An example about the risks associated with individual stocks !

Allan Roth has written a wonderful book titled ‘How a Second Grader Beats Wall Street.’ Owning the market via indexing does the trick.

In the enclosed article dated June 16^th 2010, “BP Teaches Three Key Investment Lessons,” Allan Roth highlights the risks associated with owning individual stocks! 

He uses the example of British Petroleum (BP) one of the strongest companies on planet Earth...till the Gulf of Mexico disaster (in early 2010) that afflicted one of its offshore platforms causing major oil spill.

Some excerpts,

Let me first state the obvious by saying that owning any one stock is far more risky than owning the stock market as a whole.

BP started the year as one of the most valuable companies on the planet as measured by market capitalization.

Yet it was only one company.

Markets have stayed pretty flat so far this year, but a 50 percent decline in BP stock would equate to a 5 percent decline if your portfolio had ten stocks.

Picking individual stocks increases risk without increasing expected return.

Further says Allan Roth,

Don’t confuse the unlikely with the impossible. 

The collapse of such titans as Enron, Lehman Brothers, and General Motors, could never happen to BP, right? 

BP, after all, has billions of barrels of proven oil reserves which is money in the bank. 

My observations:

·        Investors & stock pickers tend to believe in the invincibility, immortality and invincibility of their favourite companies...something like ‘this (i.e. misfortune) cannot happen to me!’

·        Hence, Roth’s wise words don’t confuse the unlikely with the impossible. 

·        Stock prices in the future are moved by future events, news and information. News is inherently random and therefore unpredictable. What is publicly known (about a company) is more or less built into the market price...what is unknown is the knowledge that will move a stock (in the future) and this is impossible to forecast.

·        Academic studies tell us that essentially all stocks have the same expected return as the market...the problem with individual stocks is they have this greater range of outcome which the academics call Standard Deviation.

·        So, it makes little sense at all to buy an individual stock with this huge range of outcomes when you can have the same expected return at a narrower range of outcomes...via a broadly diversified index!

Link,

http://moneywatch.bnet.com/investing/blog/irrational-investor/bp-teaches-three-key-investment-lessons/1606/?tag=col1;blog-river

" New Index Returns Astound Wall Street "

Enclosed is link to a terrific write up by Dan Solin....it shatters the myths of ....

* 'expertise' in active investing like picking future winners looking at past performance,

* 5-star fund ratings (obviously done in hindsight) and

* some of the 'brightest minds doing sophisticated investment analysis'.

It is time to switch to the simplicity of passive index investing i.e. broad market cap weighted index funds that capture market rate of returns-whatever that maybe.

For me the 'market rate of return' over the long-term is a reflection of the benevolence that is offered by capitalism, enterprise and the free market system.

http://www.huffingtonpost.com/dan-solin/new-index-returns-astound_b_792002.html

" Giving your SIP Investments the value edge "....link to DNA Money article

http://www.dnaindia.com/money/report_giving-your-sip-investments-the-value-edge-vip_1514781

" The Arithmetic of the Financial System "

John Bogle is the founder and former CEO of Vanguard...he is perhaps the strongest proponent of indexing & he launched the first index mutual fund way back in 1976. His creation Vanguard is currently the world’s largest mutual fund company.

John Bogle’s book Enough begins with a wonderful epigram-a short witty poem depicting the reality of the modern financial system. It goes on to read something like this,

Some men wrest a living from nature and with their hands; this is called work.

Some men wrest a living from those who wrest a living from nature and with their hands; this is called trade.

Some men wrest a living from those who wrest a living from those who wrest a living from nature and with their hands; this is called finance.

The epigram is used by the author to describe the correlation between financial system and the economy of a country!

He then goes on to describe the ironclad equation under which the system works, what he terms as The Relentless Rules of Humble Arithmetic.

They are and I am quoting them from his book,

The gross return generated in the financial markets, minus the costs of the financial system, equals the net return actually delivered to investors.

