Why Index Funds Are Like Subprime CDOs

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Nomad
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Re: Why Index Funds Are Like Subprime CDOs

Post by Nomad » Fri Sep 13, 2019 5:44 am

The other thing I should mention is that I don't actually stay in all my active funds all the time. I rotate through them depending on momentum. So that is probably another sacred cow slaughtered.

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Re: Why Index Funds Are Like Subprime CDOs

Post by 7Wannabe5 » Fri Sep 13, 2019 5:50 am

Stop loss selling doesn't make a lot of sense to me given a market with derivatives and no holding costs. Also diversification within a field of competition is kind of stupid.

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Bankai
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Re: Why Index Funds Are Like Subprime CDOs

Post by Bankai » Fri Sep 13, 2019 6:16 am

7Wannabe5 wrote:
Fri Sep 13, 2019 5:50 am
diversification within a field of competition is kind of stupid.
What do you mean by this?

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Re: Why Index Funds Are Like Subprime CDOs

Post by 7Wannabe5 » Fri Sep 13, 2019 6:55 am

@Bankai:

Some investments are in different horse races and some investments are in the same horse race.

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Re: Why Index Funds Are Like Subprime CDOs

Post by bigato » Fri Sep 13, 2019 12:59 pm

Bankai: no, he was not talking about overdiversification. He actually meant diversification makes no sense and is counterproductive if you know what you are doing. But he is too much of a gentleman to call people names like that. The blunt line "diversification is for idiots" came from Munger on a video by the side of Buffet. Mark Cuban also uses that line.

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Re: Why Index Funds Are Like Subprime CDOs

Post by Bankai » Fri Sep 13, 2019 1:35 pm

"diversification is protection against ignorance. It makes little sense if you know what you are doing"

Without context or at least defining diversification, the above is meaningless. I can't see how one can conclude from the above that one should put all money into one security. Also, Buffett was/is pretty diversified himself (double-digit number of holdings).

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Re: Why Index Funds Are Like Subprime CDOs

Post by jacob » Fri Sep 13, 2019 1:48 pm

Diversification is the poor man's risk-control. However, it is fully compatible with the EMH in the sense that it abides the postulate of equal a priori probabilities. Insofar one has an opinion on the probabilities, one should/can use a form of risk control that takes this [probability] information into account.

Much of the disagreement on risk comes from not agreeing what risk is. Practitioners see risk very differently from academics. Ditto skilled/unskilled operators.

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Re: Why Index Funds Are Like Subprime CDOs

Post by Tyler9000 » Fri Sep 13, 2019 2:32 pm

bigato wrote:
Fri Sep 13, 2019 12:59 pm
The blunt line "diversification is for idiots" came from Munger on a video by the side of Buffet. Mark Cuban also uses that line.
To be fair, I believe Cuban has also said something along the line that if you don't have enough money to influence the price of a stock, you shouldn't mess with individual stocks and should just buy index funds. BTW, he's also a lot more ERE friendly than your typical billionaire. https://www.marketwatch.com/story/anyon ... 2018-06-27

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Re: Why Index Funds Are Like Subprime CDOs

Post by jennypenny » Sat Sep 14, 2019 5:40 am

Could someone define what exactly they mean by diversification (either for or against)? I've known people who thought holding large and small cap was being diversified. Others say it's holding different types of assets (gold, bonds, RE). At what altitude or through what lens are you judging diversification? I agree that you shouldn't buy a fund because 'everybody owns large cap' or 'I don't own any like this' but that doesn't make diversification inherently bad.

Personally, I think it's good if you mean avoiding having your whole life wrapped up in one or two areas ... like making sure you don't hold a ton of company stock if you're still employed, or making sure you don't own stock mostly in your own field, or owning property in an area that's completely dominated by your field. I was shocked when Lehman collapsed and employees were saying they were ruined because they lost their job and most of their wealth was in Lehman stock. I also know a couple who felt diversified, but she worked in a law firm that specialized in real estate and he owned a construction company. They also lived in a town of mostly vacation homes. When the RE market crashed, they were completely screwed.

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Re: Why Index Funds Are Like Subprime CDOs

Post by Unseelhilr8 » Sat Sep 14, 2019 7:00 am

What he is saying is not news it's his news or his opinion.

