Why Index Funds Are Like Subprime CDOs

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jennypenny
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Re: Why Index Funds Are Like Subprime CDOs

Post by jennypenny » Sun Sep 08, 2019 4:18 pm

Jin+Guice wrote:
Sun Sep 08, 2019 1:52 pm
I also appreciate the reminder that I don't have to be all or nothing in paper assets and can start investing in stocks slowly, with relatively easy criteria. I also needed to be reminded that sitting in 100% cash equivalents, even if I am able to match inflation (which I understand is not guaranteed) is not a wise move. The goal is to have that money make money, which will always involve risk (just like staying in cash). Looking at the numbers on a screen without using them is a failure.

I also need to think more about how to withdrawal in semi-ERE. When am I o.k. with drawing down? When am I o.k. with not saving as much? When do I feel I need to save more? I've been operating under the accumulation -> retirement paradigm, but this isn't really what I want to do.
Is that your goal? I mean *your* goal since IMO it's not a universal goal. Don't get bullied into thinking that you're leaving money on the table if you don't put your savings to work. That's no different than the common complaint EREs get that they're wasting their education or hard-earned credentials by pulling the plug early on their careers.

It's totally ok to keep part of your money buried in the backyard if that helps you sleep at night. You might decide to always keep some percentage or fixed dollar amount (like 5 years expenses) in a cash equivalent and only invest the surplus. If you intend to semi-ERE, it might make perfect sense to keep a few years of expenses in cash and only invest with the rest.


I'm also going to add that you don't have to invest in the broader market. I've known traders who specialized in certain fields with which they were familiar (like biotech or pharma). Honestly, you don't have to invest in the market at all. I've also known people who were better at trading collectible-type items and did that instead (guns, art work, rare books, etc). Maybe your background in music gives you an advantage that way? Or is there an aspect of traditional investing who's business overlaps with your own interests/knowledge? I'm just tossing out ideas to get you to think about investing in a new way. You need to learn the basics of investing and grasp all the ways you can lose money, but when it comes time to invest, you might enjoy it more if you specialize in businesses that overlap with your own interests (whether through stocks or some other way).

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jennypenny
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Re: Why Index Funds Are Like Subprime CDOs

Post by jennypenny » Sun Sep 08, 2019 4:53 pm

As I reread my post, it sounds harsh and I didn't mean it that way. Sorry. It's just that I feel like it's a false choice between investing in funds and learning enough to invest in individual assets. The biggest goal should be to avoid losing money (through bad investing or frivolous spending). Other important goals are to avoid investments that make you stress out about money and to avoid thinking about money you left on the table.

Money is supposed to improve your life and it does nothing for your well-being if you're constantly stressed or thinking about the one that got away. Be happy with what you've got and invest when you feel good about the investment.

Jin+Guice
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Re: Why Index Funds Are Like Subprime CDOs

Post by Jin+Guice » Sun Sep 08, 2019 8:27 pm

Thanks for this reminder @JP. When it comes to semi-retiring I'm very liberal, but when it comes to investments I'm very conservative.
jennypenny wrote:
Sun Sep 08, 2019 4:18 pm
Jin+Guice wrote: ↑Sun Sep 08, 2019 1:52 pm
I also appreciate the reminder that I don't have to be all or nothing in paper assets and can start investing in stocks slowly, with relatively easy criteria. I also needed to be reminded that sitting in 100% cash equivalents, even if I am able to match inflation (which I understand is not guaranteed) is not a wise move. The goal is to have that money make money, which will always involve risk (just like staying in cash). Looking at the numbers on a screen without using them is a failure.

I also need to think more about how to withdrawal in semi-ERE. When am I o.k. with drawing down? When am I o.k. with not saving as much? When do I feel I need to save more? I've been operating under the accumulation -> retirement paradigm, but this isn't really what I want to do.


Is that your goal? I mean *your* goal since IMO it's not a universal goal. Don't get bullied into thinking that you're leaving money on the table if you don't put your savings to work. That's no different than the common complaint EREs get that they're wasting their education or hard-earned credentials by pulling the plug early on their careers.