Thus, as long as our financial system delivers to our investors in the aggregate whatever returns our stock and bond markets are generous enough to deliver, but only after the costs of financial intermediation are deducted (i.e., forever), the ability of our citizens to accumulate savings for retirement will continue to be seriously undermined by the enormous costs of the system itself.

The more the financial system takes, the less the investor makes.

The investor feeds at the bottom of what is today the tremendously costly food chain of investing.

John Bogle sums up the above reality in these words, On balance, the financial system subtracts value from our society.

The author laments that we live in a world where we are merely trading pieces of paper, swapping stocks and bonds back and forth with one another...!

The author correctly asserts that all such activities obviously increase the costs and has led to the creation of complex financial derivatives which add to the mayhem due to immeasurable risks.

If I were an investor (or an investment advisor) the following is what I would interpret from the wisdom contained in Enough,

·        The financial system is an additional layer to the real economy that produces goods and services which all of us consume. When I say this, I would exclude plain vanilla commercial banking which facilitates economic activities.

·        As investors, we primarily plough our savings into companies that comprise the real economy...i.e. either as stakeholders in ownership (equities) or as lenders of capital (debt)....and we do this in order to meet our financial goals and objectives. Period!

·        It implies, therefore, as an investor I should try and be closest to the returns generated by the system itself i.e. the market rate of return delivered to investors in the aggregate or as a group. The portfolio that mimics the market average return is obviously a broad market cap-weighted index (fund / ETF)

·        As elsewhere (and also in India) the ‘market rate of return’ includes the performance of various professionals such as MF managers, PMS Managers, Insurance managers, stock pickers, FIIs, hedge funds and so on and so forth.

·        To expand upon the ‘relentless rules of humble arithmetic’...some of these active investors (at random) will outperform the market average in some time periods-such that their (equally brilliant and motivated) counterparts will underperform (at random) by an equivalent amount. Both i.e. the alpha and anti-alpha are usually known in hindsight. The market is not a fairy tale mythical land where everyone can extract excess returns 'above the average' at the expense of other active investors (also trying to outperform.)

·        To conclude: As investors it makes logical sense to reap the benefits of capitalism and enterprise by buying ‘capitalism in the aggregate’ via the market (broad index) portfolio...rather than indulge in (active) guesswork about individual pieces (stocks, companies, sectors and managers)....the individual pieces will exhibit random outcomes-both desirable and undesirable! The individual pieces will have additional (concentrated) risks over and above the market risk.

" Rich and Poor Serve Their Wall Street Masters"

Enclosed is link to an excellent article by Dan Solin, an actual example of portfolio churn which destroyed value for an investor. The author does comparison with passive index portfolios that would have created much more wealth for the investor.

http://www.huffingtonpost.com/dan-solin/rich-and-poor-serve-their_b_812718.html

Criticism of 'Market Efficiency'...but does it allow you to make money hand over fist?

Art Carden is a professor of economics at Rhodes College and the following paragraph is from his write-up, Why Economics is Crucial for Ethics.

“If you are making money hand over fist exploiting inefficiencies in the market, then I will believe you and listen to your criticisms of efficient markets.  Until then, I've seen nothing to suggest that markets are systematically inefficient in a knowable, predictable way.”

Active investors generally believe that ‘pricing inefficiencies or anomalies’ can be predictably & consistently exploited in stock markets....especially in the so-called more ‘inefficient’ emerging markets (such as India).

I believe, that no market can be perfectly efficient i.e.at all times and for all people...this implies that even if inefficiencies exist in the market, they are randomly scattered such that no individual can ‘outperform’ the market averages (by profiting from those anomalies) except for random chance!

