Index Funds vs Individual Funds

[Thremp]

DC,

I have not read it personally, but the academic research I have read disagrees. Not to mention a good bit of the risk comes from increased exposure to business risk. If you have a major innovation or etc that crushes one of your 2 50% companies... You're effed. When you're young and with discretionary income and taking a shot, I don't mind this idea at all. Another bigger downside is the years spent recouping where you were originally from the misstep.

I ideally would like to keep my retirement money apart from my discretionary stock-picking money as I get older and develop this ability.

Also I think conversely as you become very wealthy then it becomes silly to keep your retirement apart from stock picking monies if you are clearly +EV. Since the difference in lifestyle from 19-20 mil isn't as pronounced. Also I'd imagine your talent level become vastly different unless you lucksack your way into the monies.

[DesertCat]

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DC,

I have not read it personally, but the academic research I have read disagrees. Not to mention a good bit of the risk comes from increased exposure to business risk. If you have a major innovation or etc that crushes one of your 2 50% companies... You're effed. When you're young and with discretionary income and taking a shot, I don't mind this idea at all. Another bigger downside is the years spent recouping where you were originally from the misstep.


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This is true. But in my case I was very certain about those two companies. The Mark Twain quote is "put all your eggs in one basket and watch that basket!". Academics have trouble explaining how Buffett can beat the market at all, let alone by such a large margin and with low variance over a long period with such focused portfolio.

Both of my picks I felt offered very high returns, as well as they had a "margin of safety" provided by their assets and earning power. On one I paid about 3x earnings for example. So I felt my worse case scenario was losing about 20% of my portfolio which I could recover from, and that would happen very infrequently. And I monitored these companies extremely closely.

Once again, that level of risk is foolhardy unless you have some real evidence that you understand how to value a company and assess it's business risks. I'm not arguing the average joe should focus their portfolio, in fact I'll repeat that almost everyone should just buy an index fund.

[Thremp]

DesertCat,

I'll go with that. I almost expected the answer, but wanted to make certain. Like someone with a couple utility companies for their whole portfolio isn't going to flip out unless cold fusion is invented. But I think a lot of people will be more speculative with a smaller number of stocks.

And on the Buffett comment. Thats why he has the monies and the rest of us don't. It's also interesting since teachers ridicule technical analysts and other people, while they grind out 80-130k a year.

Do you think most people can learn to pick stocks well? Are 90+% of the people picking stocks either extensively trained by a professional or were a professional themselves? Do you think people can pick this up just reading?

[DesertCat]

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Do you think most people can learn to pick stocks well?

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No. Not even most 2+2ers. The basics of how to value a company are pretty easy, but the uniqueness of each individual business are what makes it hard. But on top of that you have psychology. A value investor struggles to separate the noise of the market from what they factually know about the value of a stock. It's not easy, it requires a strong constitution and utter conviction in your approach.

For example during the crash of 87, Buffett went on a buying spree. Right now that might not seem like a brave act, but many people thought it was the end of the world, that a new great depression was starting and that the market would tank for years.

Robert Cialdini wrote a very good book called "influence" that describes how we all make sub optimal decisions due to psychological factors, and everything he wrote is applicable to the investor. There are many bad behaviors that reduce your effectiveness as an investor. One classic is holding on to a stock that you know know was a mistake to buy, hoping it will go back up so you can sell it a small profit to validate your own ego.

So essentially, you have to be above average in smarts, have the right training, but you absolutely need the right disposition.

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Are 90+% of the people picking stocks either extensively trained by a professional or were a professional themselves? Do you think people can pick this up just reading?

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I'm a self employed "professional" so I can't comment extensively on real professionals. I picked it all up reading Graham, Buffett, Joel Greenblatt, Philip Fisher, & Peter Lynch.

[jively]

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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?!!?

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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

[jively]

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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

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I just read the whole thread and didn't want to let this go by. I totally disagree that anyone can learn to beat the index just by putting time in. I think even Desertcat agrees. In addition to just doing incorrect analysis, the fear and greed factors are just huge.

In fact, even passive and asset allocation investors can underperform due to fear and greed. Here is a good article from William Bernstein from the winter of 2003 on what it takes to have a very successful investing experience using passive asset allocation.

-Tom

[maxtower]

What is the SD on Southern (SO)?

[Thremp]

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What is the SD on Southern (SO)?

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http://finance.google.com/finance?q=SO

[dazraf69]

Why would successful investors like Peter Lynch and Warren Buffet suggest individual investors can outperform the market over an extended period of time?

[Thremp]

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Why would successful investors like Peter Lynch and Warren Buffet suggest individual investors can outperform the market over an extended period of time?

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Probably the same reason that DS and MM write books saying you can beat poker too.