interaction, emotions, choices, perception & behaviour-which are relatively difficult to ‘forecast and predict’ (in advance) by using mathematical models or commonly tools such as charts (using past price patterns) or discounted cash flow models and so on! In other words past data can be of little predictive value going forward.

For example, in the stock markets it is rather difficult to arrive at the fair price of a security by making use of the usual tools of active management. Price at any given point in time is a reflection of what thousands and thousands of market participants are ‘thinking’-it is an estimate of what people collectively believe & perceive!

Likewise it is extremely difficult to figure out short-term market movements by using past patterns. Mr Market is almost like a human being whose thoughts change very often and hence making predictions & forecasts is tedious.

Price movements are impacted by ‘news’ or arrival of ‘fresh’ information and how numerous market participants respond / react to it (almost instantly)...I cannot think of any tool available that can accurately ‘predict’ this phenomena in advance. Fresh information could be anything-right from company specific to something like economic crises in Greece.

Arrival of fresh information / news is ‘random’ causing a random walk in prices.

Even if we assume the market is making mistakes-those errors, if any, will be accurately ‘predicted’ in hindsight.

Let me reproduce, as an example, two predictions that went horribly wrong and were highlighted in the book Black Swan, the words from the book are,

Thomas Watson, the founder of IBM, once predicted that there would be no need for more than a just handful of computers.

...Likewise, we are not spending long weekends in space stations as was universally predicted three decades ago. In an example of corporate arrogance, after the first moon landing the now defunct Pan Am took advance bookings for round-trips between earth & the moon.

Nice prediction, except the company failed to foresee that it would be out of business not long after.

The above examples represent human choices & behaviour-not easy to predict or foresee-unlike engineering problems that are easier to ‘predict’ and solve by using mathematical equations.  

Investors, often confuse between ‘natural & social’ sciences-what works for the former may not work in the latter.

We (often) erroneously believe there are ready made tools, also available in ‘social sciences’-which when used by experts can help us (easily) in beating the market-by predicting (in advance) mispricing that maybe caused due to human behaviour, choices and interaction!

Hence, the market price is closest to what we call as ‘fair estimate’ of a security’s value. Passive indexing makes no attempt to outguess market prices.

It is important to understand the inherent limitations in attempting to outguess the market (consistently)-let me end with some words from the book Black Swan,

What is surprising is not the magnitude of our forecast errors, but our absence of awareness of it.

Buffett's best tip for personal finance...Index Funds!

Enclosed is link to a 2 minute video interview of Warren Buffett, titled Buffett’s best tip for personal finance.

The greatest investor ever advices that it is a good idea to just buy index funds every month...he uses the analogy of buying a farm.

If you bought a farm it would be futile to look at the daily weather forecast or get a quote on the farm every morning-one would instead consider its productivity over a lifetime-how many bushels of corn it will produce and so on...and so forth! Similarly, if you invest in a ‘cross-section’ of American industry one can hope to do well-provided you don’t ‘dance in and out’ of that investment.

(The 'cross-section' is the reference to a broad market index-or what I call buying 'businesses in the aggregate.')

In all humility, if I may add (my two cents worth) to the Master’s words of wisdom...when you buy a farm you do it with the understanding that there will be interim volatility (some years of famine, drought, excess rainfall, crop failure and so on)-doesn’t mean that one should panic and begin doing ‘analysis’ and ‘data crunching’ about farming!

It really doesn’t help because analysis beyond a point is futile and damaging almost like an overflowing dam!

One would rather consider the 'average' performance or yield from a farm over a long-period of time-maybe even a lifetime.

According to me the Master’s sage advice has a universal application for investors everywhere.

 http://news.yahoo.com/video/us-15749625/20768089

A recent example of a 'Star' analyst who is now faltering...!

Meredith Whitney-the banking analyst who had shot to fame for correctly predicting Citigroup’s dividend cut...is now struggling to make the right stock picks.

She received many accolades (in hindsight)-but unfortunately ‘past performance’ seems to be faltering. 

Read the following link to a story titled Whitney Falters in Trying to Repeat Success of Citigroup Call.

http://www.bloomberg.com/news/2010-10-06/whitney-falters-in-trying-to-repeat-success-of-citigroup-call.html

As a firm believer of passive indexing-I see Meredith Whitney as an example (from a long list) of individual active stock pickers / managers who enjoy transient success in beating the market.

Such examples are lessons that repeatedly confirm academic studies (done in indexing) which tell us that it is difficult to consistently outperform, outpace and outguess the market.

Many similar examples exist in all stock markets around the world.

I am reminded of the following words of William Bernstein and John Bogle,

William Bernstein (author of The Intelligent Asset Allocator) stated: "It turns out for all practical purposes there is no such thing as stock picking skill. It's human nature to find patterns where there are none and to find skill where luck is a more likely explanation..."

