Inlation adjusted Dow 1906 to 1985

[moda0306]

stone,

I really think that all the details about indexing, taxes, which bond fund this which stock fund that aside, the main thing you/we need to illustrate & communicate is Modern Portfolio Theory's observation that you mention.  I consider this to be one of the pillars of understanding the PP and investing in general.  Without it, you'll always be tempted to chase yield.

You can actually BEAT the returns of two individual assets by mixing and rebalancing.  All that while reducing your volatility.

My favorite is stocks and gold, 50/50, since the 1972.  Both have returned about 10% if I'm not mistaken, while the combination of the two significantly reduces your volatility and returns you 11%.

In the end, it's the buy low & sell high nature that forces this effect, but it can appear like magic to someone fresh to investing.

Is this always going to lead to the same win/win results?  No, but it'll significantly reduce the negative effects of investing in what one assumes to be the inferior asset.  This is also a function of diminishing returns.  As you move your allocation more and more to one single asset, the benefits of having that asset go down.  This is why I hate the assumtion of 100% stock investing, even if they are right about their predictions that we're coming out of a recession and will see solid stock performance in the future.  Even then, a 10% each mix of bonds & gold will likely help even out their returns at minimal cost in long-term return if they have a rebalance plan.  Along the way they'll be using those assets to help buy stocks when they're cheap and sell when they're expensive.

[stone]

moda, I totally agree with you. What puzzles me is how/why people dismiss it. I'm also puzzled at how people seem so wary of the idea that the same kind of effect could occur between poorly correlated individual stocks (so rendering stock index funds as suckers).

[Gumby]

Gumby,

I guess since possible outcomes and diversification are obviously linked, I'm simply taking it to the next level.  Maybe I should be saying that they should be acknowledging a broader set of possibilities, and that's where their intelligence is faltering.   Since that's the source concern behind diversification, you're really getting to the core of the issue.

My point was more that we shouldn't be giving them too much credit just because they index.  It's smart in the same way tax-efficient investing is smart, or estate planning is smart, or shopping for good interest rates on a mortgage is smart.  If you have failed to understand the huge weaknesses of your indexed portfolio due to the potential for negative economic events, then the fact that you've indexed is almost completely irrelevant.

For instance, a 100% index stock investor was hardly in a good spot vs a managed fund investor (most likely) in 1929 or 2008.  Indexing is important, but far-less so than fully understanding the diverse economic circumstance we may encounter.  Better, Gumby?

Yes, exactly. And I do not think they are willing to consider diverse economic circumstances. That has become clear to me. Their excuse seems to be that the discussion would involve central banks, and central banks are a political topic that cannot be discussed on their forum. So, not only are they unwilling to consider diverse economic circumstances, but their forum rules prevent them from actually discussing it!

[moda0306]

stone,

I really think the indexing comes down to cost, not potential return being better because there are more companies.  You loose the benefits of MPT buying high & selling low when you do it in smaller and smaller doses.  Therefore, gold & stocks show GREAT improvements over the two assets individually, both in terms of performance and volatility.  Throw in LTT's, return bumbs down a bit, but volatility is significantly decreased, yet again.  Throw cash in and you smooth it out a bit more.

Any of this action within stocks doesn't really have much affect as far as I can see.  Within an index fund, does the natural buying/selling really up the buy-low-sell-high machine that is visible within the PP itself?  At least to any degree that boosts returns?

The idea with the PP is that these movements happen for fundamental macroeconomic reasons, so you can rely on the relationship to reverse as economic conditions change.  This is something you can't count on within a stock fund.  If the prices of two stocks change in relation to each other, I don't see this reversion happening with anywhere close to the reliability, or effect, anymore.

stone, are you saying you disagree with index investing?  What else do you suggest?

[moda0306]

Yes, exactly. And I do not think they are willing to consider diverse economic circumstances. That has become clear to me. Their excuse seems to be that the discussion would involve central banks, and central banks are a political topic that cannot be discussed on their forum. So, not only are they unwilling to consider diverse economic circumstances, but their forum rules prevent them from actually discussing it!

FACEPALM!  This is where I intensely value the political discussion here.  Yeah, sometimes we get a little out of hand, but it is literally inseperable from investing, IMO.  I really feel like if you don't understand our currency, neither gold nor LTT's will be sufficiently understood.  If you don't understand fiscal & monetary policy, then how do you understand our currency?

This is another one of those "pillars" to understand the PP and proper investing: Macroeconomic & Currency considerations.

