Investing in Total Markets

[elroy]

Ran across this paper by John Norstad. It is a great sumation of the investment strategy so many of us follow. A number of other papers which are more mathmatically oriented are alo available on his web site. If others have arlrady point this site out sorry for the repetition.

http://homepage.mac.com/j.norstad/finance/total.html

Elroy

 

[cute fuzzy bunny]

Interesting paper, I'll have to give it a full read tomorrow.

Ponderings...

The measurements were made when many, perhaps most, did not "do" index funds. The "market efficiency" of indexes depends to some degree on people who thrash trade or "actively manage" to try to make an extra buck or two. In other words, if everyone indexed, the markets might move slowly, with lower volatility, and be a bit more predictable and based more on earnings than psychology.

Question: now that the 'cats out of the bag', do more people index and will that dampen returns and/or volatility?

A lot of "ideas" that test well historically simply may not do well going forward because...well...everyone knows about them!

Are REIT, metals and emerging markets funds seeing some good returns over the last 5 years because people are doing portfolio diversification and buying at the market price or because they have solid fundamentals?

 

[kathyet]

Although the story is a nice read it is from 2004.

Kathyet

 

[elroy]

CFB,

Those are some questions I've seen addressed but not sure where. It may have been Bill J. Bernstein EF website. Either way I have heard the market described as a zero sum game after dividends. To me that means for someone to make a profit above dividends someone needs to take a loss. Depending on you point of view this may be a problem. To me the more savy index investors the better for our world / nation / community. Now back to my copy of Socialism and Comunism Weekly!!!

Elroy

 

[free4now]

Good article, it helped me understand the Efficient Market Hypothesis (EMH) better. Until reading the article I had the idea that the dotcom bubble disproved the EMH, but the article fleshes things out in a way that makes me think maybe there can be bubbles and EMH still be true:

Even the entire market can behave irrationally for a long period of time and still be consistent with the EMH, again as long as this irrational behavior is not predictable or exploitable. Thus crashes, panics, bubbles, and depressions are all consistent with a belief that markets are efficient.

and

The Efficient Market Hypothesis states that the market always incorporates the collective beliefs of all investors taken as a whole about the future prospects of the market, and that without private information, current prices for the market as a whole and all of its component securities, sectors, and styles are correct.

It's had to wrap your brain around the idea the market can value something much higher (or lower) than what you think is the intrinsic or fundamental worth and yet that price can still be "correct" because you can't ever really know that your calculation of the intrinsic of fundamental price is right.

 

[Texas Proud]

Hmmmm... the EMH says that the price of the market is correct because it is efficient and that everybody knows everything at the same time and the price reflects this...

OR, it is true because we say it is true

 

[wabmester]

EMH used to be interpreted to mean that rational investors would always be around to quickly exploit any inefficiencies, so any exploitable mispricings wouldn't last very long.

I believe that thinking has changed recently, and the above only holds true if irrational investors are perfectly balanced by rational investors.    In many cases, irrational investors will outnumber rational investors, and sustained mispricings occur.    That is my interpretation of bubbles: we run out of rational sellers to balance irrational buyers, so the prices reflect mass hysteria.

 

[free4now]

Right on wab.

Krispy Kreme donuts is one stock that convinced me that irrational investors had overpowered the rational investors.  It was trading with PE ratios up in dotcom fantasyland even when it was a relatively mature retail operation.  There was no possible way that the price could reflect the discounted future earnings.  It was simply a matter of people hopped up on sugary confections "buying what they know".

The million dollar question in these cases is whether we should assume that rational investors will eventually gain a foothold and take back the reigns from the irrational investors.  I think that's a safe bet, but knowing when is the hard part... could be in a year, decade, or century.  If you don't know when the irrational folks will be overpowered, you can't exploit the "mispricing" because the pricing is actually right for the current and known future ratio of irrational to rational investors.

And even if the rational investors do drive the irrational investors out of Krispy Kreme, the irrational investors may just move their money into whatever the new hot stock on the block is. 

It really becomes a demographic question of whether the ratio of rational to irrational investors is changing significantly over time.   One might think that with the new emphasis on index investing, we would be putting more "dumb" dollars into the market.  But because those dumb dollars are evenly weighted across all stocks, I don't think they necessarily cause pricing inefficiencies.

 

[wabmester]

The best argument I've heard against buying the Total Market or S&P 500 is that you're overweighting the overpriced stocks due to the nature of cap-weighted indices.

 

[cute fuzzy bunny]

Maybe I need to think that over a bit...seems to me you'd be overweighted larger companies since the cap weighting is by company size, not by stock price.