It's totally ok to keep part of your money buried in the backyard if that helps you sleep at night. You might decide to always keep some percentage or fixed dollar amount (like 5 years expenses) in a cash equivalent and only invest the surplus. If you intend to semi-ERE, it might make perfect sense to keep a few years of expenses in cash and only invest with the rest.
My non-monetary goal is to be able to do whatever I want. Some money is necessary for this, but not very much. If it wasn't for old age retirement, I probably wouldn't bother with learning how to invest. I would keep a few years cash as a buffer (as in always hold it and not use it to take time off), but 5-years is the maximum I'd hold. Otherwise I'd just earn money for awhile and then take a few years off.

However, I think investment is a game we're all forced to play if we want to participate in our society. Given this, learning the basics seems highly advisable, and if I'm going to learn the basics and be forced to play anyway... then my goal for my excess money is for it to make me more money.

It's a useful reminder that I don't have to invest in stocks and that it's advisable for me to still hold an "emergency fund" of a few years of expenses, at least until I'm comfortable with my investment choices. Stocks are not what I'm most comfortable with and not where my current strengths lie. Today I also read this thread, where Jacob outlines what he thinks it takes for someone to have the ability to beat the market. I don't really think I have what it takes, but I don't like blindly indexing either. As Jacob pointed out in the linked thread and this one, this is no excuse to skimp on the education. I also think learning how to think like his description of how an investor thinks would be desirable/ useful, even if one never touches the stock market.

MarginVariation
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Re: Why Index Funds Are Like Subprime CDOs

Post by MarginVariation » Sun Sep 08, 2019 10:28 pm

Epsilon Theory had a piece here that summarizes it. Not so much that index funds are the problem but "Always Be Buying"

https://www.epsilontheory.com/ive-got-a-secret/

To quote:

Always. Be. Buying.
And the Common Knowledge surrounding passive investing – what everyone knows that everyone knows about passive investing – is what blows this bubble.

Everyone knows that everyone knows that passive investing beats active investing.

Everyone knows that everyone knows that stocks as an asset class ALWAYS go up over time.

And if that’s the case, then why in the world would you pay more for someone to use their discretion in picking this stock or that stock? No, no … just harvest the inevitable returns that stocks in a general sense ALWAYS provide by putting your money in an inexpensive, systematic buying program. If you think yourself particularly clever, then by all means express this systematic buying program in terms of “factors” or “betas” instead of this index or that index, but the important thing is to ABB.

Jason
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Re: Why Index Funds Are Like Subprime CDOs

Post by Jason » Mon Sep 09, 2019 8:32 am

I think one of the problems is that "Don't focus on past mistakes, avoid losing money, invest in what you know" these concepts do not exist separate from behavioral patterns which are also behind the promotion of indexing - its not just that the average person doesn't understand investing, but they will behave in a manner that is counter-productive to their own interests. DCA in an index funds minimizes the enemy within, or well, it supposedly does. No one wants to lose money but everyone will. It's the response to loss that is critical. If you lose money in an index, you blame the market, or JD Collins or the economy or wall street or your neighbor for voting the way they did. Lose money in an investment you chose, well, that's on you and that can have significant personal repercussions.

It's the difference between going to a psychiatrist for a pill for anxiety or going to a psychologist to obtain a deeper understanding of oneself and why you may be experiencing that anxiety. Know thyself is not an easy course.

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Re: Why Index Funds Are Like Subprime CDOs

Post by Wads » Wed Sep 11, 2019 10:16 am

jacob wrote:
Sat Sep 07, 2019 1:27 pm
DIY fundamental analysis plays no role in the way I invest. I leave that to others ... I just read the CFRA reports instead. Analyzing that one company was helpful in understanding where a given number in the analyst report comes from (e.g. what is a quick ratio) or whether 1.2 is "a lot". But nah, I have little interest in doing forensics and reading footnotes.
CFRA reports aren't cheap. When I looked in the past the cheapest option was 430/yr for ten reports each month. Are you a paid member or getting this info elsewhere for free?