[moda0306]

PS,

What do these guys say when you bring up Japan's decades of stagnant stock market, not to mention the demographic similarities between them and the US.

[Indices]

PS,

What do these guys say when you bring up Japan's decades of stagnant stock market, not to mention the demographic similarities between them and the US.

I've mentioned this a dozen times over there and the response is that diversifying internationally will solve any issues. For some reason bonds are not seen as a solution to a stagnant stock market. Everything is stocks, stocks, stocks!

[moda0306]

Indices,

Assuming that's a legitimate solution in a normal world, what about one where the next-largest western economic zone after the US is being strangled by their own currency?

We're talking 30 Trillion of GDP (US & Eurozone) when Japan & China combined come to about 11 Trillion.  If the US is seeing a Japan-type deflation (as Japan continues to see it), and the Euro collapses, this is insanely bullish for long-term treasuries (much of which has already happened), and no stocks are going to reliably make up for it.  This is easy to see, macroeconomically, IMO.  Not to say "Invest in the PP!" or "Ignore stocks!" or "Go all in TLT!", but it's obvious that given what appeared to be obvious macroeconomic possibilities that LTT's had a place in someones portfolio in 2010 & 2011.  To ignore this was pretty fatal for their portfolios.

[Indices]

Indices,

Assuming that's a legitimate solution in a normal world, what about one where the next-largest western economic zone after the US is being strangled by their own currency?

We're talking 30 Trillion of GDP (US & Eurozone) when Japan & China combined come to about 11 Trillion.  If the US is seeing a Japan-type inflation (as Japan continues to see it), and the Euro collapses, this is insanely bullish for long-term treasuries (much of which has already happened), and no stocks are going to reliably make up for it.  This is easy to see, macroeconomically, IMO.  Not to say "Invest in the PP!" or "Ignore stocks!" or "Go all in TLT!", but it's obvious that given what appeared to be obvious macroeconomic possibilities that LTT's had a place in someones portfolio in 2010 & 2011.  To ignore this was pretty fatal for their portfolios.

It's all part of the myth of stocks. Read any book on investing, save for those by Harry Browne, and you'll see page after page about stocks, and little to nothing about bonds. Even John Bogle is guilty of this. His last book, Don't Count on It, barely had any discussion about bonds. Stocks are seen as patriotic buys showing confidence in the endless growth potential of a country. Emerging market stocks are seen as a sure bet of the guaranteed future prosperity of poor countries around the world. There's no understanding of long term declines or the possibility that countries don't last forever. Stocks are magical, mystical wealth creators that can bite you, but in the long run will love you. It's totally insane and completely based on a very short period of data.

[stone]

moda there is something about the extent to which stocks in the Dow correlate:-
http://www.greenfaucet.com/?q=node/17998
"MRK has a correlation of 0.197 to the Dow Jones, which means there is almost no correlation at all. The stocks that returned the lowest correlations include MRK, TRV, PFE, HD, and JNJ.
Those with the highest correlations included UTX, DD, CAT, XOM, and GE."

I suspect that decent active managers buy "bargin" stocks and sell them when they are no longer bargins. The rydex? equal weight Russel 1000 ETF simply rebalances every quarter. Personally I hold equall amounts of three, very  different, actively managed stock Investment trusts closed end funds (CTY, TEMIT, BRSC). I wonder whether with a larger portfolio it might be worth directly holding ten diverse decent individual stocks at 2.5% each and rebalancing. After five years, redecide which ten stocks to hold
If you look at the stocks held within Berkshire Hathaway, almost all of the holding is of just their top ten stocks. Didn't Buffet have the phrase diworsification?

[moda0306]

stone,

If there was something that appeared to be a reliable stock-picking venture I'd probalby be willing to toss some money at it, but rarely do the managed funds appear to be worth the extra cost.

[stone]

moda, index funds have hidden costs from front running and various "index arbitrage strategies" used by hedge funds and investment banks.

Remember the SP500 companies have been making big profits and returning them to shareholders via stock buybacks over the past dozen years despite the zero total returns of an index fund buy and hold investor. Some of that has manifested as synchronous volatility across stocks as an asset class (and so potentially was harvested by the PP) but I'm certain much of it was in the form of asynchronous volatility between individual stocks neither of which were in any sort of long term or terminal decline.

[moda0306]

Count me as confused.

[stone]

moda, do you mean I'm wittering nonsense? From what I can see companies constantly issue fresh stock (via employee stock options etc etc) and buy it back using the earnings of the company. That doesn't act to permanently alter the market capitalisation of the company but it does temporarily disrupt the value. It acts to make the stock price jerk up and down. Harvesting that cycling stock price by buying low and selling high is the only way you can ever access any of the earnings of the company.

