Index funds outperform all other investments over a reasonably long time horizon.
Even over a short time horizon while certain stocks and funds may outperform some index funds, it is not possible to pick what those stocks are in advance. While you may get lucky with an individual stock pick, you are more likely to get unlucky. The expected return on the index fund is higher.
Many intelligent, rational folks have written about this at great length with lots of charts and numbers. Instead of rehashing the same material, let me just point you at Eric Tyson’s Personal Finance for Dummies. as a good starting point.
As to why it’s not possible, the short answer is the weak efficient market hypothesis, which has been well proven by 100+ years of experience. I don’t personally hold the stronger version—that is, I believe it may be possible to beat the market given insider information—but unless you have such insider information, the expected return of an index fund is greater than any other investment you can make in the same sector.
To bring this back on topic for LessWrong, keep in mind that when evaluating investor performance, you have to avoid survivorship bias. I.e. you need to consider the class of investors as a whole, not merely the ones who got lucky and shout their performance from the rooftops, but also the much larger class of investors who underperformed the market. This alone may be enough to account for the Peter Lynch’s and Warren Buffet’s of the world.
And of course we also need to account for hindsight bias. I.e. in 2013 investing in Magellan or Berkshire Hathaway circa 1983 is a no-brainer, but how could you pick those in 1983 amongst all the others that looked equally good at the time? Magellan’s actually a really interesting case. When I first started paying attention to mutual funds about 15 years, it was the poster child for an actively managed fund that could outperform the indexes. However over the last 10 years or so, it’s significantly underperformed the S&P 500. If I had bought it back then instead of the index fund I did buy, I’d have less money today.
Many intelligent, rational folks have written about this at great length with lots of charts and numbers.
Let me remind you what we are talking about. You said “Index funds outperform all other investments over a reasonably long time horizon.” I believe this statement to be false. The general handwaving in the direction of “many intelligent, rational folks” does not look convincing.
Perhaps you could expand that statement a bit? What exactly do you call index fund, what are all other investments and what’s a reasonably long time horizon? Does the concept of risk enter this claim at all?
let me just point you...
Can we move the discussion a couple of levels higher? I am reasonably well-acquainted with finance and not much interested in explanations for dummies.
the short answer is the weak efficient market hypothesis, which has been well proven by 100+ years of experience.
First, I do not believe EMH, even in the weak form, has been “proven”. I also do not think it is correct (at least in a falsifiable form—you can make it unfalsifiable easily enough by saying that the “long term” isn’t here yet).
Second, weak EMH claims that it’s not possible to predict future prices solely from past prices. Your claim—“it is not possible to pick what those stocks are in advance”—looks like semi-strong EMH and that one is pretty certain to be wrong.
Oh, and I am well aware of both survivorship bias and hindsight bias.
A few months ago I proposed writing a book that would answer all your questions in detail, but there wasn’t enough interest to make it worth doing. There are many good books out there already that address these issues. I get that “Dummies” books are too low-status for you. I’ll try to dig up some equally well-written, correct references that are higher status and explain things like “what an index fund is?” “what’s a reasonably long time horizon?”, and “what other investments are possible?” For starters, I’ve heard good things about Suze Orman’s books, though I haven’t read them myself.
Your formulation of the weak efficient market hypothesis is incorrect. The weak EMH is not based solely on past prices, but on all publicly available information.
No, it’s not an issue of status. They are too simplified and do not reflect reality to the degree that I consider necessary. It’s like telling a competitive athlete “Oh, physical fitness is solved, just go to the gym”.
I don’t want references, anyway. You are claiming that investing is solved. You are saying that the only correct investment is into an index fund. Well then, tell me what’s an index fund. Is it just any passive diversified investment? There are a great many indices, are all of them equally good? How diversified is diversified enough? Is “long term” a year? five year? ten? fifty? Should commodities be part of a well-diversified portfolio? should currency? real estate? sovereign bonds? volatility?
Your formulation of the weak efficient market hypothesis is incorrect. The weak EMH is not based solely on past prices, but on all publicly available information.
