Here's an example of a trade where, in an open-ended system, everyone is a winner:
AA works for company New.Com. As a condition of the employment, AA is granted a 20,000 share stock option that is free (cost=0). After 5 years, AA's daughter Jill has been accepted by Harvard, so AA needs to pay a big tuition bill and sells the 20,000 shares for market price.
Investor BB has liked the performance of New.Com and decides to buy 20,000 shares. BB just happens to be the cross-trade for AA. New.Com pays a nice dividend and appreciates modestly.
So... AA has profited at an infinite percentage and BB profits in time. Neither one has lost as AA was able to pay the tuition and BB is getting the desired profitable investment.
***
Modifying the scenario: price of New.Com drops, but they manage to maintain their dividend after BB buys it. BB is only a "loser" if BB chooses to sell at the reduced price.
Index Funds
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George the original one
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miyatarama
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George, in your example, the grant of 20,000 shares (or exercised options) comes out of the equity of the original owners of new.com. There's nothing magically open-ended about a company selling treasury shares or issuing new shares to an employee.
Let's start at the beginning of your example. CC owns 100% of New. 20,000 shares represents 1% of New. Since New grants the shares CC is exchanging 1% of the company in exchange for AA's work (I will keep out the complexity of the options and Black-Scholes valuation if you don't mind). AA sells to BB. Now CC owns 99% and BB owns 1%. I fail to see how this is open-ended.
Let's start at the beginning of your example. CC owns 100% of New. 20,000 shares represents 1% of New. Since New grants the shares CC is exchanging 1% of the company in exchange for AA's work (I will keep out the complexity of the options and Black-Scholes valuation if you don't mind). AA sells to BB. Now CC owns 99% and BB owns 1%. I fail to see how this is open-ended.
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George the original one
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miyatarama
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George the original one
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Now we're getting somewhere!
Open-ended because companies generate profit.
If I trade a company after having shared in its profit (either through share appreciation or dividends) and the purchaser (or seller) of what I trade will (or has) also had a share in the companies profit, then it's not a zero-sum game.
Open-ended because companies generate profit.
If I trade a company after having shared in its profit (either through share appreciation or dividends) and the purchaser (or seller) of what I trade will (or has) also had a share in the companies profit, then it's not a zero-sum game.
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miyatarama
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miyatarama
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Wait, I think I see the point of contention. The open-ended aspect is exactly the same for the indexer and the stock-picker, do you agree? If so, then gains that a stock-picker receives *above* the indexer must result in losses to another stock-picker, right? Therefore, stock-picking in relation to indexing is a zero-sum game.
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George the original one
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But how can one stock-picker's gains be at the expense of a 2nd stock-picker when the company's profits (especially dividends) are figured in? It most definitely is not a zero-sum game in that instance as money is coming into the system via the company's profits.
Another way to look at it... why is the Dow worth 11,000 points when it used to only be 1,000 points? Where did all those points come from? Now if I bought the Dow components at 1,000 and sold them at 5,000 and you bought them from me at 5,000, who lost? After all, the Dow is still around, you're still collecting any dividends, and I booked a profit that went to my heirs (because it was a long time ago that the Dow was 1,000) and the taxman.
Or taking another step, if Jacob buys your Dow components at 11,000 and then the market tanks to 10,000, has he lost any money? Not unless he sells at that point and, even if it's stuck at 10,000 for eternity, he's collecting the dividends and can realize a profit. Thus not zero-sum.
Another way to look at it... why is the Dow worth 11,000 points when it used to only be 1,000 points? Where did all those points come from? Now if I bought the Dow components at 1,000 and sold them at 5,000 and you bought them from me at 5,000, who lost? After all, the Dow is still around, you're still collecting any dividends, and I booked a profit that went to my heirs (because it was a long time ago that the Dow was 1,000) and the taxman.
