Index trackers

For most private investors, the best way to invest in shares is to buy index trackers.

Private investors who do not have the time or inclination to study several investment books and research shares in depth do not have the slightest chance of beating the market over the long term using their talent, intuition, etc for selecting individual shares or by investing on the basis of tips. They would be better off betting on the races or engaging in similar gambling pursuits where they would at least know the odds and get the results quickly.

Even most professional investors are unable to beat the market other than for a few years and that too by chance only, in the same manner as flipping a genuine coin can result in a series of heads or tails though each flip has an equal chance of being a head or a tail. Many years ago, professional investors could beat the market because they were buying and selling from private investors who still had shares that accounted for a significant proportion of the market capitalisation. Also market transparency was lax and insider trading was rampant. But as the holdings of the private investors decreased and professional investors holdings became most of the market capitalisation and market transparency and insider trading rules were implemented (albeit with a lot still to be desired), professional investors found it very difficult to beat the market because they became the market. It became a zero sum game for them because for every purchase and sale, the counter party was another professional investor and all such investors received share price moving information simultaneously from the company. The markets dominated by professional investors with equal access to information became much more efficient and it became very difficult to find mispriced shares. That is why, of the hundreds of actively managed collective investments, only a tiny proportion of professional investors can boast a record of outperforming the indices in the long run. And it is impossible to know who that tiny proportion are and invest in the collective investments managed by them because they can be identified only in hindsight.

Most index tracking investments are unit trusts and exchange traded funds. When buying index tracking unit trusts, check that the tracking error is insignificant and then select the one that has the lowest total expense ratio (TER). You will find this information easily at the respective web sites. When selecting an exchange traded fund check the spreads at different times in the day - they can be quite wide for some ETFs.

Even the few investors who can boast track records of beating the index in the long run and the academics who have made rigorous studies of the performance of fund managers, advise private investors to invest in index funds rather than try to beat the market by stock picking:

Warren Buffett

  1. Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific business nevertheless believes it is in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals.
  2. Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.
  3. Stocks are the things to own over time. Productivity will increase and stocks will increase with it. There are only a few things you can do wrong. One is to buy or sell at the wrong time. Paying high fees is the other way to get killed. The best way to avoid both of these is to buy a low-cost index fund, and buy it over time. Be greedy when others are fearful and fearful when others are greedy, but don't think that you can outsmart the market.
  4. Very few people should be active investors.

Burton Malkiel
  1. The message of the original edition was a very simple one: investors would be far better off buying and holding an index fund than attempting to buy and sell individual securities or actively managed mutual funds. Now over 35 years later (in 2007), I believe even more strongly in the original thesis. An investor with $10,000 at the start of 1969 who invested in Standard & Poor’s 500-Stock Index Fund would have a portfolio worth $422,000 by 2006, assuming that all dividends were reinvested. A second investor who instead purchased shares in the average actively managed fund would have seen his investment grow to $284,000.
  2. Even Benjamin Graham came to the conclusion that fundamental security analysis could no longer be counted on to produce superior investment returns. Shortly before he died in 1976, he was quoted in an interview in the Financial Analysts Journal as follows: I am no longer an advocate of elaborate techniques of security analysis in order to find superior values opportunities. This was a rewarding activity, say, 40 years ago, when Graham and Dodd was first published; but the situation has changed, . . . [Today] I doubt whether such extensive efforts will generate sufficiently superior selections to justify their cost. . . . I'm on the side of the ''efficient market'' school of thought. Peter Lynch, just after he retired from managing the Magellan Fund as well as the legendary Warren Buffet, admit that most investors would he better off in an index fund rather than investing in an actively managed equity mutual fund.

Benjamin Graham
  1. Since anyone - by just buying and holding a representative list - can equal the performance of the market averages, it would seem a comparatively simple matter to "beat the averages"; but as a matter of fact the proportion of smart people who try this and fail is surprisingly large. Even the majority of the investment funds, with all their experienced personnel, have not performed so well over the years as has the general market.
  2. Over a ten-year period the typical excess of stock earning power over bond interest may aggregate 50% of the price paid. This figure is sufficient to provide a very real margin of safety - which, under favourable conditions, will prevent or minimize a loss. If such a margin is present in each of a diversified list of twenty or more stocks, the probability of a favourable result under "fairly normal conditions" becomes very large. That is why the policy of investing in representative common stocks does not require high qualities of insight and foresight to work out successfully. If the purchases are made at the average level of the market over a span of years, the prices paid should carry with them an adequate margin of safety. The danger to investors lies in concentrating their purchases in the upper levels of the market, or in buying nonrepresentative common stocks that carry more than average risk of diminished earning power.

Robert H Jeffrey:
  1. To the extent that the market is mostly efficient, we can expect only modest improvements in portfolio returns from active asset management.

Bruce Sherman
  1. [A client] asks if we can recommend a large-cap manager for him. I said, I’m going to save you some money. Don’t buy a manager, buy the index.

Merton Miller
  1. I favour passive investing for most investors because markets are amazingly successful devices for incorporating information into stock prices.

William Sharpe
  1. Active management is something you do with your “mad money”.

Rex Sinquefield
  1. Peter Tanous describing Sinquefield’s approach: Thus, active investment is a waste of time. You are far better off they say, spending your time, energy, and money deciding what types of stocks you want to buy, and then buying those index funds that correspond to the types of stocks you have chosen.
  2. There have been loads of scientific studies looking for evidence that can tell successful managers based on prior records. These studies do not meet with success. There is just no reliable evidence that there is persistence in professional manager performance.

2 comments:

KVSSNRao said...

Investing in index funds needs to timed. There is no point of buying index when it is much beyond value investing valuation.

For instance, I calculated value of BSE sensex using Graham's rule of P/e equal to past growth rate or 20 applied to average EPS of the past. The value comes to around 7000. why buy index fund at 20,000?

http://nrao-sapm-handbook.blogspot.com/2007/12/reilly-brown-investment-analysis-and.html

mohan said...

See my blog on "Bubbles"