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Re: Why Index Funds Are Like Subprime CDOs

Post by jacob » Wed Sep 11, 2019 11:09 am

"Free" ($7/trade in commissions) via full-service broker. Incidentally, that sounds insanely expensive... maybe we're not talking about the same type of reports.

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Re: Why Index Funds Are Like Subprime CDOs

Post by Wads » Wed Sep 11, 2019 2:50 pm

Looks like TD Ameritrade offers CFRA reports. I can't tell if I would be able to pull reports for any stock or if they just offer general industry outlook reports. I believe we are talking about the same reports. Purchasing these reports directly from their website is not wise.

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Re: Why Index Funds Are Like Subprime CDOs

Post by jacob » Wed Sep 11, 2019 3:13 pm

You get any [US] stock and as many reports you want. The sub-industry outlook is part of the report. It's almost always neutral :lol:
For smaller/less followed companies, they only offer a quant-based report.

steveo73
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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 » Wed Sep 11, 2019 10:58 pm

These threads/ideas seem to pop up regularly. My take is people worrying about this don't really understand investing.

Indexes are just a grouping of various asset classes (it could be a single asset ala Gold) into a product which can be sold. Indexes represent (and often purchase) the underlying assets.

A key point on indexes and where you have to be really careful when it comes to advice that doesn't conform to this fact is that typically everyone who tries to beat the index under performs the index. Why would people do this ? It sounds crazy and it is crazy. People think they have some special esoteric knowledge about what is going to perform in the future but we know that this is typically a false assessment.

Now what this guy is stating is that there are several problems with index funds. These consist of:-

1. It is now easy to pick stocks that will outperform the index.
2. Indexes are utilizing a large number of leveraged products to ensure the index tracks the actual underlying products.

We can pretty clearly state that no 1 is false because we don't fall for stories regarding stock picking. In the words of William Bernstein we are mature investing adults and not children. We shouldn't be thinking we have the esoteric knowledge to beat the market.

That leaves point 2. I think that this may be the case on occasions but not all the time and maybe this isn't something that will inevitably lead to chaos. Where are the facts that this is going to lead to chaos. Have all the available index funds had risk assessments done on them. Are they all using leveraged products to match the index returns.

To me this is just another example of active managers thinking they are smarter than what they are. They will get it right every so often but who cares. We bet with the odds on our side and therefore over a 30+ year investment horizon if we hold our nerve and invest whilst following a mature plan we have the odds on our favor. It should be noted that there is no guarantee we will come out ahead. That isn't the point. The point is that we are betting with the odds in our favor and that is the best that you can do.

Lastly if anyone knows active mangers you know they get it right and can make a killing but they get it wrong as well. I think the story of Soros shorting the pound is a great story. He made something like a billion dollars off that trade. I think he lost a similar amount soon after that event.

No 1 rule of investing - know yourself. You are a human being. You are not a seer. Bet with the odds in your favor.

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Re: Why Index Funds Are Like Subprime CDOs

Post by Nomad » Thu Sep 12, 2019 2:34 am

Well, Fundsmith Equity and various Lindsell Train funds (Global, Japan, UK) have beaten their respective indices for nine years straight.
This isn't by a small margin, we are talking approximately double the return of the equivalent index.
Terry Smith and Nick Train are clearly very lucky.

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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 » Thu Sep 12, 2019 2:50 am

Nomad wrote:
Thu Sep 12, 2019 2:34 am
Well, Fundsmith Equity and various Lindsell Train funds (Global, Japan, UK) have beaten their respective indices for nine years straight.
This isn't by a small margin, we are talking approximately double the return of the equivalent index.
Terry Smith and Nick Train are clearly very lucky.
Some people are going to get lucky. They may even be good. I bet they won't be good over a 30-40 year period though. Have you heard of Long Term Capital Management. They were the best of the best.