To my mind, the practical implication of Art Carden’s observation is:

In a market (e.g. Indian stock market) that has the presence of thousands and thousands of professional active investors (MFs, FIIs, PMS Managers, analysts, stock pickers, treasuries, insurance companies, advisors, family offices, and institutional investors etc)-it is rather difficult for me to believe that individual professionals can keep outperforming by consistently exploiting the mistakes of their equally brilliant and motivated counterparts.

In other words, for an individual (s) to consistently exploit inefficiencies, profit from them and thus beat the market...their counterparts (also highly motivated investors trying to generate alpha) have to consistently turn CHARITABLE and allow others to ‘consciously’ win.

However, even if we believe markets are not efficient, then, in Jack Bogle’s words, (from his interview dated 4^th January 2011, Money Magazine...Investor’s Guide-2011)

You don't need the efficient-market theory to justify indexing. Indexing wins whether markets are efficient or inefficient. In an inefficient market, a good manager may be able to win by five percentage points a year over a decade.

But by definition, a bad manager must lose by the same amount. It all has to average out. So even if the market is very inefficient, the index will still capture your share of the market return.

Link to the interview,

http://money.cnn.com/2010/12/31/pf/investing/jack_bogle.moneymag/index.htm

" Telling someone you can't beat the market, is like telling a 6-year old, Santa Claus doesn't exist."

Professor Burton Malkiel of Princeton University is the author of a very famous investment book, A Random Walk Down Wall Street. The first edition appeared in the early 1970s and it has been so popular that it is now into its 10^th edition.

Burton Malkiel is a strong proponent of low-cost indexing and in the enclosed article and interview on Yahoo Finance-he says that investments via passive indexing (including ETFs) are becoming very popular!

Markets may not be 100% efficient-but it doesn’t mean that one can (consistently) beat them or be above average.

Stock prices (into the future) move at random-because news / fresh information (which causes prices to move) hits the market at random. It essentially implies that there are no ‘past patterns’ that can predict the future.

What is not news is already discounted into the prices by the market. This happens because the market is comprised of thousands of competitive, motivated and profit seeking people who do analysis 24*7*365. In other words prices (in the market) already reflect what can be known!

Hence, all that investors need to do is invest into low cost index funds / ETFs for their long-term financial goals and objectives.

And yet active management is hugely popular, people keep trying to beat the market and pay others to do the same ...why? In the words of Burton Malkiel,

“Telling someone that you can’t beat the market, is like telling a six-year old that Santa Claus doesn’t exist,” according to Malkiel. Basically, people deny the facts that show most investors don't make huge profits. 

He explains that we all keep trying for two fundamental reasons: investing is fun and some people DO make money.

In the market peoples' beliefs are similar to the fable of Lake Woebegon-the fictional land-where all children are ‘above average!’ Unfortunately, in their attempt to chase the rainbow of 'beating the market' many fail to capture the market average return, which over the long term is decent enough to meet many of our financial goals.

According to me, the sage advice of Dr Burton Malkiel is applicable to investors everywhere!

Link to the Yahoo Finance article and interview,

http://finance.yahoo.com/tech-ticker/burton-malkiel-markets-aren’t-100-efficient-but-you-still-can’t-beat-‘em-yftt_535789.html

Dan Solin's "Best & Worst Investing Awards for 2010"...a good guide for Indian investors too!

Enclosed is a link to Dan Solin’s write-up titled Best and Worst Investing Awards for 2010...they are the writer’s hand out on best and worst awards for “best and worst predictions, investment advice, financial products..." and so on and so forth.

According to me the article is a useful guide for investors everywhere, some kind of a general check list about what one should do and the things to be avoided.

What caught my attention was Dan Solin’s hand out for The Best and Worst Financial Product...this is what he has written, at points 9 & 10 of his article,

9. Best Financial Product: Exchange Traded Funds which, when used correctly, can permit investors to invest intelligently, at low cost. Unfortunately, they are more often misused to pick sectors and trade frequently, which reduces returns.

