Most of the personal-finance-advice industry is parasitic and/or self-deluded
True.
...and it’s generally agreed on by economic theory and experimental measurement that an index fund will deliver the best returns you can get without huge amounts of effort.
Not true. Or at least much more complicated.
The first problem (minor) is with the concept of an “index fund”. Most people read it as an S&P500 index fund, that is, a fund that passively invests into US large-cap equity. At this point it’s reasonable to ask, why US large-cap equity? Why not a US equity + US bonds passive fund? Why not add European stocks or bonds? Why not add emerging markets? Why not add commodities or real estate? The answer to what kind of a mix of asset classes do you want to hold is… complicated.
The second problem (major) is with the concept of “best return”. It’s pretty meaningless to talk about best returns without involving uncertainty, volatility, and individual risk tolerance. I don’t think asserting that the risk-return profile of the S&P500 (again, US large cap equity) is just perfect for everyone is a defensible position.
Finance is a hard problem. There’s no easy universal answer to “what should I do with my money”—the answer is it depends. Sure, compared to investing in S&P500 there are a lot of worse things you can do—but that doesn’t mean buying the Vanguard index fund is the optimal choice.
Finance is a hard problem. There’s no easy universal answer to “what should I do with my money”—the answer is it depends. Sure, compared to investing in S&P500 there are a lot of worse things you can do—but that doesn’t mean buying the Vanguard index fund is the optimal choice.
The argument is that the added value of the “it depends” answer doesn’t pay for the additional cost in calculating what it depends on. With perfect knowledge, not everyone would go for the Vanguard index fund, but that’s not the situation we have, and with imperfect knowledge it’s a solid choice for nearly every situation. Having it as a default choice (that you possibly move away from after doing research) is much better than not having it as a default choice.
More than a hundred years of academic research points to index funds as an investor’s best investment.
They have several recommendations by Nobel laureates on that page, and have a index of papers here. As a general comment, the Efficient Markets Hypothesis is relevant: unless your money manager is insider trading (and if you, as a customer, know about that, then probably so does the SEC), you should not expect them to do significantly better than the market as a whole. The EMH has holes; Buffet has famously outperformed the market and index funds by dint of superior rationality, but most people are not qualified to judge which money managers are rational enough to be better than index funds.
You don’t think they might be a bit, um… biased? :-)
Marketing BS is not evidence.
And before we get into the EMH mess (by the way, how strong a version are you arguing for?) let me ask you, which market? There are a whole bunch of different markets—what makes large-cap US equity special?
You don’t think they might be a bit, um… biased? :-)
Possibly. I linked them because they’re convenient. I know enough economics that index funds being optimal for investors without special knowledge is obvious to me; you can find more on wikipedia or Motley Fool.
let me ask you, which market? There are a whole bunch of different markets—what makes large-cap US equity special?
I personally recommend VTSMX for investors in the US, because there are a handful of reasons to prefer investing in domestic funds (especially if you live in the US). There is advice out there targeted at low-load funds if you’re interested in putting more thought into the choice. If you live elsewhere, there may be tax considerations that make other funds superior (google ‘index fund [your country]’, and you should probably find some useful advice), but if you live in a particularly small country investing only in domestic stocks will probably increase your volatility significantly over an American only investing in US stocks.
I know enough economics that index funds being optimal for investors without special knowledge is obvious to me
I suspect I know more economics than you and that optimality is not obvious to me at all.
Let me ask you again the question which you sidestepped—which market? An “index fund” is a shortcut for “passively managed diversified portfolio” and that’s a very large territory.
Let’s even assume market efficiency. First, investors are different. Let’s take a few: a 25-year-old grad student in Singapore with $5,000; a 65-year old Canadian with about $5m saved for retirement; a 40-year-old Indian who has ten lakhs rupees with which he intends to open a business in a couple of years. None of them have “special knowledge”—is the same investment vehicle optimal for all of them?