Or taking another step, if Jacob buys your Dow components at 11,000 and then the market tanks to 10,000, has he lost any money? Not unless he sells at that point and, even if it's stuck at 10,000 for eternity, he's collecting the dividends and can realize a profit. Thus not zero-sum.
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miyatarama
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You are using an index which proves my point, any returns ABOVE the index must come at the expense of another stock-picker. In other words, if there is only the Dow, and you beat the return of the Dow, someone else had to do worse than the Dow. Are you arguing that the "average return" of the index is not the average return?
"It most definitely is not a zero-sum game in that instance as money is coming into the system via the company's profits."
Which applies equally to indexes and stock-pickers, therefore it is not an advantage of stock-picking over index investing. I'm not sure I can explain further in a different way than I have previously. In which case, we may have to agree to disagree.
"It most definitely is not a zero-sum game in that instance as money is coming into the system via the company's profits."
Which applies equally to indexes and stock-pickers, therefore it is not an advantage of stock-picking over index investing. I'm not sure I can explain further in a different way than I have previously. In which case, we may have to agree to disagree.
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George the original one
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I merely used the Dow because it was easier to show that money is coming into the system and thus, by definition, the market is not a zero-sum game. So if the Dow is not a zero-sum game, then trading Dow components is similarly not a zero-sum game.
I'll agree that my argument applies equally to indexes and stock-pickers, but your examples have been zero-sum games and the market is clearly not a zero-sum game, so your examples have not helped, either.
By the way, by rebalancing your portfolio of index funds 4-5 times per year since 2002, are you not trading and thus getting an edge on the individual indexes? Who are the losing traders when you do that?
I'll agree that my argument applies equally to indexes and stock-pickers, but your examples have been zero-sum games and the market is clearly not a zero-sum game, so your examples have not helped, either.
By the way, by rebalancing your portfolio of index funds 4-5 times per year since 2002, are you not trading and thus getting an edge on the individual indexes? Who are the losing traders when you do that?
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miyatarama
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Trading the Dow components to achieve a *higher return* than the Dow is by definition a zero-sum game. For you to win (above average return), someone else must lose (below average return).
Here are the variables for investing in the stock market:
1. Active (stock-picking or even managed mutual fund) vs Passive (indexing)
2. Selection of particular bond, stock or index
3. Timing the purchase of securities (methods are varied across both Active and Passive investing)
4. Timing the selling of securities (methods are varied across both Active and Passive investing)
Rebalancing is a technique for achieving 3 and 4 in a strategic way. It can even be done in conjunction with Active investing. To the extent that rebalancing my portfolio achieves higher returns than the individual indexes, someone else must be achieving lower returns on those indexes (in other words, there is ultimately someone on the other end of my transaction). 100% of the market cannot buy high and sell low.
I fully recognize that in this way I am playing in the zero-sum game of volatility between indexes. What makes it a non zero-sum game is that overall I own a small piece of many different companies that, on average, make a profit. That aspect doesn't change whether I rebalance, own an index, pick stocks, etc.
Here are the variables for investing in the stock market:
1. Active (stock-picking or even managed mutual fund) vs Passive (indexing)
2. Selection of particular bond, stock or index
3. Timing the purchase of securities (methods are varied across both Active and Passive investing)
4. Timing the selling of securities (methods are varied across both Active and Passive investing)
Rebalancing is a technique for achieving 3 and 4 in a strategic way. It can even be done in conjunction with Active investing. To the extent that rebalancing my portfolio achieves higher returns than the individual indexes, someone else must be achieving lower returns on those indexes (in other words, there is ultimately someone on the other end of my transaction). 100% of the market cannot buy high and sell low.
I fully recognize that in this way I am playing in the zero-sum game of volatility between indexes. What makes it a non zero-sum game is that overall I own a small piece of many different companies that, on average, make a profit. That aspect doesn't change whether I rebalance, own an index, pick stocks, etc.
