Picking Investments: Only Two Things Matter

http://blog.futureadvisor.com/picking-investments-only-two-things-matter

by jonxu • 16 years ago

57 31 16 years ago

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patio11• 16 years ago

2b) Tax consequences matter. Take advantage of options to reduce them, for example by fully funding your IRA. Particularly for the young kids here, you should be maxing your IRA every year if you're debt free. (And you should not, not, not tap it when you change jobs, want to fund a startup or wedding, etc.)

bolu• 16 years ago

You're absolutely right, and I agree with your advice. Also contributing to your 401(k) - assuming your options aren't terrible - is in the same realm of advice.

We should have been more clear - this particular post is all about security selection for the individual investor, i.e. "I have this much money to put into my IRA and what should I buy" type questions.

ct• 16 years ago

Respectfully disagree about not dipping into your IRA to fund a startup if you're driven to succeed and raising capital otherwise falls through. Just make sure it's for the right idea and it'll pay multiples over the crappy returns the S&P has over the past 10 years (which is almost nothing).

ahi• 16 years ago

Everyone thinks they have "the right idea and it'll pay multiples over the crappy returns the S&P has over the past 10 years."

nowarninglabel• 16 years ago

http://www.nytimes.com/interactive/2011/01/02/business/20110... A longer timeline of perspective to enhance your comment.

yannickt3• 16 years ago

"crappy returns the S&P has over the past 10 years"

The returns were only crappy for those who invested a lump sum at the peak in 2000 and never reinvested dividends.

johnrob• 16 years ago

Most people's IRA money is a drop in the pan compared to the market rate salary people forgo to pursue a startup. If your value system has you protecting your IRA, it should also have you earning a full salary.

hugh33• 16 years ago

Does anyone know anything about the consequences of these IRA things for people who are currently working in the US but may or may not move back to their home countries in future years?

Tichy• 16 years ago

Who creates the indices, though? And if everybody would act like that, the system would fail, because nobody would trade stock anymore.

smeatish• 16 years ago

No, if everyone acted that way then there would be HUGE arbitrage opportunities. In the process of people arbitraging those inefficiencies, the prices would be corrected.

rsepassi2• 16 years ago

Tichy is exactly right, and this point on its own makes passive investing extremely dangerous (though I tend to agree that on average, putting your money with an active money manager is even more dangerous). The indices are rather arbitrary and set by institutions whose incentives have nothing to do with investor returns. The securities included in the indices are in no way selected for expected performance, and it's been well-documented that simply being included in the index artificially inflates a company's stock price (just as getting booted out artificially depresses a company's stock price), mostly because so many people have shifted to blind passive investing that there's just a bunch of forced selling and buying instead of thoughtful analysis of business values.

Though Warren Buffett has indeed recommended index funds to individual investors, he has repeatedly argued that the fundamental premise of index investing (that is, EMH, the efficient market hypothesis) is fatally flawed and that index investing is basically a stupid thing to do: "Naturally, the disservice done to students and gullible investment professionals who have swallowed EMT [efficient market theory] has been an extraordinary service to us and other followers of Graham. In any sort of a contest -- financial, mental, or physical -- it's an enormous advantage to have opponents who have been taught that it's useless to even try. From a selfish point of view, Grahamites should probably endow chairs to ensure the perpetual teaching of EMT." Buffett basically says that if you don't have time to dig into stocks, then index funds are the way to go - though they're still a terrible way to go. I disagree. When you look at the academic literature as well as Buffett's own philosophy (which draws heavily on the work of Benjamin Graham and David Dodd), investing based on value works over time and handily beats the broad indices. That is, if an investor buys what is undervalued, they will outperform the market. Now, to truly understand if a security is undervalued requires an enormous amount of knowledge and analysis, but it's been shown that even rough proxies for undervaluation (i.e. simplistic statistical screens such as price/earnings or price/book) work, and work well.

Joel Greenblatt, another very successful and highly respected investor (who subscribes to the same investment philosophy known as "Value Investing" that Buffett follows and Graham birthed), also disagreed with Buffett and he proposed a system that does in fact recommend buying undervalued securities as determined by statistical screens. Here's his site below: http://www.magicformulainvesting.com/welcome.html

If you buy the index when the market is overvalued, you'll end up doing very, very poorly. This is not about market timing; this is about valuation. You could use a simple P/E or a Schiller P/E (http://www.multpl.com/) to understand where the market stands on a valuation basis. This is the sort of analysis that Jeremy Grantham, another very successful value investor, does when he determines asset allocation and security selection (http://www.gmo.com/America/). If a certain asset class is overvalued, then why would you put the same amount of money into it? You want to put more money into the asset classes that are undervalued. Asset allocation should not be a static allocation; it should vary based one very important factor - value.

cloudkj• 16 years ago

I think you're taking quite an extreme interpretation of Graham's/Buffet's thoughts on index investing. It's a given that, with index investing, your returns will match the market. Index investing isn't aimed at getting higher returns. Rather, Graham actually spends more time discussing and differentiating between different classes of investors.

