When people talk about the efficient market hypothesis, the usual takeaway is that you should invest in index funds. The idea with the efficient market hypothesis is that stocks are already close to being priced perfectly, so it doesn’t make sense to pay someone to pick stocks for you.
However, there’s another possible takeaway that I haven’t ever heard: Because stocks are already close to being priced perfectly, it doesn’t matter which stocks you buy. Even if you’re relatively uninformed about the markets, you might as well play the market and buy stocks at random, or based on vague intuitions, or whatever. Because stocks are close to being priced perfectly, on average you will do about as well as the market does.
Some arguments in favor of index funds:
By buying lots of stocks, your portfolio is less vulnerable to fluctuations in the price of particular stocks.
Save money on trading fees?
Save time and attention.
Some arguments in favor of buying individual stocks:
Buying individual stocks could act as rationality training, getting you in the habit of betting your beliefs and testing your predictions against reality.
It’s entertaining.
If you have private information or insights that the market hasn’t priced in (i.e. the efficient market hypothesis isn’t completely true), you could beat an index fund. (Note that the efficient market hypothesis is a self-refuting prophecy.)
Due to the “no one ever got fired for buying IBM” principle, managing other peoples’ money arguably incentivizes herd behavior over the long term. That suggests that markets could provide financial rewards for patient contrarians investing their own money, if most money being invested is other peoples’ money.
Thoughts? Note: I don’t think I would want individual stocks to comprise more than 10% of my portfolio.
(Disclaimer: I’m a financial professional, but I’m not anyone’s investment advisor, much less yours.)
You mention diversity as an advantage because it reduces your risk, but this framing is missing the crucial point that you can transmute a portfolio that’s 0.5x as risky as your baseline to one that returns twice as much as your baseline. (Wei_Dai mentions this, but obliquely.) The trick is to use leverage, which is not as hard to get (or as expensive, or as complicated) as you think.
To be explicit about it: if you increase the per-dollar riskiness of your portfolio without increasing the per-dollar expected value, then after you leverage it down until it’s at the optimal level of risk for your utility function (which you were going to do, right?), you will have lower expected returns.
The relevant question is “how much lower?” (which is precisely to say “how much does it increase your per-dollar risk?”), which I answer in my response to Wei_Dai (nephew to this). The answer turns out to be “very little”, but in order to get there, you have to be asking the right question first.
Another important takeaway from this observation is that there is no point in rebalancing a portfolio of stocks with any regularity, which makes hand-made stock portfolios almost as efficient (in hassle and expenses) as index ETFs. Rebalancing is only useful to keep it reasonably diversified and to get rid of stocks that risk reduced liquidity. This is how index ETFs fall short of the mark of what makes them a good idea: a better ETF should stop following a distribution of an index and only use an index as a catalogue of liquid stocks. Given how low TERs get in large funds, this doesn’t really matter, and accountability/regulation is easier with keeping to the distribution from an index, but smaller funds could get lower TERs by following this strategy while retaining all benefits (except the crucial marketing benefit of being able to demonstrate how its performance keeps up with an index). For the same reason, cap weighted index ETFs are worse by being less diversified (which actually makes some index ETFs that hold a lot of stocks a bad choice), while equal-weight ETFs are worse by rebalancing all the time (to the point where they can’t get a low TER at all).
Aside from that, a very low TER index (that’s not too unbalanced due to cap-weighting) is more diversified than a hand-made portfolio with 30 stocks, without losing expected money, so one can use a bit more leverage with it to get a similar risk profile with a bit more expected money (leveraged ETFs are hard to judge, but one could make a portfolio that holds some non-leveraged index ETFs in a role similar to bonds in a conservative allocation, i.e. as lower-risk part, and some self-contained leveraged things in the rest of it).
There might also be tax benefits to how an index handles dividends, getting more expected money than the same stocks (not sure if this happens in the US, or how it depends on tax brackets). Similarly, stocks that pay no dividends might be better for a hand-made portfolio (and there is less hassle with receiving/reinvesting dividends or having to personally declare taxes for them if they are not automatically withheld higher in the chain in your jurisdiction).
you could beat an index fund
(Replying to the phrase, not its apparent meaning in context.) All liquid stocks give the same expected money as each other, and the same as all indices composed of them. Different distributions of stocks will have different actual outcomes, some greater than others. So of course one can beat an index in an actual outcome (this will happen exactly half the time). A single leveraged stock gives more expected money than any non-leveraged index fund (or any non-leveraged stock), yet makes a very poor investment, which illustrates that beating an index in expectation is also not what anyone’s after.
Humans are very bad at making random decisions and the policy that you advocate has little to do with randomly buying stocks.
There’s zero sum competition between traders (actually it’s a bit negative sum, given that trading fees are involved). Some of those traders are hedge funds which complex computer models and highly payed analysts. Those hedge funds can make some money by taking the opposing trade from dumb market participants.