10. Worst Financial Product: Another tough one. Hedge funds, variable annuities, equity-index annuities and private equity funds all qualify. However, the award goes to Principal Protected Notes. Their name got them the nod. The principal is not protected against issuer default. They have excessive fees and the upside is grossly overstated. Their complexity makes it very difficult for investors to understand how they are being ripped off and why much simpler alternatives would be superior investments. This combination of qualities typifies the conduct of many brokers and other "investment professionals", and earned this product the award, but it was very close.

Daniel 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

Link to the write-up,

http://www.huffingtonpost.com/dan-solin/the-first-annual-solin-aw_b_801249.html

" What we can learn from Paul the octopus? "

Dan Gardner is a prolific writer with profound insights! 

His latest book is Why Expert Predictions Fail-and Why We Believe Them Anyway.

Some words from the author’s website,

In 2008, as the price of oil surged above $140 a barrel, experts said it would soon hit $200; a few months later it plunged to $30. In 1967, they said the USSR would have one of the fastest-growing economies in the year 2000; in 2000, the USSR did not exist. In 1911, it was pronounced that there would be no more wars in Europe; we all know how that turned out. Face it; experts are about as accurate as dart-throwing monkeys.

Predictions & forecasts form a sizeable component of active investing i.e. relative to passive investing. Enclosed is link to a wonderful article titled What we can learn from Paul the octopus written by Dan Gardner.

The article points out that a few right calls or predictions or winning streak-whether it is a fund manager or an economist or Paul the octopus...doesn’t make any of them an oracle, an expert or a guru. One should consider the hand of luck and randomness!

The author points out to our unfortunate habit of paying attention to hits while ignoring misses.

I am reproducing these words from the article,

Consider Nouriel Roubini, the economist who shot to global gurudom after he correctly predicted the meltdown of 2008. Every time he is interviewed, every time he is introduced to an audience, Roubini's famous call is mentioned. What is never mentioned is that Roubini also called for a recession in the United States in 2004, 2005, 2006, and 2007. Or that after the crash of 2008 he said oil would stay below $40 a barrel throughout 2009 (it doubled in price). Or that he said stocks were going nowhere but down (they soared).

I'm not saying Roubini simply got lucky in 2008. He's a smart guy with lots of genuine insight. But he's no oracle.

Link to the article, the author gives some examples: successful fund managers, economists and of course Paul...no one is an oracle!

http://www.dangardner.ca/index.php/articles/item/32-what-we-can-learn-from-paul-the-octopus

" Active or Passive? "....an objective analysis by Vanguard.

Enclosed is a link to an objective analysis of ‘Active or Passive?’ done by John Ameriks on Vanguard Blog in September 2009!

Vanguard’s founder and former CEO John C. Bogle launched the first index mutual fund in 1976-which now happens to be one of the largest equity funds in the world.

According to me, the basic arguments posted on the blog are akin to the laws of gravity and hold good for all geographies and free financial markets.

Consider the following words; I have underlined the important sentences,

Zero-sum: You don’t need to believe in efficient markets, rational behaviour, economics, or the tooth fairy to establish that a portfolio that holds all the securities in a capitalization-weighted market index (i.e., an index weighted like the S&P 500 and other common indexes, but containing all the securities in the market) will, after costs, outperform the average dollar invested in the market if active management costs more than cap-weighted indexing, which it generally does.

You do have to believe in basic arithmetic. (And the index must be cap-weighted, as this wouldn’t necessarily be true for other indexing methods.) But the result is purely mathematical from there, and is based only on the definition of the word “average”—not on fancy/complicated theories that require any additional assumptions.

Importantly, this basic math applies regardless of the market, or the so-called efficiency of the market.

Further....

...that in inefficient markets (think small-cap stocks or emerging markets), you tend to get much wider dispersion in manager results. There are lots of home runs, and lots of strikeouts (or worse).

But it’s still the case that, regardless of which investors beat the average and which fall below, the performance of the average dollar in an inefficient market is equal to the performance of a cap-weighted index of that inefficient market...