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George the original one
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Real world example: I'm pretty sure everyone would say JNJ and PG are good companies and wouldn't hesitate to invest in them. If we jumped back in time to December 1999, they were both yielding 1.5%. JNJ sold for 33.3 and PG sold for 42.96 while the Dow was 9358.83.
Jumping forward to Dec 2009, the Dow has advanced to 9358.83, an 11.4% gain. PG jumped to 59.27 for a 38% gain and the yield has more than doubled. Even better, JNJ jumped to 62.75 for an 88% gain and the yield has more than doubled.
So why do people want to buy the Dow index fund instead of picking on the components that are known to perform? Do I know which one will perform better in the future? No, but I do have high confidence that they'll outperform the Dow index and yield more than the Dow index.
Jumping forward to Dec 2009, the Dow has advanced to 9358.83, an 11.4% gain. PG jumped to 59.27 for a 38% gain and the yield has more than doubled. Even better, JNJ jumped to 62.75 for an 88% gain and the yield has more than doubled.
So why do people want to buy the Dow index fund instead of picking on the components that are known to perform? Do I know which one will perform better in the future? No, but I do have high confidence that they'll outperform the Dow index and yield more than the Dow index.
"by definition, the market is not a zero-sum game"
Whether the market is a zero-sum game depends on what you use as the baseline. Overall, the stock market keeps going up over time (as the economy grows) and it's not a zero sum game.
However, if you express returns relative to the market average, then it is a zero sum game. By the definition of an average, if someone does better than the average, then another person must necessarily do worse.
Indexers get the average return (for what they index). If a stock picker does better than the average then necessarily there must be someone (a stock picker) who does worse than the average.
Whether the market is a zero-sum game depends on what you use as the baseline. Overall, the stock market keeps going up over time (as the economy grows) and it's not a zero sum game.
However, if you express returns relative to the market average, then it is a zero sum game. By the definition of an average, if someone does better than the average, then another person must necessarily do worse.
Indexers get the average return (for what they index). If a stock picker does better than the average then necessarily there must be someone (a stock picker) who does worse than the average.
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George the original one
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Going with the notion that there is a loser and a winner on every trade (I still don't believe it's a zero-sum game, though photoguy does offer a compelling argument within the confines of a single index)... then there are lots of different trades where the winning stock picker isn't trading with another stock picker:
If a stock picker is doing better than the average, it doesn't necessarily mean that a stock picker is on the other
Since (some) indexers are rebalancing, then it isn't a stock picker who is doing worse than the average.
When the index fund has to liquidate shares because someone wants a redemption, then it isn't a stock picker who is doing worse than the average.
When the index fund has to buy a stock because it's been added to the index, then it isn't a stock picker who is doing worse than the average.
When a company repurchases shares to boost per share statistics, then it isn't a stock picker who is doing worse than the average.
When an employee sells shares they've gotten free through grants, then it isn't a stock picker who is doing worse than the average.
So why stick with the notion that only stock pickers are on the losing sides of the trades?
If anything, then the notion of NOT trading is reinforced if every trade has a winner and a loser as one could only be average in trading. Why would you want to rebalance then? You're trying to have it both ways, that it's impossible to beat an index through trading and yet trading between indexes is how you beat the market? Wouldn't an index of indexes then be the be-all, end-all of markets because the trading is a zero-sum game? If not, then we're back to stock picking and market timing.
If a stock picker is doing better than the average, it doesn't necessarily mean that a stock picker is on the other
Since (some) indexers are rebalancing, then it isn't a stock picker who is doing worse than the average.
When the index fund has to liquidate shares because someone wants a redemption, then it isn't a stock picker who is doing worse than the average.
When the index fund has to buy a stock because it's been added to the index, then it isn't a stock picker who is doing worse than the average.
When a company repurchases shares to boost per share statistics, then it isn't a stock picker who is doing worse than the average.
When an employee sells shares they've gotten free through grants, then it isn't a stock picker who is doing worse than the average.