If you believe you have better knowledge about what the price of a stock should be then the hedge funds because you have private information/insights, then you might profit from entering the market. If you think you have worse information then them, you are likely on average losing money to them.
It’s worth noting that purely random decisions might be a bit better then index funds as index funds have to buy a lot of stock in predictable times four times each year and there needs to be a market maker that sells them the stocks and that can make a little bit of profit for being the market maker.
Because stocks are close to being priced perfectly, on average you will do about as well as the market does.
I think that’s right, but the downside is that your portfolio will have greater volatility/risk for the same average performance, so you’ll no longer be on the efficient frontier. However I don’t have a good intuition about how costly this actually is in practice, if you only play with 10% of your portfolio.
If you have private information or insights that the market hasn’t priced in (i.e. the efficient market hypothesis isn’t completely true), you could beat an index fund.
I think the problem with this argument is that yes you can beat an index fund if you have private information or insights, but you also need to be no more biased than the people you’re trading against, but they may actually be a lot less biased than you are, at least as far as stock trading is concerned, because they’re professionals (hence selected for having less bias) and they’ve had a lot more chances to practice.
(I personally bought some individual stocks when I was younger for reasons similar to ones you list, but they mostly underperformed the market so I stopped.)
I don’t have a good intuition about how costly this actually is in practice, if you only play with 10% of your portfolio.
tl;dr extremely little.
Here’s some numbers I made up:
Let the market’s single common factor explain 90% of the variance of each stock.
Let the remaining 10%s be idiosyncratic and independent.
Let stocks have equal volatility (and let all risk be described by volatility).
Now compare a portfolio that’s $100 of each of a hundred stocks with one that’s $90 of each of a hundred plus $1k of another stock. (I’ll model each stock as 0.75 times the market factor plus 0.25 a same-variance idiosyncratic factor.) Compared to a $10k single-stock portfolio...
the equal-weighted portfolio has σ like √(75∗100)2+252∗100√75002+25002≈0.9492
the shot-caller’s portfolio has σ like √(81∗100+900)2+22.52∗100+2502√75002+25002=0.9496
...for an increase in σ of 4.5 basis points. So, pretty negligible.
Even if the market’s single factor explains only half of the variance of each stock, the increased risk of the shot-caller’s portfolio is just 40 basis points (0.7135 vs 0.7106). In the extreme case where stocks are uncorrelated, the increased risk is +34.5%, though I think that that’s unrealistically generous to the diversification strategy.
Since an increase in volatility-per-dollar of x basis points means that you give up x basis points of your expected returns, I’m going to say that this effect is negligible in the “10% of portfolio” setting.
When people talk about the efficient market hypothesis, the usual takeaway is that you should invest in index funds. The idea with the efficient market hypothesis is that stocks are already close to being priced perfectly, so it doesn’t make sense to pay someone to pick stocks for you.
However, there’s another possible takeaway that I haven’t ever heard: Because stocks are already close to being priced perfectly, it doesn’t matter which stocks you buy. Even if you’re relatively uninformed about the markets, you might as well play the market and buy stocks at random, or based on vague intuitions, or whatever. Because stocks are close to being priced perfectly, on average you will do about as well as the market does.
Some arguments in favor of index funds:
By buying lots of stocks, your portfolio is less vulnerable to fluctuations in the price of particular stocks.
Save money on trading fees?
Save time and attention.
Some arguments in favor of buying individual stocks:
Buying individual stocks could act as rationality training, getting you in the habit of betting your beliefs and testing your predictions against reality.
It’s entertaining.
If you have private information or insights that the market hasn’t priced in (i.e. the efficient market hypothesis isn’t completely true), you could beat an index fund. (Note that the efficient market hypothesis is a self-refuting prophecy.)
Due to the “no one ever got fired for buying IBM” principle, managing other peoples’ money arguably incentivizes herd behavior over the long term. That suggests that markets could provide financial rewards for patient contrarians investing their own money, if most money being invested is other peoples’ money.
Thoughts? Note: I don’t think I would want individual stocks to comprise more than 10% of my portfolio.
(Disclaimer: I’m a financial professional, but I’m not anyone’s investment advisor, much less yours.)
You mention diversity as an advantage because it reduces your risk, but this framing is missing the crucial point that you can transmute a portfolio that’s 0.5x as risky as your baseline to one that returns twice as much as your baseline. (Wei_Dai mentions this, but obliquely.) The trick is to use leverage, which is not as hard to get (or as expensive, or as complicated) as you think.
To be explicit about it: if you increase the per-dollar riskiness of your portfolio without increasing the per-dollar expected value, then after you leverage it down until it’s at the optimal level of risk for your utility function (which you were going to do, right?), you will have lower expected returns.
The relevant question is “how much lower?” (which is precisely to say “how much does it increase your per-dollar risk?”), which I answer in my response to Wei_Dai (nephew to this). The answer turns out to be “very little”, but in order to get there, you have to be asking the right question first.
