Home > Uncategorized > Index Picking Is The New Stock Picking

Index Picking Is The New Stock Picking

September 27, 2011 Leave a comment Go to comments

It’s commonly said is that stock picking was easier a long time ago (50, 70, or 100 years ago) but the market is getting more efficient so it’s harder to beat an index by picking individual stocks now. This has led many investors to use index funds these days, and I’m among them. But in investing every success is self-defeating when it goes too far. This could lead to opportunities for investors who are informed and have the right emotional balance.

It seems that markets are moving more and more as a whole, especially in the last 10 years. This comes from a variety of effects. Individual investors will frequently sell their stock funds (which are either index funds or closet index funds) causing the whole market to go down since their funds cover most of the market. Or institutions that have a very broad asset exposure and get into trouble will sell one asset class to rescue another, causing a whole market to drop for reasons that have nothing to do with it. On the other side I’m not sure yet if a rising market would draw in more indexed capital or if people would try picking stocks for even bigger wins (see 1999).

In reality the fundamentals have not changed. A large part of the market is driven by emotion (even professional investment administrators at institutions that pick other professional managers to handle the money have to face the emotions of justifying their job every year). The actual amount of capital that’s driven by rational investors seems pretty small sometimes, although they do have a tendency to make money over time and have more to work with. What’s happened (starting around 40 years ago) is that instead of individual stocks bouncing around wildly on top of peoples’ shifting emotions, this effect is being transferred to markets as a whole.

This has interesting implications for thoughtful investors. If stock picking is dead, is “index picking” the new opportunity? This could include a variety of ways to adjust weightings between different indexes. I keep substantial positions in the indexes that interest me and adjust the allocations slightly when I think there’s an opportunity. Someone who’s more confident might only be invested in 4 of the 10 indexes they’re interested in depending on the current conditions.

Stock picking also may not be dead. With increased index following stocks may move together more often and with more active managers the opportunities may be smaller and shorter. But if a whole market is driven down or pushed up it’s likely that some of the individual companies in it don’t belong in the same boat. I’m not interested in stock picking at this point though because the best picks can be dragged down when the whole market is punished. Using indexes allows me to work at a higher level and have more options for diversification without having to do a lot more research.

What’s really required to “beat the average” is to have a better emotional balance than the average influencer (not the average investor since some investors answer to someone else). For example this might mean making decisions on a 10-year time-frame while everyone else is thinking about the next 3 months. If you can do this there are many ways to apply it.

The math is clear: the average person is not above average and never will be. When it comes to advice that anyone can follow, the average returns from the capital markets are generally fair and we’re lucky to have them available to us. If I have to “settle” for average returns that’s perfectly fine. But if I can put the cold metallic side of my heart to work and earn a slightly higher return I’m willing to experiment with that.

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  1. October 2, 2011 at 3:21 am

    Hey Value Indexer,

    A great article. I really enjoyed it.

    I think index investing will kick the living crap out of most actively managed funds, and dare I say it, the vast majority of fund managers out there that are putting other people’s money to work. When we take into account the management fees, the investor to whom the money manager is responsible for is already at a disadvantage before the gates are open.

    For most, an index investing strategy is primarily aimed to yield a return as close as possible as the markets.

    From a personal standpoint, at the core of my investment strategy lies one in which I place a large importance on dividend paying stocks and investments that generate income. Other than the market performance of these stocks, I believer there is tremendous value with a strategy that offers an income stream to the investor. I’m also optimistic in that my stocks will outperform the markets in the long-term.

    With that being said, I just started a new series on my blog, titled, “Becoming An Index Investor”. I have decided that I will be allocating a certain percentage of my portfolio in index funds or low-cost ETFs as part of my overall strategy to further diversify and expand upon the fixed income side of my portfolio. Feel free to check it out; it’s going to be a fun series.

    With the increasing number of ETFs in our markets, one thing I think that is important to be aware of is the potential negative effect these instruments can have on the markets. There are a number of ETFs that use derivatives or are swap-based, and others that are tailored to currency hedging; in fact, many do not even hold any stocks or bonds. In my view, these are signs that not all is well with the ETF world and the investor is to be cautious before putting their hard earned dollars in some of these investments.

    Nice post!
    TWC

    • October 2, 2011 at 5:16 am

      Thanks TWC! I saw your new index investing series and I’m looking forward to seeing more about how you get into it.

      Index investing is definitely not closely associated with ETFs any more. I’m not sure if they were actually created by the indexing side but the rest of the industry has “innovated” their way into ETFs in force. In the end I’ll take index funds in any form that lowers the cost. Just like some people think of “buying an rrsp” and don’t understand that it’s just a label you put on an ordinary account, everyone should know that an ETF is just a way for you to give your money to someone and they could do anything with it. That’s the kind of knowledge every investor can profit from. Might be a good topic for your investing basics series 🙂

  2. October 2, 2011 at 1:36 pm

    I think ETFs have evolved to the point where many new investors are puzzled with respect to how to incorporate them into an investment strategy, largely because there are so many available to choose from. There are many ETFs that remind me of mutual funds in that when you take into account their MERs, management fees, and TERs, you find out that a chunk of your hard earned dollars have been stripped away from you.

    Take Horizon’s leveraged ETFs, HSU & HSD S&P 500 Bull & Bear. Just because the underlying index is the S&P500, investing in such a product has additional risks embedded inside the investment.

    Like you, I like low-cost index ETFs. By the 3rd part of my series, I will have what I have coined the “Ride The Tide Portfolio”, which will consist exclusively of low cost index funds or ETFs. It may sound a bit corny, but I’m having fun putting it together.

    Cheers,
    TWC

  3. October 2, 2011 at 4:25 pm

    Absolutely right! Keep up the good work educating beginners 🙂

  4. October 4, 2011 at 4:44 pm

    Index investing is not dead; but there are better strategies out there for those that can spend some time on their investments.

  1. October 2, 2011 at 4:28 am

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