Some more wisdom....

...given the amount of noise in the data, we very often just can’t say whether any outperformance or underperformance is due to luck or skill.

Sure, there are some managers/investors who will frequently end up on the upside of wild swings, but there are also those who frequently end up on the downside. In such an environment, it’s generally harder to distinguish who is really adding value or subtracting it, given the additional background noise.

My Observations:

Considering the fact that modern Indian financial markets are highly competitive due to the presence of a large number of professional active investors (who are paid to generate alpha-a short list would include numerous MF managers, Insurance managers, PMS managers, FII and hedge fund managers, treasury managers, pension managers, family offices, analysts, stock-pickers, advisors, and many more)-the zero-sum equation mentioned above kicks in leading to randomness of outcomes.

On account of intense competition, out and under performers are a result of randomness and unpredictability. Out performances are usually transient and known in hindsight.

By default if some active investors / managers beat the market by a wide margin-their equally brilliant, motivated and competitive counterparts will be hit badly!  To quote the blog, you tend to get much wider dispersion in manager results.

Therefore the realistic return from any market or asset class is the ‘market average’ return as measured by broad market cap-weighted indices that map a sizeable component of market capitalization! To my mind, buying the market portfolio (cap-weighted index) is a more logical method of investing in a country's enterprise / businesses-which is what equities as an asset class are all about.

http://www.vanguardblog.com/2009.09.25/active-or-passive.html#more-245

A famous fund manager and stock picker turns to indexing !

Jeffery Vinik, a famous fund manager and stock picker, turns to indexing after stock picking gains....read on...

http://www.bloomberg.com/news/2010-12-17/jeff-vinik-s-hedge-fund-turns-to-index-funds-after-stock-picking-gains.html

" Index Funds are Fabulous "-Meir Statman

Meir Statman of Santa Clara University is a professor of behavioural finance. Behavioural studies in finance have become a rage over the past few years-behavioural finance, in brief, tells us that market participants are not always rational!

Professor Statman says that ‘index funds are fabulous’ in a recent interview with Morningstar, titled, Knowing Others’ Mistakes Won’t Make You Rich.

In the interview, he also gives a few examples of cognitive errors that people tend to make, some excerpts,

“...there is a range of cognitive errors that people commit, and it's important for people to know that. For example, mutual fund companies tend to advertise their most successful funds, the ones that have five stars from Morningstar.

Well, investors are left thinking that it's very easy to get a very successful fund. They never advertise their one star funds, and so you have to be aware that because mutual fund companies do that it tilts your view as to the likelihood of success. And so you should tilt it back, and say wait a minute, this cannot happen.

 Hindsight is another one that is very important to guard the gains. It is very easy for all of us to say that in 2007 we knew for sure that the market is going to be terrible in 2008.

If you actually had people write down in pen what they thought in 2007 at the time you would find that they said maybe it will go down, but then maybe it will not go down until 2009 and so on.

But now when we get to be in 2010 they remember only that they knew that the market is going to go down, and that really is hindsight that is speaking. So these are two of more cognitive errors that get in the way.”

Link to the interview,

http://www.morningstar.co.uk/uk/news/article.aspx?lang=en-GB&articleid=93968&categoryid=13

I believe, Indian markets are getting increasingly competitive with an ever increasing number of professional participants-a short list-would include active investors such as: MF managers, PMS managers, Insurance scheme managers, FII and hedge fund managers, treasury managers, other institutional investors, analysts, stock-pickers and so on and so forth.

With the presence of numerous brilliant, competitive and highly motivated participants-it is not easy, for individual professionals to find and exploit mistakes / pricing anomalies-i.e. consistently.

Asset allocation to passive indexes (ETFs / funds) is important as markets become more competitive & efficient thus resulting in a reduction of pricing mistakes and anomalies!