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Re: Why Index Funds Are Like Subprime CDOs

Post by jacob » Sat Sep 14, 2019 7:40 am

@jp - For a given risk-factor (lets say CEO-risk), diversification means holding more than 1 independent variables. The level of diversification goes as 1/sqrt(N). This is all mathematical and essentially relies on the central limit theorem. Although it is hard in practice (sample space is small and ill-defined(*)), one can statistically test independence. Ideal correlation is zero for the risk-factor tested. If it's negative or some other number, you're doing something else. (E.g. when people talk about bonds being negatively correlated with stocks, they're not diversifying, they're hedging).

(*) But really no worse than a Mickey Mouse study in psychology.

Holding the S&P500 gives you a diversification factor of 1/sqrt(500) over company or CEO risk. 1/sqrt(11ish) over sector risk. Maybe 1/sqrt(4ish) over market risk. But none (~1) against credit risk.

In slightly advanced investing, instruments are synthesized so as to construct other risk factors. Pair-trading is the simplest possible. For example one might want to trade on CEO-risk but try to cancel everything else by setting up (COP-XOM), e.g. two similar companies that would expect to respond equally to oil prices, hurricanes, bla bla, ... or as equal as you can get.

In options, this is what people are doing when they're trading gamma and "higher" greeks.

In advanced portfolio building, all instruments are remapped to a risk universe as well and the portfolio manager would optimize for alpha while the risk manager would minimize all the risk factors. In an ideal world, one would not hold B to hedge A. Rather, A has alpha, and B has alpha and it just so happens that when owned together (or rather in combination with everything else) that risk is minimized. Instead of pairs, it becomes vectors and tensors.

It's also important to has out what "risk" actually means. To academia, mutual/pension/ETF funds, and retail investors/retirement planners, it means price volatility. Academics like it because it's easy to calculate a standard deviation. Funds are interested in it because they're the middle-level between customers and the market. Retailers like it because of sequence of return issues and because they don't know any better/more. To market professionals, money is rarely measured in "square-dollars" and the event of random price increases are not considered a risk but a boon. Here risk is measured in respectively the money loss from ignorance, the probability of the loss, and the liquidity of covering it/getting out. I

This also means that ideally risk management is never something one should have to pay for. E.g. some buy put options to reduce their delta risk ... but a smart person would also price the put option and only buy it if it has alpha. Point being, in advanced risk-management, the risk-control is how you put the portfolio together. It's essentially super-synthesized. In many ways it's the difference between organic chemistry at the high-end and mixing sand and water on the low-end.

Another analogy for looking at the difference between simple and advanced would be chess. A beginner sees the board as a collection of single pieces. An advanced player sees the board as constellations or even as previous games.

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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 » Sun Sep 15, 2019 11:45 pm

Nomad wrote:
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?
Here is the thing. He has basically matched the index over the past 10 odd years and he is the best investor of all time.

I think it's already been said but none of these high performers that you can raise change the facts. The facts are that index investors are among the best investors when it comes to obtaining the best returns. They are the best because the vast majority of people under perform the index.

A couple of examples of beating the index do not mean that index investing isn't the best approach for the vast majority of investors. Alternatively the fact that the vast majority of punters under perform the index is a very very very good argument to use the index.

If you want to be a top investor use index funds.
Last edited by steveo73 on Sun Sep 15, 2019 11:56 pm, edited 1 time in total.

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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 » Sun Sep 15, 2019 11:50 pm

bigato wrote:
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.
I'm not really stating this. I'm stating that statistically the best way to become a top investor is to use the index.

I would bet that stock picking is really simple. There will be tons of theories and approaches out there. The problem is that the vast majority of stock pickers will under perform compared to the index. I think that the smart person bets with the odds in their favour. I also think that some people will do well stock picking. I doubt they will do well over the longer term so for typical retirement saving stock picking is probably not a good idea. Even stating that some people may do well. That person being you or me though is exceptionally unlikely.

You can change stock picking to any sort of active investing approach as well.
Last edited by steveo73 on Sun Sep 15, 2019 11:57 pm, edited 2 times in total.

