I feel like it is useful to mention that because of efficient markets (which implies assets are “fairly priced”) and the benefits of diversification (lower risk), it’s almost always better to buy a low fee mutual fund than any particular stocks or bonds. In particular, Index Funds merely keep a portfolio which tracks a broad market index. These often have very low operating costs, so they are a pretty good way to invest. You can buy these as ETFs, or you can buy them through something like Vanguard.
I think some more detail is called for here too, on mutual funds vs ETFs:
When you buy part of a mutual fund, you are giving your money to professional fund managers to invest for you. Mutual funds are often devoted to a single investment strategy (value, growth, index...) or a specific business sector (energy, health care, high technology), or even a specific kind of investment vehicle (stocks, bonds, commodities...).
You pay the fund managers a small percentage of your assets each year (the number you want to look for here is the “expense ratio”). Something on the order of 1%. Sometimes you also pay a fee when you put your money in or when you take it out; funds that do this are called “load” funds, funds that don’t are called “no-load” funds.
When you buy into an ordinary mutual fund, it’s a similar process to having a savings account: you send the fund money, they use it to buy financial investments. Mutual funds are generally sold and redeemed at par; each dollar you invest in the fund buys a dollar’s worth of investments. When you cash out, each dollar of investments they sell is a dollar that goes back into your pocket.
ETFs are similar to stocks. When you buy shares of an ETF, you’re buying a piece of the fund from another investor, not putting money into the fund directly. ETFs are often traded at a discount to net asset value. In other words, you pay less than the market price of the investments the fund owns. But that doesn’t necessarily make it a better deal, because of course when you want to cash out, you will probably be selling below par as well.
This is very, very good advice, and is worth understanding in more detail. My favorite article on index funds is this one, which angles its discussion of index funds around the unusually good investment advice many Google employees received when they became millionaires after the IPO in 2004. My second-favorite is this one from Overcoming Bias (LessWrong’s sister site).
Investing in index funds should be one of the big instrumental wins of rationality. It requires the ability to defend against overconfidence bias, the ability to defend against the wily marketing of financial advisers who don’t have your best interests in mind, enough understanding of economics to comprehend what Yudkowsky called anti-inductive markets, and some not-especially-common knowledge about what investment options are available.
Perhaps you are still being insufficiently cynical. Yes, index funds outperform managed funds, and investment professionals get rich off their fees and their media, not because they personally know how to beat the market.
But if I am to believe the analyses poured out daily at zerohedge.com, volume in the US stock market is now dominated by a few large institutional investors, looking for a place to put the free money they get by frontrunning the Fed’s purchases of Treasuries, and this is a political choice: US federal debt is being monetized, and the US dollar debased, but since the bankers are all buying equities with their play money, the stock market is being driven up, which creates the illusion that growth is happening somewhere in the economy. :-)
I don’t know how much of that is true, but my real point is that a revival of the financial crisis (this time because of sovereign debt rather than corporate debt) could put stocks into a zero-growth doldrum—of frequent crashes and long-term decline in value—for a decade or more. It’s happened before, if it happens again then even index funds will be losing value, and it is precisely the sort of thing that would happen after the comprehensive discrediting of an overgrown and politically connected financial sector. People would go back to seeing stocks as a game of risk for the rich, rather than a happy place to put their retirement savings.
The result of making everyone an investor is that when everyone loses their money, they become a mob and burn the casino down, and run the people who were connected with it out of town. That hasn’t happened in the US yet, but you can be sure that more than a few politicians are readying a line of populist nationalist outrage, for the day when the big banks become even more politically radioactive than they are now. Politics might even come down to who can mount the more convincing attack on the banks, the left or the right; and I would guess that the political red line will be the bankruptcy of cities and states.
You can already see the basic choice in Europe: Ireland, or Iceland. Ireland, so far, is agreeing to pay off the debts of its failed banks with taxpayer money, and the IMF has come in to supervise the process. Iceland’s people said no way will we do that (even though they were happy to partake of the boom while it was still on), and had a small revolution in which they disowned responsibility for the actions, and the debts, of their financier class. It’s part of how they ended up playing host to an entity as subversive as Wikileaks for a while.
So what I’m saying—what I’m predicting—is that you will see that same dilemma being faced at all levels in the US as the debt pyramid implodes, and in a country as big and diverse as the US, there will be cities and regions who take the radical option. Local politics will trump external economics, and they will disown or rewrite the agreements which would otherwise leave them in debt to outsiders for a generation. In some places, this will manifest as a reversion to the traditional local economy. In others, there might be some new thinking—green futurism or digital fabricators might be touted as the way forward. In such a turbulent context, even traditionally superior insights (“invest in index funds”) may cease to apply, as the system undergoes a bigger change than most had imagined possible.
I’ve been worried about index funds for a while. They’re predicated on the assumption that someone is doing to the research while you free ride on their work.
So—if I understand you correctly—you’re saying we have a market with some actors who are buying at higher-than-justifiable prices, and the rest of the market lacks the liquidity to short-sell, adjusting the prices downward? That doesn’t match my understanding of these things...but my lack of understanding of these things is part of why I delegate my decision-making to index funds, rather than trying to time or beat the market.
I feel like it is useful to mention that because of efficient markets (which implies assets are “fairly priced”) and the benefits of diversification (lower risk), it’s almost always better to buy a low fee mutual fund than any particular stocks or bonds. In particular, Index Funds merely keep a portfolio which tracks a broad market index. These often have very low operating costs, so they are a pretty good way to invest. You can buy these as ETFs, or you can buy them through something like Vanguard.
