7. What To Invest In?

In this blog post we will show why all the authors think it’s a loss-incurring idea to pick your own securities and why you should focus on an index instrument instead.

Let us first look at the market in general and then ask ourselves: what is the absolutely lowest gross return that we would be able to accept?

Expected return

The minimum return anyone should expect from a security class over time is the market average. By simply buying all securities in proportion to the their market cap you by definition will get the average return of all securities. From the superstars to the average to the dogs. Doing this you do not have to spend time making more than a single decision but simply get an index fund that mirrors a public broad market cap weighted index.

To improve upon this one would need to get get returns that overtakes the extra cost. For example if you would need to spend an extra 30 days investigating your purchases, you would need an extra months worth of salary in return in addition to the average returns that the market already yields. How does this suggestion hold up to a professional portfolio manager? I.e., one who spends every day of the week trying to deliver increased returns to its customer that are larger than his or her fees?

A Random Walk Down Wall Street

Malkiel presents fund data from 1970 to 2013. One can see fund managers as professional stock pickers whose job it is to select the very best securities. Where where about 10% of the 358 beat the index. Four (4!) beat the market by 2% or more. He repeateadly makes the point that it is highly unlikely to beat the market. It’s so rare that it’s like looking for a needle in a haystack. (Malkiel, p. 180)

No scientific evidence has yet been assembled to indicate that the investment performance of professionally managed portfolios as a group has been any better than that of a broad based-index, (Malkiel, p. 182).

Let’s recap that last statement. No scientific evidence exists that a group of portfolios with similar investment strategies, managed by people with the profession of picking the best, has beaten a broad based market index over time.

“A strategy far more likely to be optimal is to buy the haystack itself, that is, buy an index fund.” (Malkiel, p.182)

Bogle On Mutual Funds

His views are summarized below

Professional fund management does not promise you superior performance. Rather, it promises all investors hope that a particular management will outpace it’s peers. But only some investors will ultimately be rewarded. In sum, the collective performance record of professional managers strongly suggests that you might consider simply owning the market via an index fund, at least for a core segment of your equity portfolio. (Bogle, p.53)

The logic of adopting an equity investment strategy focused on at least in part on indexing seems almost overpowering. There is every reason to assume that in the future index funds will be equally successful in surpassing the long-term results of most professional advisers. (Bogle,177)

Bogles views area clear: an index fund will outpace most professional advisers. Can you then, invest better than the professional financial advisor? Only then should you veer outside of having a central core of

The Intelligent Investor

The Intelligent Investor looks back from December 31 2002 and investigates how many US stock funds outperformed Vanguard 500 index fund. (Graham, 249)

One year, 1186 out of 2423 (48.9%)
Three years, 1157 out of 1944 (59.5%)
Five years, 768 out of 1494 (51.4%)
Ten years, 227 out of 728 (31.2%)
Fifteen years, 125 out of 445 (28.1%)
Twenty years, 37 out of 248 (14.9%)

Notice that numbers are impacted by survivorship bias, i.e. the ones that have shut down or merged are not included in the percentages.

Financial scholars who have been studying mutual fund performance for the last half century are unanimous upon a few points
1) The average fund does not pick stocks well enough to overcome the costs of researching and trading them.
[…] (Graham, p.243)

The Intelligent Investor, Part Two

For full disclosure, we will mention that Graham believes there are two types of investors: defensive and enterprising. A defensive investor should invest in the index. An enterprising investor should try to identify securities which beat the return of the index. Only when you can numerically argue that your investments will yield returns above the index so that the cost of researching them is repaid should you become an enterprising investor. And even then should a core of your portfolio be invested in the index. (Graham, p. 367)

Investment policy, as it has been developed here, depends in the first place on a choice by the investor of either the defensive or enterprising role. The enterprising investor must have a considerable knowledge of security values — enough, in fact, to warrant viewing his security operations as equivalent to a business enterprise. There is no room in this philosophy for a middle ground, or a series of gradations, between the passive and aggressive status. Many, perhaps most, investors seek to place themselves in such an intermediate category; in our opinion that is a compromise that is more likely to produce disappointment than achievement.

As an investor, you cannot soundly become “half a businessman”, expecting thereby to achieve half the normal rate of business profits on your funds. It follows from this reasoning that the majority of security owners should elect the defensive classification. They do not have the time, or the determination, or the mental equipment to embark upon investing as a quasi business. They should therefore be satisfied with the excellent return now obtainable from a defensive portfolio (and with even less), and they should stoutly resist the recurrent temptation to increase this return by deviating into other paths. (Graham, 176)

A dilemma for enterprising investors and the cryptocurrency market is that there exists no proven method to value a crypto currency. This is a problem for the enterprising investor as any method they use as basis for their investments, until proven, only results in speculation. As such, it is hard to argue that anyone should engage themselves as an enterprising investor unless one can make methodical bets that statistically have shown to beat a broad market index.

A low cost index fund is the best tool ever created for low-maintenance stock investing and any effort to improve on it takes more work (and incurs more risk and higher costs) than a truly defensive investor can justify. (Graham, p.367)

Summing up

It is overwhelmingly clear that over time it is very hard to beat the market, and only if you have proof that you can beat the market should you consider becoming an enterprising investor and expect increased returns compared to a market index.

It is also overwhelmingly clear that the any investor can enjoy low risk with spectacular performance over time by hiring the market as your portfolio manager.

Next, let’s continue with discussing the advantages of an index fund and the reason why they outperform the average fund, in The Power Of An Index Fund