" A Dying Banker's Last Instructions "

Enclosed is a NY Times article dated 26^th November 2010, titled, A Dying Banker’s Last Instructions.

The article is about Gordon Murray-a former salesman at Goldman-who rose to become Managing Director at Lehman and CSFB. As he was diagnosed with brain cancer-he decided to pen a small book The Investment Answer.

The article mentions that Gordon Murray later in his career learnt about the failings of active portfolio management, which had taught him to erroneously believe It’s American to think that if you’re smart or work hard, then you can beat the markets.

Gordon Murray, later on in his career, is influenced by Dimensional-a passive mutual fund company, which teaches him, No one can predict the future with any regularity, so why would you think that active managers can beat their respective indexes over time?

http://www.nytimes.com/2010/11/27/your-money/27money.html

' The market ...it's crazy...but the fact it's crazy doesn't make you a psychiatrist '

Meir Statman of Santa Clara University is a Professor of Finance whose research focuses on behavioural studies.

Despite being a proponent of behavioural finance he believes that ordinary investors cannot get a better risk-adjusted return than they can in low-cost index funds!

Being a behavioural finance proponent he does not believe that markets are efficient-but that does not mean people should not Index, his brief explanation is as under,

Q: You pound the drum for index funds. Is that because you think the markets are efficient and therefore unbeatable over the long-term?

A: The market is not efficient. It's crazy, but the fact that it's crazy doesn't make you a psychiatrist. It's crazy like a wild animal. You wouldn't want to go against a wild lion because it's crazy. It's crazy in ways you cannot understand and cannot forecast.

People in behavioral finance and standard finance come to the same conclusion - don't try to beat the market. Whether it is rational, as people in standard finance say, or crazy, as I say, don't try it.

Practically speaking, individual investors should treat the market as unbeatable and realize that when they try to beat it because it is inefficient, they are likely to injure themselves, rather than gain at the expense of another.

Can professionals beat the market? His answer,

Q: Do you think pros can beat the market?

A: Yes, they can. But it's still a zero-sum game. If some people win, it means that some people lose relative to what they can get by being in an index fund.

My interpretation of the above for Indian investors / advisors,

·        Indian markets are competitive because they comprise of a large number of professional investors who are all attempting to generate alpha, a brief list includes: MF, PMS, insurance, treasury, FII and hedge fund managers, stock pickers, analysts both fundamental and technical and so on and so forth.

·        The constant analysis and activity of the above ensures that Mr Market knows more than individuals and hence it is difficult for individuals to beat it (outguess the market) consistently.

·        Therefore, ‘beating the market’ is a) more of a random outcome b) it is known in hindsight and c) past data is of little predictive value going forward.

·        I am tempted to repeat Meir Statman’s sage advice for Indian investors: People in behavioral finance and standard finance come to the same conclusion - don't try to beat the market. Whether it is rational, as people in standard finance say, or crazy, as I say, don't try it. Practically speaking, individual investors should treat the market as unbeatable...!

Link to the article,

http://www.sfgate.com/cgi-bin/article.cgi?f=/c/a/2010/11/16/BU991GCEF9.DTL&type=printable

' Buy and Hold is still a winner '....Burton Malkiel

Dr Burton Malkiel is the economics professor at Princeton and author of a best-seller A Random Walk Down Wall Street. If my memory serves me right it has run into nine editions till date and remains an all time investment classic.

In a recent WSJ article, titled ‘Buy and Hold is still a winner-’ Professor Malkiel reinforces the timeless wisdom of a buy and hold investment strategy using passive indexing i.e. even during the turbulent first decade of the 21^st century.

The lessons from his analysis, in principle, are applicable to Indian investors also: it is rather difficult to outguess and beat the markets consistently!

Some outstanding words (in italics) from the article,

Many obituaries have been written for the investment strategy of buy and hold. Of course, investors would be better off if they could avoid being in the stock market during periods when it declines. But no one—either professional or amateur—has ever been able to time the market consistently. And when they try, the evidence shows that both individual and institutional investors buy at market tops and sell at market bottoms.