So why stick with the notion that only stock pickers are on the losing sides of the trades?
If anything, then the notion of NOT trading is reinforced if every trade has a winner and a loser as one could only be average in trading. Why would you want to rebalance then? You're trying to have it both ways, that it's impossible to beat an index through trading and yet trading between indexes is how you beat the market? Wouldn't an index of indexes then be the be-all, end-all of markets because the trading is a zero-sum game? If not, then we're back to stock picking and market timing.
"then the notion of NOT trading is reinforced if every trade has a winner and a loser as one could only be average in trading."
Bingo. This is a very strong reason not to trade. There's lots of evidence that making excess returns by picking is very difficult (see Random Walk down Wall Street or coffeehouse investor, or one of the many studies that look at stock selection performance).
However it is possible to earn excess returns over the market. Here are two ways:
(1) you get lucky. Like the chimp in russia that picked stocks and beat 90% of fund managers. If you select stocks by chance, you have roughly a 50% shot at beating the market in a given year.
(2) you take on more risk than the average market participant. For example, if you buy value stocks (either through an index or by picking) you are generally purchasing distressed companies that may go out of business. Because they are not healthy companies they are generally priced at a discount and have a higher expected return. There's some correlation between dividend stocks and value stocks, and so people who buy dividend stocks and beat the market are likely doing so because on average they are picking riskier stocks and not necessarily because the selection skills are adding excess return.
Bingo. This is a very strong reason not to trade. There's lots of evidence that making excess returns by picking is very difficult (see Random Walk down Wall Street or coffeehouse investor, or one of the many studies that look at stock selection performance).
However it is possible to earn excess returns over the market. Here are two ways:
(1) you get lucky. Like the chimp in russia that picked stocks and beat 90% of fund managers. If you select stocks by chance, you have roughly a 50% shot at beating the market in a given year.
(2) you take on more risk than the average market participant. For example, if you buy value stocks (either through an index or by picking) you are generally purchasing distressed companies that may go out of business. Because they are not healthy companies they are generally priced at a discount and have a higher expected return. There's some correlation between dividend stocks and value stocks, and so people who buy dividend stocks and beat the market are likely doing so because on average they are picking riskier stocks and not necessarily because the selection skills are adding excess return.
@George, regarding your real examples with PG and JNJ, why do you continue to expect them to out perform the index? I don't think that statement can be made without some research into the companies, otherwise that same line of advice/thinking could easily have you buying into a bubble. Without further research into the fundamentals of the companies (and some crystal ball reading on the future of their markets), it's hard to call it a better bet than indexing.
To me buying an index is betting that the economy will keep growing. For the economy to grow, I see that we need more stuff to be done/made. One way is to increase the number of people, and the other is to increase the per-capita amount of stuff each person has/uses. So at some base level it's like betting that sex and greed will still be around. I guess I better hope ERE doesn't catch on too widely or my returns will suffer
To me buying an index is betting that the economy will keep growing. For the economy to grow, I see that we need more stuff to be done/made. One way is to increase the number of people, and the other is to increase the per-capita amount of stuff each person has/uses. So at some base level it's like betting that sex and greed will still be around. I guess I better hope ERE doesn't catch on too widely or my returns will suffer
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George the original one
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@csdx - The research required for making those choices takes about an hour per company (or less in the case of the Dow companies). While past performance is not a guarantee of future performance, it's still a pretty darn good predictor.
By the way, the economy does not need to grow for profits to be made. For instance, as long as the amount of product sold is greater than the cost of production, a profit is made.
Total profits can actually go up even when the market for the product shrinks if the company becomes more efficient when producing the product. Thus the economy can continue to grow even if more stuff is not made.
By the way, the economy does not need to grow for profits to be made. For instance, as long as the amount of product sold is greater than the cost of production, a profit is made.
Total profits can actually go up even when the market for the product shrinks if the company becomes more efficient when producing the product. Thus the economy can continue to grow even if more stuff is not made.