Am I hopelessly muddled about this?

[moda0306]

I guess I get it... I just don't really know about how companies use these strategies and how indexers miss out.

Is there a fund that takes advantage of this?  For some reason I feel like trying to take advantage of these moves were obvious, the market would eliminate the benefits of it pretty quickly.

[stone]

moda the equal weight etfs are one way:-

http://www.rydex-sgi.com/products/etfs/ ... ight.shtml

"Disciplined Rebalancing – As portfolios are regularly rebalanced back to equal weight, they take profits on outperforming components of the index—such as specific companies or sectors. Those proceeds are reinvested in out-of-favor components, resulting in equal and unbiased exposure to the index constituents, which may help balance market risk factors and provide enhanced risk control."

Some investment trusts have a very long history of outperforming the index. Passive investing enthusiasts have trouble explaining that. Berkshire Hathaway is itself to some extent an actively managed closed end fund.

I think it is essential to take on board that the efficient market hypothesis is utter BS. The PP itself is proof of that. In principle your allocation to gold, LTT and stocks could just follow the market capitalisation of each. As more gold was mined, you would buy more. If more LTT were issued by the government, you would buy more. As a believer of the efficient market hypothesis you would never rebalance out of stocks and into LTT in response to the 35% and 15% PP bands. Instead you would believe that you should float along as the market took you, passively letting each asset class bubble and crash without rebalancing. That could reduce the costs of holding the PP assets.

[moda0306]

Interesting.... I'll have to digest this.

[Indices]

Equal weighting is interesting, but it will probably underperform an index fund of a comparable index over time. Why? It favors small cap and it has slightly higher expense ratios.

[moda0306]

Favoring small caps would probably good, long-term, wouldn't it?  Aren't they historically better performers since there's more risk involved with growing companies than established ones?

[Lone Wolf]

Some investment trusts have a very long history of outperforming the index. Passive investing enthusiasts have trouble explaining that.

Isn't it a statistical certainty that there will always be active investors that beat the market when one looks backward over time?  The question that matters, then, is whether this reliably predicts who will be successful going forward.  The Boglehead position is "no", or at least "not by enough to justify their expense ratios" and I agree.

Harry Browne's analogy was the room of 128 people that all flip a coin.  Anyone that gets "tails" will leave the room.  By the end, you'd expect to have someone left over who flipped heads 7 times in a row.  But if you get this amazing "heads-flipping" individual to try again, he or she is no more likely than you or I to flip heads.

Berkshire Hathaway is itself to some extent an actively managed closed end fund.

Berkshire Hathaway has been reliably underperforming the index for a while now.

[Indices]

Favoring small caps would probably good, long-term, wouldn't it?  Aren't they historically better performers since there's more risk involved with growing companies than established ones?

Remember: past performance does not necessarily guarantee future returns. This is why you use a PP portfolio and not a stock heavy one.

[stone]

I'm really intrigued why and how you guys seem quite so rock solid wedded to the belief that rebalancing between stocks can never in itself provide a benefit. If you were simply shown charts of say Merck and Microsoft prices and not told that they were stocks but simply told that they were "securities" and you were asked whether it seemed sensible to rebalance between them; then I think you would think it was a no brainer. Once you were told that they were stocks, then the shutters would come down and the index fund mantra would prevail.

[stone]

Lone Wolf, do you think the Ben Graham and David Dodd stuff is just nonsense and Buffett was simply a flukey coin flipper?

[Lone Wolf]

Lone Wolf, do you think the Ben Graham and David Dodd stuff is just nonsense and Buffett was simply a flukey coin flipper?

I'd simply argue that nobody's especially likely to find and attach themselves to the next Warren Buffett.  As evidenced by the fact that Warren Buffett underperformed the market for the last decade, it's clear that whatever magic he may have bottled in the past, it hasn't been working especially well lately.

If even Buffett gets shellacked by index investing in a decade-long run, how likely am I to pick someone who can outperform the market by enough to justify their expense ratios?  What criteria could I use to pick such a person?  That they have to be "better" than Buffett?  How would I find this individual?  I genuinely wouldn't know where to start.

Any money you save by keeping expenses low and investing as tax-efficiently as possible is guaranteed money in your pocket.  I prefer to go for the sure thing.

[stone]

Lone Wolf, I've just looked up the BRK versus the SP500 charts and I'm struggling to see the lagging behind the index that you're talking about. It seems to do better over 1year, 5years and 10 years