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Re: Why Index Funds Are Like Subprime CDOs

Post by Nomad » Thu Sep 12, 2019 6:44 am

steveo73 wrote:
Thu Sep 12, 2019 2:50 am
Some people are going to get lucky. They may even be good. I bet they won't be good over a 30-40 year period though. Have you heard of Long Term Capital Management. They were the best of the best.
Well, Terry Smith has been lucky since the 90's. He went solo with Fundsmith 9 years ago. Now he is currently 66 so could retire at any point.
How long does he need to be at this before it is recognized that picking good companies and avoiding bad ones is a definite skill?

Note, he did write a best-selling book on sharp accountancy practices that allow poor businesses to have impressive financial returns (for a while).
The book is 'Accounting For Growth: Stripping the Camouflage from Company Accounts'.
https://www.amazon.co.uk/Accounting-Gro ... 0712652809

No, I had not heard of 'Long Term Capital Management', they only appeared to trade for a few years and from the Wikipedia page their strategy
was 'convergence trading' - which is something I have never heard of.
I would suggest that no, they were not the best by any measure.

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Re: Why Index Funds Are Like Subprime CDOs

Post by bigato » Thu Sep 12, 2019 2:04 pm

LTCM was a very specific chapter in the history of investing. They pretty much invented quant trading. They are an interesting case but may not be exactly the best comparison here if you are trying to gauge stock picking skill.

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Re: Why Index Funds Are Like Subprime CDOs

Post by Nomad » Thu Sep 12, 2019 5:45 pm

I will throw in another name. Warren Buffet. He is not definitely not in the 92% of active fund managers who fail to beat the index.
Is he just lucky?

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Re: Why Index Funds Are Like Subprime CDOs

Post by bigato » Fri Sep 13, 2019 4:23 am

Well that does not help your argument either since he advocates that normal people should just index because it is too complicated to stock pick for the normal person.

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Re: Why Index Funds Are Like Subprime CDOs

Post by Bankai » Fri Sep 13, 2019 4:32 am

Sure, since 'normal person' buys and sells on tips from bulletin boards or 'informed friends' and ignores pretty much all the safety rules (stop loss, diversification etc.).

Saying that one can't do well as a retail investor is like saying one can't do well starting/running a business. Both have stats to back it up as 90% 'fail'. But guess what, 90% of people just plain suck at complicated endeavours other than their work. So you might also say that it's impossible for a normal person to run a marathon since 99% of casual runners never run the distance.

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Re: Why Index Funds Are Like Subprime CDOs

Post by bigato » Fri Sep 13, 2019 4:43 am

Well, Buffet pretty much don't stop loss (never sells) and has been spotted in a video with Charles Munger joking about diversification is for the stupid, so...
I actually agree with your premises, it's just that using Buffet as argument for stock picking won't get you far.

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Bankai
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Re: Why Index Funds Are Like Subprime CDOs

Post by Bankai » Fri Sep 13, 2019 5:03 am

I'm pretty sure he meant over diversification. The more you diversify, the closer to the average your results will be. There was a study showing diminishing returns above 15 or so holdings. For a 'normal person' even holding this many might be too much to keep up with. But I doubt Buffet would advocate for 'one shot at glory' approach.

And yeah, he's not a good example anyway.

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Re: Why Index Funds Are Like Subprime CDOs

Post by Nomad » Fri Sep 13, 2019 5:40 am

bigato wrote:
Fri Sep 13, 2019 4:43 am
Well, Buffet pretty much don't stop loss (never sells) and has been spotted in a video with Charles Munger joking about diversification is for the stupid, so...
I actually agree with your premises, it's just that using Buffet as argument for stock picking won't get you far.
I'm not using Buffet as an argument for me for stock picking. I'm using his skill as an example of what competent active fund managers can achieve. Between June 1990 and today, the S&P has gone from 360.39 to 3009.88 in the same time Berkshire Hathaway has gone from 7100 to 317308 per share. So $7100 dollars could give $59297 via the index or $317308 via BH.

At present though he is sitting on over $100 billion in cash because he sees most stocks are very overpriced. So prices may need to drop significantly before he makes further plays. Failing that he intends to buy back shares of Berkshire Hathaway.

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