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miyatarama
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George, I thought I would dig this thread up so as not to go off on a tangent about the "zero-sum" question in a different thread. Photoguy said it better than me above, and that was my intent in this and the other thread.
Regarding JNJ and PG vs the Dow Jones in the last 6 months, JNJ is down 5%, PG around break even and the DJI is up 13%. Not that this is a predictor of what will happen in the next year or 20 years, but that is the performance since your post.
Regarding JNJ and PG vs the Dow Jones in the last 6 months, JNJ is down 5%, PG around break even and the DJI is up 13%. Not that this is a predictor of what will happen in the next year or 20 years, but that is the performance since your post.
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jacob
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Keep in mind that the stock market is not a closed system for nominal values. As such is not necessarily a zero-sum game to trading.
Consider
Trader1 owns a stock A at price 1 and $2 in cash = $3 in total.
Trader2 owns a stock A at price 1 and $2 in cash = $3 in total.
There are $6 of value in the system.
Trader1 sells A to Trader2 for $2.
Trader1 now has 0 units of A and $4 in cash = $4 total.
Trader2 now has 2 units of A valued at $2 and $0 in cash = $4 total.
There are now $8 of wealth in the system.
Question: Where did the extra $8-$6=$2 come from?
When the talking heads speak of "wealth-destruction" (and possibly creation) it is these $2 they're talking about. There were always $4 in cash and 2 stocks in this system. However, since we were adding transaction prices in our accounting scheme we have the illusion of creating wealth and destroying wealth simply be rearranging ownership.
Some conclusions:
1) Trading is not a zero-sum game, even relative to the index. The index is NOT "the average". It is based on some weighed sum of the last transaction prices.
2) It is easy to see how one can devise a scheme to suck cash (what ultimately matters) out of indexers by selling them overpriced/overvalued stocks and then letting the stock price crash and subsequently buying the stock back at a lower price. Then a little later you can sell this stock back again. This is how investment banks make money off of main street.
3) Whether it is possible to do this on a consistent basis is an entirely different matter. However, it is certainly possible to suck cash out of the index-investing faction by trading.
Also keep in mind that there are different ways of using indexes.
There's dollar cost averaging. "Investing" is a terrible word to use here. These are the sheep who will buy Pets.com at $800 thinking it safe because it's part of the index. They receive the full "suck".
There's also indexers who mainly consider macroeconomic trends. They only receive a partial "suck" from relatively mispriced companies while getting the average right. They will still buy when some of the companies are overvalued but not when most of them are [because that would show up on the macrolevel].
Overall, you can think of it as a giant game with a fixed amount of cash and a fixed number of stocks that are distributed between people. These are the preserved quantities (not including IPOs, offerings, credit and Fed manipulations). Wealth and index values are not real. They are derived quantities based on transactions.
Consider
Trader1 owns a stock A at price 1 and $2 in cash = $3 in total.
Trader2 owns a stock A at price 1 and $2 in cash = $3 in total.
There are $6 of value in the system.
Trader1 sells A to Trader2 for $2.
Trader1 now has 0 units of A and $4 in cash = $4 total.
Trader2 now has 2 units of A valued at $2 and $0 in cash = $4 total.
There are now $8 of wealth in the system.
Question: Where did the extra $8-$6=$2 come from?
When the talking heads speak of "wealth-destruction" (and possibly creation) it is these $2 they're talking about. There were always $4 in cash and 2 stocks in this system. However, since we were adding transaction prices in our accounting scheme we have the illusion of creating wealth and destroying wealth simply be rearranging ownership.
Some conclusions:
1) Trading is not a zero-sum game, even relative to the index. The index is NOT "the average". It is based on some weighed sum of the last transaction prices.