I am reproducing a sample of ‘market timing’ from the article.

Market strategists called for a sharp market decline in late August 2010 as technical indicators were uniformly bearish. The market responded with its best September in decades.

The logic of passive indexing, in brief,

Low-cost passive (index-fund) investing remains an excellent strategy for at least the core of every portfolio. All the stocks in the market must be held by someone. Therefore, if one active portfolio manager is holding the better-performing stocks, then some other active manager must be holding those with below-average returns.

http://online.wsj.com/article/SB10001424052748703848204575608623469465624.html

Pearls of investment wisdom from 'The Little Book of Commonsense Investing'

John C Bogle’s The Little Book of Commonsense Investing is one of my favourites. John C Bogle as we know launched the first index mutual fund in 1976 and it went on to become one of the largest equity funds in the world.

Mr Bogle remains a dyed-in-the-wool indexer and has been a strong advocate of cap-weighted indexing, ever since his senior thesis as a student at Princeton University more than 60 years ago.

Some wisdom from the book-these are quotes from ‘investment giants’ other than Mr Bogle-who also support passive indexing.

I believe that in principle the following words (from the book) have a universal application and hence should be understood by investors and investment advisors everywhere!

‘For the markets in total, the amount of value added, or alpha, must sum to zero. One person’s positive alpha is someone else’s negative alpha. Collectively, for the institutional, mutual fund, and private banking assets, the aggregate alpha return will be zero or negative after transaction costs.’ --Gary P. Brinson, CFA, former president of UBS Investment Management in ‘The Future of Investment Management’, Financial Analyst’s Journal, July / August 2005, Vol.61 No.4

‘A low cost index fund is the most sensible equity investment for the great majority of investors. My mentor, Ben Graham, took this position many years ago, and everything I have seen since convinces me of its truth. In this book, Jack Bogle tells you why’. -- Warren Buffet.

‘By periodically investing in an index fund, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb…’--Warren Buffett

‘Market cap based indexing will never be driven from its deserved perch as core and deserved king of the investment world. It is what we should all own in theory and it has delivered low-cost equity returns to a great mass of investors…the now and forever king-of-the-hill’. --Clifford A. Asness-hedge fund manager, of AQR Capital Management in an unpublished paper called, ‘Capitalization vs. Fundamentally Weighted Indices’.

‘Toss a coin, heads and the manager will make $10,000 over a year, tails and he will lose $10,000. We run (the contest) for the first year (for 10,000 managers). At the end of the year, we expect 5000 managers to be up $10,000 each and 5000 to be down $10,000. Now we run the game a second year. Again, we can expect 2500 managers to be up two years in a row; another year 1250; a fourth one, 625; a fifth, 313 managers who made money for five years in a row. (And in 10 years, just 10 out of the original 10,000 managers). Out of pure luck…. A population entirely composed of bad managers will produce a small amount of great track records…. The number of managers with great track records in a given market depends far more on the number of people who started in the investment business (in place of going to dental school), rather than on their ability to produce profits’. --Nassim Nicholas Taleb, Fooled By Randomness, (NY, Texere, 2001)

‘Buying funds based purely on their past performance is one of the stupidest things an investor can do.’ --Jason Zweig, columnist Money magazine.