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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 » Sun Sep 15, 2019 11:54 pm

Bankai wrote:
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.
There is some truth here. Sure some people will make it in small business. Some people will make it as stock pickers. What makes me think that you personally need to be very careful is your mention of stop losses.

I know a guy who is a multi-millionaire from trading and he thinks stop losses are terrible ideas. In his words they will pull you out too early, He believes you need the balls to hold a position if you are going to make money.

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Re: Why Index Funds Are Like Subprime CDOs

Post by Bankai » Mon Sep 16, 2019 12:40 am

Your friend made money despite not using stop losses, not because of it. Perhaps he had some other ways of controlling risk. For me, not using them ticks the following boxes (and more): no risk control, sunk cost fallacy, denying reality, arguing with the market, having too big ego, not being able to admit a mistake.

A simple way to verify if stop loss would work for you is backtesting your trading history with hypothetical stop loss on every position (probably somewhere between 5-10% below purchase price). If you'd make more money, you should start using them. For me this way an eye opener as it showed how just a few losing positions (double digit losses up to 90% in one case) can drag the performance down.

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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 » Mon Sep 16, 2019 12:57 am

I understand stop losses. My point is that stop losses weren't used by a guy I know has made a fortune trading. I'll tell you another story. Someone paid him to systematise his trading. That was a failure as well. How many people though get funded to have their trading systematised. I get your comments about back testing but I don't think it works very well.

My point being that trading is really about developing your own personal style and the emotional part of trading is probably a lot more important than supposed technical rules.

I'll tell you how he traded and how he taught me to trade. You analyse the market & you check the charts. From this you develop a feel for the market. Then you trade and you trade big. I think that this is how someone like George Soros would trade as well. Don't think that this is a 2 hour analysis effort. It's like a lifetime of investing and being educated in that field.

I see punters all the time with the same sort of advice as what you have. I've never met a successful punter. Not once.

My friend made money because be picked correctly more often than not and he has the balls to hold big positions. He typically takes 20 million positions and each big figure is equivalent to about 200k profit or loss. He took us out for lunch once after getting back to even after he was down 8 big figures (so 1.6 million). He would have held this trade for a long time. I've also seen him with multiple massive positions (20 million) and making money (and this is real money - enough to fund multiple retirements).

I understand how you feel about stop losses. I used to think the same way. I thought that way because I was educated in how to trade by the standard advice. They all say stuff like you stated above. I just think it's basically a scam to take dollars off you and give it to the market.

When I learnt how to trade by someone who was actually successful I realised that successful trading isn't necessarily anything like what the standard advice is.

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Bankai
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Re: Why Index Funds Are Like Subprime CDOs

Post by Bankai » Mon Sep 16, 2019 1:33 am

I'm glad your friend's approach works for both of you.
steveo73 wrote: My point is that stop losses weren't used by a guy I know has made a fortune trading.
Understood. But this is anecdotal evidence. Also, achieving the desired result doesn't prove one's method/approach was correct/best.
steveo73 wrote:I get your comments about back testing but I don't think it works very well.
Why?
steveo73 wrote:My point being that trading is really about developing your own personal style and the emotional part of trading is probably a lot more important than supposed technical rules.
Absolutely. In my opinion risk control including stop loss is a very important part of investing and 'taming' emotional human nature. I don't see any contradiction here.
steveo73 wrote:You analyse the market & you check the charts. From this you develop a feel for the market. Then you trade and you trade big. I think that this is how someone like George Soros would trade as well. Don't think that this is a 2 hour analysis effort. It's like a lifetime of investing and being educated in that field.
This is quite esoteric. What I take from this is that your friend is very experienced and uses intuition a lot. However, if he's 'trading big' (assuming his positions are relatively large %-wise) he needs strong risk controls not to get wiped out in a downturn. What does he use for that?
steveo73 wrote:I see punters all the time with the same sort of advice as what you have. I've never met a successful punter. Not once.
So risk control is bad? I never saw a successful punter with no risk control. Doesn't prove anything.