Could be that some of the largest companies have the softest stock price...which seems to be the case right now that a lot of large cap issues are being bandied about as 'bargains'...

Krispy Kreme...seems like all popular food/restaurant stocks do nutty things their first few years. My ex girlfriend made a killing buying Ben and Jerrys at the IPO and selling a while later when it was at a crazy price. They used to be one of my customers...it was a whole days drive up there and back but they were real nice folks and always gave me somewhere between 40 and 50 pints of ice cream in a big box full of dry ice. Even put it in the trunk for me.

Surprised the heck out of me the first time. On my way out they said "want some ice cream to take home" "sure" "back your car in here". When I got back to the office and opened the trunk I figured "must be a lot of dry ice in that box".

I was good and sick of "chunky monkey" six months later...

 

[wabmester]

seems to me you'd be overweighted larger companies since the cap weighting is by company size, not by stock price.

Market cap is just stock price * number of shares.

Let's break this down into a series of bite-sized arguments.

The slice and dicers say you should slice the market up into various capitalizations, then dice into various valuations, then pick the chunks with the best historical returns.

The EMH crowd says that the market is smart, so they'll take a cap-weighted index that represents how the market allocated capital.

The S+D camp will moan and groan that the cap-weighted index approach gives you too much large-cap and not enough small-cap.

The EMH camp will say that it doesn't make any sense to bet more on small caps, because those stocks have a small cap for a reason.   You should weight the large caps more, which is what the cap-weighted index does for you.

The S+D camp will sigh and tell you that the market ain't so smart.   Just look at the capitalizations it gave to dot-coms.    Cap-weighting gives you more of those overpriced companies and less of the value-priced companies.

This is where the EMH camp says "Oh, you're right."

 

[free4now]

Just look at the capitalizations it gave to dot-coms. Cap-weighting gives you more of those overpriced companies and less of the value-priced companies.

I suppose different folks define dotcom differently, but I generally considered dotcoms to be primarily small cap. i.e. "I know we are starting from nothing but online lettuce sales are a sure thing".

So capweighting would actually give less small cap dotcoms.

 

[wabmester]

I suppose different folks define dotcom differently, but I generally considered dotcoms to be primarily small cap.  i.e. "I know we are starting from nothing but online lettuce sales are a sure thing".

So capweighting would actually give less small cap dotcoms.

Well, today Google has a market cap of $115B and Ford Motor has a market cap of $15B. So, regardless of what you call dot-coms, a cap-weighted allocation will tell you to put 7X more of your money into Google than into Ford.

Who knows, that may be the right thing to do, but I just wanted to make it clear that that's what you're doing when you buy the Total Market in a cap-weighted index.

 

[cute fuzzy bunny]

But wasnt that .com bit just a flash in the pan? Since the 'nifty 50' I dont think the top of the s&p 500 has been riddled with overpriced, underearning companies.

And despite a few current lagging examples of stupidity, like google, are the top stocks really overpriced?

XOM obviously is up there but I'm not sure its overpriced at a PE of 10.5. Walmart, Microsoft, Citigroup, J&J...are those all really overpriced?

 

[Texas Proud]

Why you buy the total market is that as an average investor you can not pick 'good' stock from 'bad' stocks.... so, you just buy everything and get a lift when the whole market rises...

I can remember Boston Market being the big thing prior to Krispy Kreme... but, eveybody was thinking they were the next Starbucks... and Starbucks still amazes me that people will continue to pay so much for a cup of coffee!!

Yes, it does look like the large caps are underpriced.. and I do think Google is overpriced... but who knows about Ford... there is a good chance of bankruptcy..

Good information from all!!

 

[wabmester]

are the top stocks really overpriced?

No idea. Buying the Total Market may be a clever thing to do if large-caps are undervalued, but my point was that you only know two things for certain when buying the Total Market:

1) If a company is overvalued, you're getting more of their stock by cap-weighting.

2) If a company is undervalued, you're getting less of their stock by cap-weighting.

These statements are true regardless of whether the stocks in question are large caps or not.

 

[d]

1) If a company is overvalued, you're getting more of their stock by cap-weighting.
2) If a company is undervalued, you're getting less of their stock by cap-weighting.

i don't think believe this is correct.  it is true that you would be overpaying for #1 as you've defined it as being overvalued, and that you would be underpaying for #2 as you've defined it as being undervalued.  having taken into consideration the over and under payments, you end up with the appropriate number of shares. 

Whenever you buy in the market, you necessarily overpay for anything that the market has overvalued, and underpay for anything that the market has undervalued, whether you buy an indexed portfolio or not. Large caps are not necessarily overvalued and small caps are not necessarily undervalued.