‘As a dyed in the wool indexer, of course, I believe the classic index fund must be at the core of that winning strategy. But even I would never have the temerity to say what Dr. Paul Samuelson of MIT said in a speech to the Boston Society of Security Analysts in the autumn of 2005: ‘The creation of the first index fund by John Bogle was the equivalent of the invention of the wheel and the alphabet’. Those two essentials of our existence that we take for granted every day have stood the test of time. So will the classic index fund.’ --John C Bogle

‘Well, Jack, we are wrong. You win. Settling for average is good enough, at least for a substantial portion of most investors’ stock and bond portfolios. In fact, more often than not, aiming for benchmark-matching returns through index funds assures unit holders of a better-than-average chance of outperforming the typical managed stock or bond portfolio. It’s the paradox of fund investing today: Gunning for average is your best shot at finishing above average. We’ve come around to agreeing with the sometimes prickly, always provocative, fund executive known to admirers and detractors alike as Saint Jack (Bogle): Indexing should form the core of most investors’ fund portfolios. So here’s to you, Jack. You have a right to call it, as you recently did in a booklet you wrote, The Triumph of Indexing.’ Tyler Mathisen ‘In Your Interest’ Money magazine August 1995.

" Investment Club " is an oxymoron !

Another terrific write-up by Dan Solin, titled “Investment Club” is an Oxymoron...his analysis conceptually, is also applicable to Indian investors because the fundamental logic of passive investing is valid for all geographies!

The success of active management is typically known in hindsight, is not predictable from past performance and is associated with randomness-as a result of market efficiency.

Dan Solin writes,

I was recently invited to debate active vs. passive management at an investment club. The club members, a group of wealthy retired men, refer to themselves as investment "gurus." They are absolutely convinced of the merits of active management (defined as the ability to pick stocks or mutual funds that will beat designated benchmarks).

Read the entire article, the link is as under,

http://www.huffingtonpost.com/dan-solin/investment-club-is-an-oxy_b_779933.html

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

" Why I Index?"-Commonsense observations !

Something that I had read on passive indexing a couple of years back...these happen to be " Why I Index? " kind of general observations from a fee-only financial advisor based in America.

According to me the following " Why I Index? " are typical issues that are applicable in principle to all geographies. They should be kept in mind by investors / advisors while deciding their strategic asset allocation.

I index because I grew tired of being disappointed by active funds that delivered wonderful returns right up until the day I invested.

I index because for years I only discovered funds that I should have owned, not that I should own.

I index because I enjoy my free time and have not seen any overall gain from the hours spent analyzing active funds.

I index because it occurred to me that those who argue the strongest for active funds tend to be the same people who benefit the most if I buy active funds.

I index because I trust indexes more than active managers. Indexes do not get bored, get overconfident, quit, die, or defect to other firms.

I index because indexes are transparent. I know what my money is invested in and why.

I index to eliminate risk without sacrificing return. The high probability that an active fund will not keep up with its benchmark adds uncompensated risk.

I index because as my assets grow I prefer simplicity to complexity.

I index because as I get older cost matters more to me.

I index because I now realize that all I need is the return of index funds to achieve my financial objectives. And that is what really matters.

Fund Manager turnover...wise advice from John Bogle !

John C Bogle is the founder and former CEO of Vanguard-he launched the first index mutual fund way back in 1976.  Till this day he remains one of the most vocal proponents of passive indexing.

I am reproducing an interesting extract from his interview that appeared in ‘Investment Advisor’ issue of May 2010.

This is what he said...although it is in the American context; a quintessential Indian investor who is investing in equities in order to benefit from the long-term India growth story should take note of Mr Bogle advice,

“...the index fund simply gives you the returns earned by American business and those returns are very similar to the growth of earnings in corporate America and are very similar, and this shouldn't surprise anybody, to the growth of our GDP, the growth of the American economy.

So in fact you're getting a share in American business or a share in America when you buy an index fund. You can hold it forever. You don't have to worry about the portfolio manager changing. This is a world where the portfolio manager changes every five years for mutual funds.

So if you're investing for a lifetime, and it's very important to get this idea out there, and you have four mutual funds, that means you have four managers in five years, eight managers in 10 years, 16 managers in 20 years and 32 managers in 40 years.

Anybody seriously put forth the proposition that you can beat the market when you have 40 managers in 50 years.”

Link to the entire interview,

http://www.advisorone.com/article/30-30-interviews-john-bogle