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Re: Why Index Funds Are Like Subprime CDOs

Post by steveo73 » Mon Sep 16, 2019 3:20 am

Heaps here but I'll do my best:-

1. Anecdotal evidence is crap. It's why I believe that the standard approach should be to invest in index funds. You are correct in that the desired result doesn't equate to proving a method or approach. I will state though that the idea of there being a correct method or approach is in my opinion showing a lack of understanding of investing. I think (and this touches on back-testing) that the idea that there is a correct approach is deluding yourself. You are betting on the future and there is no correct approach.
2. Back testing to me is simply data mining. It gives you a false impression of reality. It doesn't correlate to a good trading approach because a good trading approach doesn't work all the time. In fact back testing is worse. It gives you false confidence and more than likely false signals. The markets today are different than yesterday.
3. I understand that you believe the emotional part of trading is important and that is why you use a stop loss. I think the idea of a stop loss is nothing at all to do with handling the emotional side of trading. I think it's just a way to stuff up your trading. This is difficult to explain until you do it but markets will go your way and go against you but it will do that haphazardly. If you can't hang on when the market goes against you then you will get pushed out. The weak hands go.
4. My friend has big pockets (from having a successful career as a trader) but he still trades big. He doesn't use risk controls like you state. He has been doing this for years. He accepts he can get wiped out but all he will lose is his margin. He sometimes adds more funds into his accounts and he might have to borrow to get those funds. Interesting the hedge fund he managed went bust. I think that this was predominantly because the billionaire who also traded did it bigger than him but got it wrong.
5. Risk control sounds good in theory. It sells books about how to successfully trade. It can also flip you out of successful trades. The big traders ala Soros and the guy I know don't trade the same way as the books tell you how to trade. Interestingly people that buy and hold index funds do the same thing. It's an all in approach. It also works.
6. When it comes to the emotional side of trading a good example is how my friend handles his losses and his profits. He hangs on and sleeps well. When he was trading in the hedge fund he managed the billionaire called him up and 3 am and said he had put a massive position in but the market had just sucked it up. They traded so big they moved markets and it was the foreign currency market. We are not talking small shit here. Anyway my friend woke up, answered the phone and said we can't do anything now and went back to bed. When markets move against him he can still sleep. He doesn't stress and panic. It hurts but he doesn't react and sell or buy quickly.
7. Trading doesn't work for me. I have made good profits and some losses but it doesn't make sense for me to do it. The main reason why is that my profits get taxed and my losses get no tax benefits (I know I can off-set these but that still doesn't work for me). For me investing in index funds, working in my job and saving money is a reliable way to get ahead. I don't need some special bonus or anything like that. I like simple and robust. I may trade when I retire but it will always be play money. Personally I prefer spending my time on other stuff.

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Bankai
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Re: Why Index Funds Are Like Subprime CDOs

Post by Bankai » Mon Sep 16, 2019 3:59 am

Well, I don't believe there's a single best approach to investing so glad we agree. There are people employing various strategies here that work for them, so it's clear there are many ways to skin the cat.

I don't agree stop loss doesn't help with emotional part of investing . It's quite obvious to me it does - you just get out of the position at pre determined point you decided rationally while having clear head, rather than agonising wether you should hold or sell while watching your stock tank.

So your friend's approach to trading, after his hedge fund went bust, is to trade big on margin with no risk controls and borrow money at times to cover margin? I don't think this is a good advice for the average folk. Also, what works for billionaires should not be treated as dogma and default advice for 'small fish' - they play different game with different rules.

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Re: Why Index Funds Are Like Subprime CDOs

Post by Nomad » Mon Sep 16, 2019 8:07 am

steveo73 wrote:
Sun Sep 15, 2019 11:45 pm
Here is the thing. He has basically matched the index over the past 10 odd years and he is the best investor of all time.

I think it's already been said but none of these high performers that you can raise change the facts. The facts are that index investors are among the best investors when it comes to obtaining the best returns. They are the best because the vast majority of people under perform the index.

A couple of examples of beating the index do not mean that index investing isn't the best approach for the vast majority of investors. Alternatively the fact that the vast majority of punters under perform the index is a very very very good argument to use the index.

If you want to be a top investor use index funds.
If you consider his record for the last fifty years, e.g. include the forty before the last 10, he has far exceeded it.

At present market valuations, especially those in the US are very high and Warren as a value-based investor isn't pulling the trigger.
He is sitting on far in excess of $100 billion in cash. So when valuations drop at some point he will quite possibly make an enormous killing - even
when compared to the index.

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