Another important takeaway from this observation is that there is no point in rebalancing a portfolio of stocks with any regularity, which makes hand-made stock portfolios almost as efficient (in hassle and expenses) as index ETFs. Rebalancing is only useful to keep it reasonably diversified and to get rid of stocks that risk reduced liquidity. This is how index ETFs fall short of the mark of what makes them a good idea: a better ETF should stop following a distribution of an index and only use an index as a catalogue of liquid stocks. Given how low TERs get in large funds, this doesn’t really matter, and accountability/regulation is easier with keeping to the distribution from an index, but smaller funds could get lower TERs by following this strategy while retaining all benefits (except the crucial marketing benefit of being able to demonstrate how its performance keeps up with an index). For the same reason, cap weighted index ETFs are worse by being less diversified (which actually makes some index ETFs that hold a lot of stocks a bad choice), while equal-weight ETFs are worse by rebalancing all the time (to the point where they can’t get a low TER at all).
Aside from that, a very low TER index (that’s not too unbalanced due to cap-weighting) is more diversified than a hand-made portfolio with 30 stocks, without losing expected money, so one can use a bit more leverage with it to get a similar risk profile with a bit more expected money (leveraged ETFs are hard to judge, but one could make a portfolio that holds some non-leveraged index ETFs in a role similar to bonds in a conservative allocation, i.e. as lower-risk part, and some self-contained leveraged things in the rest of it).
There might also be tax benefits to how an index handles dividends, getting more expected money than the same stocks (not sure if this happens in the US, or how it depends on tax brackets). Similarly, stocks that pay no dividends might be better for a hand-made portfolio (and there is less hassle with receiving/reinvesting dividends or having to personally declare taxes for them if they are not automatically withheld higher in the chain in your jurisdiction).
(Replying to the phrase, not its apparent meaning in context.) All liquid stocks give the same expected money as each other, and the same as all indices composed of them. Different distributions of stocks will have different actual outcomes, some greater than others. So of course one can beat an index in an actual outcome (this will happen exactly half the time). A single leveraged stock gives more expected money than any non-leveraged index fund (or any non-leveraged stock), yet makes a very poor investment, which illustrates that beating an index in expectation is also not what anyone’s after.
Humans are very bad at making random decisions and the policy that you advocate has little to do with randomly buying stocks.
There’s zero sum competition between traders (actually it’s a bit negative sum, given that trading fees are involved). Some of those traders are hedge funds which complex computer models and highly payed analysts. Those hedge funds can make some money by taking the opposing trade from dumb market participants.
If you believe you have better knowledge about what the price of a stock should be then the hedge funds because you have private information/insights, then you might profit from entering the market. If you think you have worse information then them, you are likely on average losing money to them.
It’s worth noting that purely random decisions might be a bit better then index funds as index funds have to buy a lot of stock in predictable times four times each year and there needs to be a market maker that sells them the stocks and that can make a little bit of profit for being the market maker.
I think that’s right, but the downside is that your portfolio will have greater volatility/risk for the same average performance, so you’ll no longer be on the efficient frontier. However I don’t have a good intuition about how costly this actually is in practice, if you only play with 10% of your portfolio.
I think the problem with this argument is that yes you can beat an index fund if you have private information or insights, but you also need to be no more biased than the people you’re trading against, but they may actually be a lot less biased than you are, at least as far as stock trading is concerned, because they’re professionals (hence selected for having less bias) and they’ve had a lot more chances to practice.
(I personally bought some individual stocks when I was younger for reasons similar to ones you list, but they mostly underperformed the market so I stopped.)
tl;dr extremely little.
Here’s some numbers I made up:
Let the market’s single common factor explain 90% of the variance of each stock.
Let the remaining 10%s be idiosyncratic and independent.
Let stocks have equal volatility (and let all risk be described by volatility).
Now compare a portfolio that’s $100 of each of a hundred stocks with one that’s $90 of each of a hundred plus $1k of another stock. (I’ll model each stock as 0.75 times the market factor plus 0.25 a same-variance idiosyncratic factor.) Compared to a $10k single-stock portfolio...
the equal-weighted portfolio has σ like √(75∗100)2+252∗100√75002+25002≈0.9492
the shot-caller’s portfolio has σ like √(81∗100+900)2+22.52∗100+2502√75002+25002=0.9496
...for an increase in σ of 4.5 basis points. So, pretty negligible.
Even if the market’s single factor explains only half of the variance of each stock, the increased risk of the shot-caller’s portfolio is just 40 basis points (0.7135 vs 0.7106). In the extreme case where stocks are uncorrelated, the increased risk is +34.5%, though I think that that’s unrealistically generous to the diversification strategy.
Since an increase in volatility-per-dollar of x basis points means that you give up x basis points of your expected returns, I’m going to say that this effect is negligible in the “10% of portfolio” setting.