John Bogle (founder and former CEO of indexing giant Vanguard): I have taken these words from his speech The Stock Market Universe-Stars, Comets and the Sun dated February 15^th 2001 before the Financial Analysts of Philadelphia,

Yes, there have been some star investors, but they are precious few, and I take my hat off to them. But no, there is no way to be certain how long today’s stars will remain in that celestial realm. Nor have I ever seen any methodology by which tomorrow’s stars can be identified in advance. But beyond serious refutation is the evidence that the overwhelming majority of yesterday’s stars are destined to be tomorrow’s comets.

The wise words of William Bernstein and John Bogle are valid for all competitive and hence ‘efficient’ stock markets around the world!

Ironically, it is the presence of many brilliant analysts, investors and managers that makes the market competitive and this leads to random outcomes (i.e. winning and losing performances) of individual active investors, analysts, stock pickers, market timers and managers.  

I will explain market efficiency using simple analogies in future posts.

Logic tells us that it is rather futile to ‘guess’ (forecast, predict and pick) future ‘stars’ (i.e. individual stocks, managers or time the markets) because it is not only difficult to foretell future ‘stars’ in advance-it is equally difficult to predict the turning points when ‘stars’ will turn into ‘comets’ or ‘black holes.’

We have read the discoveries in astrophysics and astronomy-when a ‘star’ collapses in the heavens it turns into a ‘black hole’-the gravitational forces are so huge that the ‘black hole’ begins to suck all matter around it-even light cannot penetrate through-hence the name ‘black hole.’

The ‘heavenly’ drama also occurs on Earth in the markets when a ‘star’ (individual stock or manager or analyst) collapses-investors get sucked into the proverbial ‘black hole.’

It is more logical to invest in the market (universe) itself-i.e. the index!  Mr Market contains more knowledge, information and insights than any ‘star’!

The failure of 'market timing' a great example...!

Mark Hebner is the founder & President of Index Funds Advisors and in his book Index Funds-The 12-Step Program for Active Investors (2007 edition) he quotes a terrific study of how market timers fail miserably...

Mark quotes an analysis done by Robert Merton-the Nobel Laureate in Economics,

Writes Mark, (I have deliberately underlined some words to signify their importance)

Robert Merton wanted to estimate what a clairvoyant time picker would earn. To that end, he calculated the value of being invested in the market during upturns and T-Bills during downturns.

His findings show that investors who stayed invested in T-Bills from 1927 through 1978 would have seen their $1,000 investments grow to $3,600.

Meanwhile, in the broad market of the NYSE index, a $1,000 investment would have grown to $67,500 during the same period.

A time picker with the vision to forecast all the months that the NYSE outperformed T-Bills during the 52-year period would normally invest in the market at the beginning of each of these months. According to this timing system $1,000 would have grown to $5.36 billion.

Now that is a real incentive to figure out how to pick the right times to invest. It also proves that if timers really had psychic powers that allowed them to see next month’s market trends, they would grace the covers of Forbes, Business Week, and the Wall Street Journal. But, they do not.

 Is it possible that there are a few visionary timers out there? Sorry, but they just don’t exist. In 1978, the wealthiest individual on record didn’t come close to these numbers. Wealth is not created by purposeful market timing. There may be cases where one got lucky for a while, but that is not a reliable strategy for long-term investors.

What does this mean?

* Timing the market correctly and consistently is an important component of active investing-in its attempt to beat the market (index) i.e. relative to a typically ‘buy-and-hold’ kind of passive investor.

* It implies that active investors have a huge incentive in forecasting (correctly) major turning points in the market.

* All of us have seen & read numerous studies which tell us something like this The market (index) gave a compounded annualized return of XYZ% (say) over the past 2 or 3 decades...and if an investor missed 10 or 20 or 30 best days (in trying to time the market) the return would have crashed to a measly ABC% instead of the XYZ% that an investor could have (otherwise) obtained by ‘buying and holding’ the market index.

A corollary to the above could be,

Had an investor stayed out of the market for the 10, 20 or 30 worst days over a 2 or 3-decade time period then that individual could have beaten the market (index) by a wide margin.

* The only catch is that the typical market timer, in order to be successful, would have to be a terrific ‘soothsayer’ possessing container loads of luck.

Conclusion:  We know that the big moves in the market (both upwards and downwards) happen over a relatively small number of trading days-hence profitable market timing into the future (based on past data, models, and patterns) remains elusive and an utopian situation.

Successful market timing is therefore transient, mainly due to luck (or skill?) & an unreliable strategy, almost like throwing darts into the future!

A superb example of 'market efficiency'

Link to a superb write-up, dated 3^rd October 2010, by Daniel Solin titled ‘How to Protect Your Investments from a Falling Dollar’

The author argues that currency markets (like the stock market / any free financial market) are ‘efficient.’