Let’s see… Wikipedia: “In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. … Share prices exhibit no serial dependencies, meaning that there are no “patterns” to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk.”
Investopedia: “The weak-form EMH implies that the market is efficient, reflecting all market information. … The semi-strong form EMH implies that the market is efficient, reflecting all publicly available information.”
Your wikipedia quote is badly out of context. The article as a whole does not agree with you. A better summary of wikipedia’s definition is given right at the start of the article:
There are three major versions of the hypothesis: “weak”, “semi-strong”, and “strong”. The weak-form EMH claims that prices on traded assets (e.g., stocks, bonds, or property) already reflect all past publicly available information. The semi-strong-form EMH claims both that prices reflect all publicly available information and that prices instantly change to reflect new public information. The strong-form EMH additionally claims that prices instantly reflect even hidden or “insider” information.
Your investopedia quote is less out of context, but you still omit a key component of the semistrong hypothesis: that prices adjust quickly. Personally I neither agree nor disagree that prices adjust quickly. I think the wikipedia version is what most people in finance and economics understand as the weak efficient market hypothesis. However if you want to redefine these terms so only the semistrong hypothesis includes all publicly available information, then fine. I would agree with that part of the semistrong hypothesis.
Now on to your specific question. A few stinkers here and there aside, The Dummies Books are incredibly well written and an excellent introduction to most topics. The ones by Eric Tyson on investing and finance are definitely among the best, and I highly recommend them to you if your goal is to increase your wealth and income.
But if you really don’t like the Dummies books, many other references are available. I consulted some folks who spend way more time and energy thinking about this than I do, and here are some sources they recommend:
Bogle’s Common Sense on Mutual Funds is “page after page of raw data from Vanguard Research and others. It’s an onslaught of irrefutable evidence of the superiority of low-cost index funds”
These answer all your questions and more. I’m not going to write my own 700 page tome rehashing what’s readily available elsewhere. You can dispute or ignore the evidence if you like, but you’ll just be setting yourself up to be money pumped by hucksters in fancy suits who are ready, willing, and able to take your money.
Can you provide an unfolded argument as to why index funds are the right investment vehicles for everyone on this planet?
Index funds outperform all other investments over a reasonably long time horizon.
Even over a short time horizon while certain stocks and funds may outperform some index funds, it is not possible to pick what those stocks are in advance. While you may get lucky with an individual stock pick, you are more likely to get unlucky. The expected return on the index fund is higher.
Really? Surely you will be able to provide data to support this rather amazing claim. It certainly does not look true to me.
Why is that? How do you know what’s possible and what’s not?
Many intelligent, rational folks have written about this at great length with lots of charts and numbers. Instead of rehashing the same material, let me just point you at Eric Tyson’s Personal Finance for Dummies. as a good starting point.
As to why it’s not possible, the short answer is the weak efficient market hypothesis, which has been well proven by 100+ years of experience. I don’t personally hold the stronger version—that is, I believe it may be possible to beat the market given insider information—but unless you have such insider information, the expected return of an index fund is greater than any other investment you can make in the same sector.
To bring this back on topic for LessWrong, keep in mind that when evaluating investor performance, you have to avoid survivorship bias. I.e. you need to consider the class of investors as a whole, not merely the ones who got lucky and shout their performance from the rooftops, but also the much larger class of investors who underperformed the market. This alone may be enough to account for the Peter Lynch’s and Warren Buffet’s of the world.
And of course we also need to account for hindsight bias. I.e. in 2013 investing in Magellan or Berkshire Hathaway circa 1983 is a no-brainer, but how could you pick those in 1983 amongst all the others that looked equally good at the time? Magellan’s actually a really interesting case. When I first started paying attention to mutual funds about 15 years, it was the poster child for an actively managed fund that could outperform the indexes. However over the last 10 years or so, it’s significantly underperformed the S&P 500. If I had bought it back then instead of the index fund I did buy, I’d have less money today.
Let me remind you what we are talking about. You said “Index funds outperform all other investments over a reasonably long time horizon.” I believe this statement to be false. The general handwaving in the direction of “many intelligent, rational folks” does not look convincing.