2) It is easy to see how one can devise a scheme to suck cash (what ultimately matters) out of indexers by selling them overpriced/overvalued stocks and then letting the stock price crash and subsequently buying the stock back at a lower price. Then a little later you can sell this stock back again. This is how investment banks make money off of main street.
3) Whether it is possible to do this on a consistent basis is an entirely different matter. However, it is certainly possible to suck cash out of the index-investing faction by trading.
Also keep in mind that there are different ways of using indexes.
There's dollar cost averaging. "Investing" is a terrible word to use here. These are the sheep who will buy Pets.com at $800 thinking it safe because it's part of the index. They receive the full "suck".
There's also indexers who mainly consider macroeconomic trends. They only receive a partial "suck" from relatively mispriced companies while getting the average right. They will still buy when some of the companies are overvalued but not when most of them are [because that would show up on the macrolevel].
Overall, you can think of it as a giant game with a fixed amount of cash and a fixed number of stocks that are distributed between people. These are the preserved quantities (not including IPOs, offerings, credit and Fed manipulations). Wealth and index values are not real. They are derived quantities based on transactions.
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George the original one
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To be fair, you should include dividends in the total return:
Closing prices Oct 6, 2010 / Apr 6, 2010
JNJ 63.21 (59.66+1.08 div) --> -4% Not good!
PG 60.87 (61.76+.964 div) --> +3% Weak
Dow 10,967.65 (12,426.75+1.365% div) --> +15% Excellent!
(Dow div calculated by dividing current average yield, as reported at http://indexarb.com/dividendYieldSorteddj.html by 2)
Or, if you're looking for income without selling any shares...
JNJ 1.08/63.21 = 1.709%
PG .964/60.87 = 1.584%
Dow = 1.547% (current avg yield converted to points and divided over original price... not sure if the Dow index would calculate it that way)
So if you picked the Dow over JNJ, you'd want about 10% more Dow to generate the same income. PG has a slight edge of only 2.4% for the same income.
Now... what happened in my regular account (as opposed to my leveraged income account) is that I bought JNJ on Aug 25, 2010 for $58.18 (incl commission) and sold on Oct 19, 2010 for $62.80 (incl commission) on the continued bad news of manufacturing problems. 7.9% profit in 2 months. With JNJ back in the 58-59 range, I'm considering buying again and anticipating a dividend increase to boost the shares regardless of the bad press.
Dow went 10060.06 to 10978.62 for that same period, 9.1%, so I didn't match it with JNJ. (My portfolio, however has continued to beat the Dow, S&P500, & NASDAQ indexes, even with their average dividends added in).
Closing prices Oct 6, 2010 / Apr 6, 2010
JNJ 63.21 (59.66+1.08 div) --> -4% Not good!
PG 60.87 (61.76+.964 div) --> +3% Weak
Dow 10,967.65 (12,426.75+1.365% div) --> +15% Excellent!
(Dow div calculated by dividing current average yield, as reported at http://indexarb.com/dividendYieldSorteddj.html by 2)
Or, if you're looking for income without selling any shares...
JNJ 1.08/63.21 = 1.709%
PG .964/60.87 = 1.584%
Dow = 1.547% (current avg yield converted to points and divided over original price... not sure if the Dow index would calculate it that way)
So if you picked the Dow over JNJ, you'd want about 10% more Dow to generate the same income. PG has a slight edge of only 2.4% for the same income.
Now... what happened in my regular account (as opposed to my leveraged income account) is that I bought JNJ on Aug 25, 2010 for $58.18 (incl commission) and sold on Oct 19, 2010 for $62.80 (incl commission) on the continued bad news of manufacturing problems. 7.9% profit in 2 months. With JNJ back in the 58-59 range, I'm considering buying again and anticipating a dividend increase to boost the shares regardless of the bad press.
Dow went 10060.06 to 10978.62 for that same period, 9.1%, so I didn't match it with JNJ. (My portfolio, however has continued to beat the Dow, S&P500, & NASDAQ indexes, even with their average dividends added in).