The market is all knowing-and whatever people believe they know (exclusively)...unfortunately (for them) the market ‘knows it too’-hence all competitive markets are efficient!

Publicly known information is already factored into the markets-currency or stock or any other free market.

Hence attempting to outguess the market is futile-just buy index finds!

http://www.dailyfinance.com/story/investing-basics/how-to-protect-your-investments-from-a-falling-dollar/19653202/

‘You don’t (always) get what you pay for and ironically you may also get what you don’t pay for !’

The debate between the advantages and disadvantages of active and passive management is always intense...however in this write-up let us keep passive management aside and be focussed on active management itself.

Active management resembles ‘you don’t (always) get what you pay for and ironically you may also get what you don’t pay for.’

Let me explain,

·         Normally we pay a differential rate (price) for obtaining diverse qualities of goods and services in the real economy, in day to day life...some examples are...

·         If I pay a higher fare I can fly business class with more facilities relative to economy class.

·         If I pay more I can drive a sedan car instead of a hatchback or an entry level vehicle. Even among the same segment there will be a price difference for vehicles with more features, engine power, frills and gadgets.

·         If I am willing to pay a higher rate-I can see a movie in a prime-time show instead of a matinee show on Monday morning.

·         I can travel Rajdhani Express 1^st class-if I am willing to shell out more money-than any other train.

·         I can buy a high-end laptop or mobile phone-with more features for a higher price than other lower-end phones and laptops with lesser applications.

·         I can go for a swanky apartment at an enviable address by paying a couple of crore relative to other locations.

·         I can take a holiday to Europe by paying more relative to a cheaper holiday in South East Asia.

·         I can buy a Rolex or an Omega by shelling out more money than watches that are cheaper

·         I can stay put in a 5-star deluxe hotel by paying a much higher tariff than the ones in the lower segments

·         I can avail of top-class healthcare facility by paying more to state-of-art super-speciality hospitals as compared to government run facilities.

·         I can buy branded shirts, shoes and everything else by paying more relative to lesser known brands.

·         I can buy higher quality soaps and toiletries for a higher price relative to ones with lesser features

Inference: In almost every aspect of life there is a price differential for a higher quality, more features, more punch (perceived or genuine) and...this implies that you usually or typically get what you pay for!

 Does this happen in active management?

·         Let us hypothesize that all portfolio managers in a given sample beat the market (a rare feat)-and let us also assume that they all charged a uniform rate of 2% (expense ratio) as their fees. Further assume that all other costs like exit loads etc (if any) are common to all schemes in the sample.

·         Although all managers in the sample outperformed the market (index)-there is yet a very wide range of outcomes (at random) i.e. a wide variation in returns.

·         It implies that unlike the examples we saw above-some investors don’t get what they pay for while other get what they don’t pay for.

·         The cost is uniform in our sample-however some managers beat the (market) index by a wide margin-whereas some by a much lesser margin...

·         ...This is almost like saying that all car-buyers (in a given sample) paid a uniform price-but some at random got a Mercedes while others at random ended up with Nanos’-in this example let the index be a ‘two-wheeler’-hence everyone ‘out performed’ by getting cars-but the outcome was a very wide range for the same price.

·         One more analogy-all airline passengers paid exactly same fare-but a few (at random) serendipitously ended up in business-class and at the same time others were squeezed into economy.

·         Investors pay managers to get the best returns-(although best in active management also entails higher risk)-none the less the mandate is ‘usually’ to earn high returns (i.e. in the given sample)-but in reality this does not happen even if all managers hypothetically beat the market...

·         ...For the same price (expense ratio, loads & other costs, if any)-some investors at random will end up in 5-star hotels while others will end up in much lower segments.

·         Hence, in active management-YOU DON’T (ALWAYS) GET WHAT YOU PAY FOR AND YOU MAY ALSO GET WHAT YOU DON’T PAY FOR. This is the randomness of outcomes-the hall mark of an efficient market.

·         The above is true for all forms of active management i.e. stock picking, manager picking, timing, advisory-the rates are more or less similar-but the outcomes exhibit a very wide range and variation.

·         In the zero-sum game of outperformance, even though costs and expenses are similar-one may end up with a good or a bad out come-at random. Both outcomes are transient and it is almost impossible to differentiate luck from skill.

·         On the other hand in passive indexing-one is normally getting what one pays for-the average market return in a properly-run index fund / ETF.

Introduction to my Blog !

I have decided to start my blog-it will contain my thoughts on passive investing / indexing. I firmly believe that passive investing is a potent method of capturing the returns from a market or an asset class.

I have named my blog http://weraverage.blogspot.com/

‘We r average’ represents the ‘average’ returns from an asset class, its sub-segments or the market...!

Unlike many other human endeavours, in financial markets ‘average’ represents a compelling argument in favour of indexing-i.e. relative to the transience and randomness associated with active investing.