Perhaps you could expand that statement a bit? What exactly do you call index fund, what are all other investments and what’s a reasonably long time horizon? Does the concept of risk enter this claim at all?
Can we move the discussion a couple of levels higher? I am reasonably well-acquainted with finance and not much interested in explanations for dummies.
First, I do not believe EMH, even in the weak form, has been “proven”. I also do not think it is correct (at least in a falsifiable form—you can make it unfalsifiable easily enough by saying that the “long term” isn’t here yet).
Second, weak EMH claims that it’s not possible to predict future prices solely from past prices. Your claim—“it is not possible to pick what those stocks are in advance”—looks like semi-strong EMH and that one is pretty certain to be wrong.
Oh, and I am well aware of both survivorship bias and hindsight bias.
A few months ago I proposed writing a book that would answer all your questions in detail, but there wasn’t enough interest to make it worth doing. There are many good books out there already that address these issues. I get that “Dummies” books are too low-status for you. I’ll try to dig up some equally well-written, correct references that are higher status and explain things like “what an index fund is?” “what’s a reasonably long time horizon?”, and “what other investments are possible?” For starters, I’ve heard good things about Suze Orman’s books, though I haven’t read them myself.
Your formulation of the weak efficient market hypothesis is incorrect. The weak EMH is not based solely on past prices, but on all publicly available information.
No, it’s not an issue of status. They are too simplified and do not reflect reality to the degree that I consider necessary. It’s like telling a competitive athlete “Oh, physical fitness is solved, just go to the gym”.
I don’t want references, anyway. You are claiming that investing is solved. You are saying that the only correct investment is into an index fund. Well then, tell me what’s an index fund. Is it just any passive diversified investment? There are a great many indices, are all of them equally good? How diversified is diversified enough? Is “long term” a year? five year? ten? fifty? Should commodities be part of a well-diversified portfolio? should currency? real estate? sovereign bonds? volatility?
Let’s see… Wikipedia: “In weak-form efficiency, future prices cannot be predicted by analyzing prices from the past. … Share prices exhibit no serial dependencies, meaning that there are no “patterns” to asset prices. This implies that future price movements are determined entirely by information not contained in the price series. Hence, prices must follow a random walk.”
Investopedia: “The weak-form EMH implies that the market is efficient, reflecting all market information. … The semi-strong form EMH implies that the market is efficient, reflecting all publicly available information.”
Your wikipedia quote is badly out of context. The article as a whole does not agree with you. A better summary of wikipedia’s definition is given right at the start of the article:
Your investopedia quote is less out of context, but you still omit a key component of the semistrong hypothesis: that prices adjust quickly. Personally I neither agree nor disagree that prices adjust quickly. I think the wikipedia version is what most people in finance and economics understand as the weak efficient market hypothesis. However if you want to redefine these terms so only the semistrong hypothesis includes all publicly available information, then fine. I would agree with that part of the semistrong hypothesis.
Now on to your specific question. A few stinkers here and there aside, The Dummies Books are incredibly well written and an excellent introduction to most topics. The ones by Eric Tyson on investing and finance are definitely among the best, and I highly recommend them to you if your goal is to increase your wealth and income.
But if you really don’t like the Dummies books, many other references are available. I consulted some folks who spend way more time and energy thinking about this than I do, and here are some sources they recommend:
Rick Ferri’s columns at Forbes, specifically
Mutual Fund Managers Fall Short Again
Index Fund Portfolios Reign Superior
5 Lies About Index Funds
Bogle’s Common Sense on Mutual Funds is “page after page of raw data from Vanguard Research and others. It’s an onslaught of irrefutable evidence of the superiority of low-cost index funds”
The Coffeehouse Investor
The Elements of Investing
Passive Investing: The Evidence the Fund Management Industry Would Prefer You Not to See
These answer all your questions and more. I’m not going to write my own 700 page tome rehashing what’s readily available elsewhere. You can dispute or ignore the evidence if you like, but you’ll just be setting yourself up to be money pumped by hucksters in fancy suits who are ready, willing, and able to take your money.
This is pointless. We are speaking at different levels right past each other.