Index Funds vs Individual Funds

[meditate89]

How many stocks do you need? 90% of my portfolio is in 5 of them.
I don't believe that you need to check on your stocks every day or even every week if you just want a better return than index funds. I check my watch list every other day to see if anything good is on sale, but I certainly don't spend a lot of time running numbers every day, or trying to predict what may or may not happen in the next month or the next year. Once you discover and acquire your target business, it'll keep running itself whether you pay attention to it or not!

I honestly think it can be done in 10-20 hours a month... but only determination and due diligence will help you here- I'm not suggesting you go read the paper, see the picture of the pretty Iphone, and go buy AAPL for $97. That doesn't really count as research.

[bav]

Taking some of these theories to the extreme, everyone should invest in one company. Who needs diversity when all it does is reduce risk while also reducing performance? With that perspective, you should thoroughly research things and drop 100% of what you have into the single investment you think has the greatest probability of returning the most. Doing anything else decreases your expected return, after all, since you believe every other investment has a lower expected return.

But I'm not a gambler...I don't play black chip craps or blackjack and I don't dump $thousands into slot machines. I don't believe 5 stocks is nearly enough diversity.

If diversity is not what turns your crank, fine. If you're 22yo and you've got found money burning a hole in your pocket, gamble away. But that's not advice that fits very many investors; I'm investing a lifetime of earned income that I've worked my fanny off to get for almost 30 years and I don't like the idea of a single Enron or MCI event wiping out 30% of my networth.

[Thremp]

Meditate,

I think you aren't beating index funds on a risk adjusted basis and are exposing yourself to a large amount of non-systematic risk purely from a lack of knowledge.


gull,

I don't see why either. If you feel you need ~3 hours per week to pick one winning stock, and are only able to spend 10 hours a week... What would be wrong with straddling the fence? And shouldn't we differentiate retirement funds from discretionary income (Of course, but rarely stated on this board)? Why not use your discretionary funds to pick stocks before delving into money that is earmarked?

[meditate89]

Bav, I realize I may be more against diversification than many people- I would rather focus on a few great ideas than spread my money over 10 or 20 stocks- but only 1 probably wouldn't make me very comfortable( unless it was BRK-A =p).
Also I am trying to keep some money liquid for merger/ arbitrage opportunities- if I wasn't doing this I might have a few more long positions.

I'm also young and have more time than you probably do to recuperate if I somehow lost money. However, I think the Sarbanes Oxley act will help to prevent future Enrons from occurring. I think it is also very important to scrutinize the actions of management and make sure the financial statements of a company makes good sense to you before you invest of course. It would be devastating if one of the companies I own went bankrupt... but it's hard for me to calculate the likelihood of this. One in a million? It's not that I believe it's impossible... but do you worry about getting hit by lightning whenever there's a storm? I think that because of my tendency to pick stocks with strong balance sheets, solid earnings, trustworthy and competent management, usually low debt to asset ratio, etc, that it wouldn't be fair to say... for example... there are 10,000 companies, 100 went bankrupt, therefore you have a 1% chance of each of your companies going bankrupt.

Also, I don't think it's fair to compare the stock market to blackjack or slot machines which are -EV games that you can never ever win in the long run. I think everyone can agree that with a larger amount of time to dedicate, anyone can beat an index fund- but I don't know anyone who can beat slow machines or blackjack ( assuming no card counting), no matter how much effort/ time they dedicate

I'd say it's more like this:

Would you rather get all in with AA vs AK for a $1200 pot,
or get in with KK vs AK for a $300 pot, 4 times in a row?

Your expectation is higher with AA vs AK, but your likelihood of having SOME money left at the end is MUCH greater showing down KK four times.

Assuming my bankroll could handle the swings, I would much rather buy the one AA 'stock' than the 4 KK 'stocks'

[meditate89]

thremp- you may or may not be right. I've only held stocks for about 2 years, and right now my record is rather good- hopefully it will remain this good for the next 8+ years so I have a track record worth bragging about.

Could you please explain what you mean by a risk adjusted basis? Stocks are clearly much more risky than index funds, but is there any way you could quantify this risk for me? Are stocks twice as risky as index funds? 1.5 times? 5/10 times?!!? I feel that many of your comments just aren't specific enough to really add much value to the discussion... i'm not trying to call you out or anything, but every post i see of yours seems to be like 2-3 lines long- how can you possibly explain and articulate an important point?

[maxtower]

Stocks aren't more risky than index funds. Stocks are in index funds. So it depends on how you are discussing risk. If you own a stock or an index fund, you have the same asset class risk. A lot of the time, especially large caps, the share price of a particular stock will move with the market.
The risk you are talking about is the risk of owning one or a few companies versus owning hundreds through an index. This is hard to quantify. I think you would obviously want to be in more than one position to eliminate the risk of bad information creating a nightmare scenario for you, but if you have about 10 positions across different industries and geographies, you could eliminate most of this risk.

Some people also talk about risk in terms of the daily fluctuations of the price of the asset when compared to another. (Look up Beta) You could probably pick 10 stocks that have less of this kind of risk than the entire S&P 500. It has a lot to do with the type of business. Utility stocks for example don't move around a lot. A lot of them have a virtual monopoly, and inelastic demand for their services. Owning 10 utilities would give you a pretty stable portfolio.

[Thremp]

Maxtower,

Yeah, RoR v variance is an issue as people use "risk" to describe both. You have nonsystematic risk with <20 stocks IIRC. Obviously these would also need to be diversified with reasonable respect to industry as just buying every uranium stock isn't going to cut it.

Beating the market isn't very hard in a given time frame. Beating it on a risk adjusted basis is much more difficult.

[jively]

[ QUOTE ]
Could you please explain what you mean by a risk adjusted basis? Stocks are clearly much more risky than index funds, but is there any way you could quantify this risk for me? Are stocks twice as risky as index funds? 1.5 times? 5/10 times?!!?

[/ QUOTE ]
Annual standard deviation is one way to gauge risk. DC said the SD for the market is about 18%. I agree. The S&P 500 from 1973-2005 had a SD of 17.7%.

How about AAPL? From 1997-2006, Apple stock had an annual SD of 101%. (1997 -37.1%, 1998 +211.9%, 1999 +151.1%, 2000 -71.1% etc.)

BRK stock 1997-2006 SD is 22%.

Utility stocks are safer? ED (Con Ed) SD is 21%, KSE (Keyspan) SD is 32.9%, DUK (Duke Energy) SD is 33.8%, T (AT&T) SD is 28.8%. (These are all from 1997-2006.)

In terms of risk-adjusted returns, here is an article on Sharpe Ratio.

Not going into all the details, if the index returns 10%, and your account returns 12%, you may or may not have outperformed on a risk-adjusted basis. If your standard deviation is twice as high as the index, you didn't. If yours was the same as the index, you did.

If you only have 2 years of data, you might look at monthly standard deviation instead so you have a few more data points.

-Tom

[Thremp]

Meditate,

Are you beating the market on a risk adjusted basis?

[meditate89]

[ QUOTE ]
Meditate,

Are you beating the market on a risk adjusted basis?

[/ QUOTE ]

I already asked if you could explain what exactly you mean by this, do you even read my posts?

I also ALREADY STATED that I don't really want to comment on whether or not I'm capable of beating the market or not based on two years of results.