For the "enterprising investor", s/he can afford to spend more time to find undervalued stocks and possibly outperform the market. For the "passive investor", to paraphrase Graham, it is good enough to simply invest in a representative set of securities, such as an index.

In fact, if I remember my Intelligent Investor correctly, there are various passages where Graham actually admits to the EMH being somewhat inevitable. Note that there are different variants/degrees of the EMH, and Graham probably subscribes to the weak or semi-strong versions.

Nonetheless, the point is that a belief in the EMH is not mutually exclusive with value investing. It depends a little on the extent to which you believe the market is efficient, and a lot on how much work you're willing to put into it.

Umalu• 16 years ago

You make useful points. The efficient market hypothesis, particularly in its stronger forms, is in retreat. Value investors like Buffett are a big reason for this. But... for most people without the skill or the time to find the next great investment or the next great investment manager, index investing offers the lowest cost of investment and, if you dollar-cost average over a long enough time, you will invest in up and down markets, thereby minimizing your market timing risk. Clearly this is not a swing-for-the-fences investing strategy, but for most people it is good enough.

seanahrens• 16 years ago

very well written, and very clear. thanks for the good insight, jon and bo.

Eliezer2• 16 years ago

Two words: Berkshire Hathaway.

tomjen32• 16 years ago

Ten years ago maybe, but since Buffet has promised to give away his money, why should I trust him to handle mine? His is not hungry for it anymore.

AndyParkinson• 16 years ago

To be fair, I don't think he ever was that hungry for the trappings of wealth. He just wanted to accumulate. Based on my understanding of Buffett, his entire identity is so wrapped up in Berkshire that you have to assume he will be giving it 110% until the day he croaks.

That said, I wouldn't touch BRK. Size is the anchor now and there are very limited opportunities for BRK to grow at the same pace they've grown over the last 25 years.

hugh33• 16 years ago

Those are, indeed, two words.

They'd be more useful if placed into a full sentence, for instance "I think you should put all your net wealth into shares of Berkshire Hathaway" or "I think you should try to replicate Berkshire Hathwaway's investment strategy" or "Hey, you should think about buying a little bit of Berkshire Hathaway as part of a diversified portfolio which also includes other asset classes".

Eliezer2• 16 years ago

"Berkshire Hathaway is something you can defensibly buy that isn't an index fund."

yannickt3• 16 years ago

Asset allocation matters. Investors who took the time to develop a plan, figure out an asset allocation that matches their risk tolerance, and actually rebalanced periodically to adjust their portfolio back to their allocation target, probably did just fine during the so-called lost decade.

Tax efficiency matters. A badly designed portfolio may lose 1% a year to taxes. Tax-inefficient investments should be held in tax-advantaged accounts (e.g. tax-free or tax-deferred accounts).

And it matters that you have the discipline to stick to your plan through all market conditions.

fexl2• 16 years ago

Harry Browne demonstrates the effectiveness of asset allocation and periodic balancing in his book "Why the Best-Laid Investment Plans Usually Go Wrong". It's an old book from 1987, but the principle is timeless.

For example, I'm looking at a chart of his "Permanent Portfolio" from 1970 through 1987, which weights four asset classes equally at 25% each: gold, stocks, bonds, and cash. The portfolio has far lower volatility and far lower draw-downs than gold, stocks, or bonds alone. The portfolio also outperforms stocks or bonds alone. It does not outperform gold over this 17 year period, but by 1987 it comes close. It probably overtakes gold alone in subsequent years, since gold vastly underperformed the stock market from 1987 to 2001.

One good aspect of asset allocation is that it keeps on the opposite side of manic up or down trends. This strategy would have you selling gold at $800 in 1980, and buying gold at $250 in 2001. Gold has vastly outperformed the stock market since then.

Similarly, this strategy would have you buying stocks in 1974, when many people thought equities were "dead" and only fools were in the stock market.

You might think these references are a little dated, but again the principle is timeless. Anyone who says "it's different this time" is probably wrong.

yannickt3• 16 years ago

Another great book is "All About Asset Allocation" by Richard Ferri.

hugh33• 16 years ago

One obvious asset class that's missing from that allocation is real estate, which (if you bought in a sensible area) has probably easily outperformed all of those since 1974 with the possible exception of gold.

kia• 16 years ago

Here is a recent thread about index funds

http://news.ycombinator.com/item?id=1949158

tl;dr Before IPO Google made several seminars so it's employees can get investment advice on how to invest their future millions. The advice was to invest in index funds.

Picking Investments: Only Two Things Matter

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