I think some more detail is called for here too, on mutual funds vs ETFs:
When you buy part of a mutual fund, you are giving your money to professional fund managers to invest for you. Mutual funds are often devoted to a single investment strategy (value, growth, index...) or a specific business sector (energy, health care, high technology), or even a specific kind of investment vehicle (stocks, bonds, commodities...).
You pay the fund managers a small percentage of your assets each year (the number you want to look for here is the “expense ratio”). Something on the order of 1%. Sometimes you also pay a fee when you put your money in or when you take it out; funds that do this are called “load” funds, funds that don’t are called “no-load” funds.
When you buy into an ordinary mutual fund, it’s a similar process to having a savings account: you send the fund money, they use it to buy financial investments. Mutual funds are generally sold and redeemed at par; each dollar you invest in the fund buys a dollar’s worth of investments. When you cash out, each dollar of investments they sell is a dollar that goes back into your pocket.
ETFs are similar to stocks. When you buy shares of an ETF, you’re buying a piece of the fund from another investor, not putting money into the fund directly. ETFs are often traded at a discount to net asset value. In other words, you pay less than the market price of the investments the fund owns. But that doesn’t necessarily make it a better deal, because of course when you want to cash out, you will probably be selling below par as well.
This is very, very good advice, and is worth understanding in more detail. My favorite article on index funds is this one, which angles its discussion of index funds around the unusually good investment advice many Google employees received when they became millionaires after the IPO in 2004. My second-favorite is this one from Overcoming Bias (LessWrong’s sister site).
Investing in index funds should be one of the big instrumental wins of rationality. It requires the ability to defend against overconfidence bias, the ability to defend against the wily marketing of financial advisers who don’t have your best interests in mind, enough understanding of economics to comprehend what Yudkowsky called anti-inductive markets, and some not-especially-common knowledge about what investment options are available.
Perhaps you are still being insufficiently cynical. Yes, index funds outperform managed funds, and investment professionals get rich off their fees and their media, not because they personally know how to beat the market.
But if I am to believe the analyses poured out daily at zerohedge.com, volume in the US stock market is now dominated by a few large institutional investors, looking for a place to put the free money they get by frontrunning the Fed’s purchases of Treasuries, and this is a political choice: US federal debt is being monetized, and the US dollar debased, but since the bankers are all buying equities with their play money, the stock market is being driven up, which creates the illusion that growth is happening somewhere in the economy. :-)
I don’t know how much of that is true, but my real point is that a revival of the financial crisis (this time because of sovereign debt rather than corporate debt) could put stocks into a zero-growth doldrum—of frequent crashes and long-term decline in value—for a decade or more. It’s happened before, if it happens again then even index funds will be losing value, and it is precisely the sort of thing that would happen after the comprehensive discrediting of an overgrown and politically connected financial sector. People would go back to seeing stocks as a game of risk for the rich, rather than a happy place to put their retirement savings.
The result of making everyone an investor is that when everyone loses their money, they become a mob and burn the casino down, and run the people who were connected with it out of town. That hasn’t happened in the US yet, but you can be sure that more than a few politicians are readying a line of populist nationalist outrage, for the day when the big banks become even more politically radioactive than they are now. Politics might even come down to who can mount the more convincing attack on the banks, the left or the right; and I would guess that the political red line will be the bankruptcy of cities and states.
You can already see the basic choice in Europe: Ireland, or Iceland. Ireland, so far, is agreeing to pay off the debts of its failed banks with taxpayer money, and the IMF has come in to supervise the process. Iceland’s people said no way will we do that (even though they were happy to partake of the boom while it was still on), and had a small revolution in which they disowned responsibility for the actions, and the debts, of their financier class. It’s part of how they ended up playing host to an entity as subversive as Wikileaks for a while.
So what I’m saying—what I’m predicting—is that you will see that same dilemma being faced at all levels in the US as the debt pyramid implodes, and in a country as big and diverse as the US, there will be cities and regions who take the radical option. Local politics will trump external economics, and they will disown or rewrite the agreements which would otherwise leave them in debt to outsiders for a generation. In some places, this will manifest as a reversion to the traditional local economy. In others, there might be some new thinking—green futurism or digital fabricators might be touted as the way forward. In such a turbulent context, even traditionally superior insights (“invest in index funds”) may cease to apply, as the system undergoes a bigger change than most had imagined possible.
People who claim that the “dollar is being debased”, don’t know the basic facts. Inflation has actually been significantly lower than typical, the last couple of years. See for example http://investingforaliving.files.wordpress.com/2010/11/cpi-us-vs-japan.png
Market based inflation expectations (TIPS spreads) also indicate lower than typical expected inflation.
I’ve been worried about index funds for a while. They’re predicated on the assumption that someone is doing to the research while you free ride on their work.
Are enough people doing the research?
Absolutely. You can not beat that market. There is too much money involved and more than enough people interested.
Yep.
So—if I understand you correctly—you’re saying we have a market with some actors who are buying at higher-than-justifiable prices, and the rest of the market lacks the liquidity to short-sell, adjusting the prices downward? That doesn’t match my understanding of these things...but my lack of understanding of these things is part of why I delegate my decision-making to index funds, rather than trying to time or beat the market.