 

[wabmester]

Whenever you buy in the market, you necessarily overpay for anything that the market has overvalued, and underpay for anything that the market has undervalued, whether you buy an indexed portfolio or not. Large caps are not necessarily overvalued and small caps are not necessarily undervalued.

I never said that large caps are overvalued.   I said that all overvalued stocks have a larger cap than they deserve -- by definition.   Which means you're getting a *relatively* bigger serving of them than they deserve when you buy a cap-weighted index.

Some people think that by buying the Total Market, they are riding the coat-tails of all the smart investors out there.   In reality, you're riding the coat-tails of both smart and dumb investors.   By definition, dumb investors pay more for stocks than they are worth.    So, cap-weighting gives you both more exposure to large caps (which EMH says is OK) and more exposure to dumb caps (which EMH doesn't want you to know).

 

[d]

Which means you're getting a *relatively* bigger serving of them

you're not getting a "bigger serving" share-wise, just overpaying ... "bigger serving" dollar-wise

 

[Texas Proud]

WAB,

I absolutely agree with your statement.... the problem is who is the smart investor and who is the dumb investor...

History has shown that MOST... and I would say a huge majority of people are dumb... and this includes all of the people who are experts and are running mutual funds..

It would be interesting to see if there is someone who consistently beats the market on a risk adjusted basis.. and I am not talking a specialty fund such as energy or gold who is doing it now.. but over a very long period..

Don't get me wrong.. I am only half indexed as I do think that a few Vanguard funds seem to be able to beat the market... but it is a rare thing.

 

[wabmester]

"bigger serving" dollar-wise

Yeah, unfortunately, when I buy my groceries they want dollars, not shares.  And dollars are how we allocate our investments.

So, what are the alternatives for a passive investor?

1) Equal-weighting instead of cap-weighting.   Historically, equal weighting has done better, but it flys in the face of EMH.

2) Slice and dice.

3) Tilt towards value and/or small.    That's basically what I do.   Buy the Total Market knowing that you're going to get a heavy allocation of both large-caps and dumb-caps, but try to counter by adding a side-dish of value and small.

 

[d]

equal weighting would have the benefit of underweighting overpriced and overweighting the underpriced ... but would not appropriately weight (otherwise appropriately priced) large vs small companies.

don't believe either slice 'n dice or small or value would solve the problem, as you necessarily overpay for (and hence relatively overweight) anything that the market has overvalued, and underpay  for (and hence relatively underweight) anything that the market has undervalued ... and there are plenty of overvalued "value" stocks out there!

since we buy at market prices, we're likely going to pay too much for something     

 

[Nords]

It would be interesting to see if there is someone who consistently beats the market on a risk adjusted basis..  and I am not talking a specialty fund such as energy or gold who is doing it now.. but over a very long period..

Bill Miller & the Danaher brothers are just getting to the statistical point where they can claim to be separating skill from dumb luck & dartboards. And they've chosen to compete against the S&P500, which may not be the right benchmark for their investments.

Otherwise I think the best record goes to Buffett. He's not very impressed with beating the S&P500, either, and stocks make up a much smaller portion of Berkshire Hathaway than they used to.

 

[lazyday]

1) Equal-weighting instead of cap-weighting.

BRLIX!

You left out #4: Become a Fundie.
RAFI is expensive today for the individual investor, but there's a pension? fund which might (or already has) put over a billion in it, most likely for much cheaper than the Powershares ETF.

In W. Berstein's latest website update, he says the historical outperformance after accounting for size,value,market loading isn't statistically significant, so the jury is still out on RAFI even if it were free to use it.

and there are plenty of overvalued "value" stocks out there!

I agree, and don't like the value indexes today. Maybe something like DODGX could be ok, but lately I'm liking the idea of stockpicking. Or stockpickstealing (stockpickerpicking?) where you pick a manager you agree with and use some of their stock picks, with the help of EDGAR or other websites.

 

[lazyday]

I said that all overvalued stocks have a larger cap than they deserve -- by definition. Which means you're getting a *relatively* bigger serving of them than they deserve when you buy a cap-weighted index.
....[snip]
So, cap-weighting gives you both more exposure to large caps (which EMH says is OK) and more exposure to dumb caps (which EMH doesn't want you to know).

I agree with the above, but don't have a practical solution that I'd reccomend to others, with today's investment choices.
In fact, if I were to construct myself a brand new portfolio today, with no tax or transaction cost penalties, I'd probably just use VTI and VGHCX for the U.S. portion.

Or, just maybe, instead of VTI, I'd look into combining BRLIX with a little of the VG S&P completion index. If the S&P500 suffers from front running, then wouldn't the completion index benefit from it?