Second, I’ve still seen no argument as to why large-cap US equity (aka S&P500) is the best. Why is it better than a stock-and-bond mix, for example? Should you throw emerging market equity in there, too? it will increase diversification. And what about commodities? Strategy-based ETFs? They are all different and they will all increase the diversification of your portfolio—under the EMH assumptions that’s the only way you can win. Theoretically your portfolio should consist of all investable assets available and yet the usual recommendation is to invest in the S&P500-based index fund? That doesn’t look optimal to me at all.
Third, what about leverage? I can easily double my leverage or halve it (by leaving half of my money in cash). What’s the optimal leverage? Why would you consider the default leverage of 1 to be optimal?
Let me ask you again the question which you sidestepped—which market?
How is recommending a specific fund sidestepping the question? If you mean that I sidestepped the meta question of “which method do you use for selecting which market?”, then yes, I did. I don’t think the value gained from researching that sort of topic is very high once you subtract the costs of researching. I also don’t think the question of how much of one’s wealth should be invested is very sensitive to the asset class that you choose to invest in for most investors. (Yes, lower wealth investors should be more risk averse, and older investors should be more risk averse. But, for older investors at least, that suggests a passively managed fund with a targeted retirement date which they use to adjust their allocation between stocks and bonds, which still falls in the recommended class of index funds!)
Indeed, it might be better to treat the claim “invest in index funds” as a consequence of the broader claim that “treating finance as hard is a mistake.” It looks to me like there are two sorts of people that consistently do well in personal finance:
Finance is impossible. This group believes the EMH and invests in passively managed funds, which seek to get average returns on capital without losing money to financial services.
Finance is easy. This group carefully prices assets, waiting until there is a significant difference between their price of the asset and the market’s price, and then buying (or shorting) with that significant margin of safety. If they don’t see mispricings, they don’t act. (I’m calling this group “finance is easy” because of Buffet: “There seems to be a perverse human characteristic that likes to make easy things difficult”.)
The people that believe that finance is hard do not seem to consistently do well, and seem to be easy prey for financial parasites.
It’s not clear to me what advice you’re giving with the statement “Finance is hard.” Is that a “become a financial advisor” or “hire a financial advisor”? If so, how do you square that with acknowledging that most of the industry is parasitic or deluded? On average, people have average financial advisors.
We seem to have a baseline disconnect with respect to how one goes about picking what to invest in, so I’ll let the subject drop and not get into line-by-line argument.
However let’s take a look at the broader claim “treating finance as hard is a mistake”.
It looks to me like there are two sorts of people that consistently do well in personal finance
Um, evidence? It does not look to me like that, so where’s the data?
The “finance is impossible” group is better known as passive long-only investors. They don’t get “average” return on capital in any meaningful sense of the word “average”—they are just willing to accept whatever returns the basket of assets (index) they chose will generate. And they still have to make decisions—very meaningful decisions—about which index to pick and how much leverage to deploy.
The “finance is easy” group is usually called value investors. Note that they are active investors, not passive. Given this I am not sure why do you think they consistently do well—this seems to contradict your acceptance of EMH earlier. And, of course, “pricing assets” is very very hard.
It’s not clear to me what advice you’re giving with the statement “Finance is hard.”
The advice is: there are no good one-size-fits-all solutions. Investments should be custom-tailored to individual circumstances which include things like risk tolerance, expected use, expected time horizon, etc. That custom-tailoring is complex and there are no obvious ways to make it simple. Simple solutions exist but are typically sub-optimal. Generic advice (other than “don’t fall for scams”) is pretty worthless.
Um, evidence? It does not look to me like that, so where’s the data?
Who do you think consistently does well, and what data do you use to support that view? That’ll help me determine if I have evidence you’ll find convincing.
They don’t get “average” return on capital in any meaningful sense of the word “average”
Similarly, what does “average” mean to you?
Given this I am not sure why do you think they consistently do well—this seems to contradict your acceptance of EMH earlier.
The EMH has holes; Buffet has famously outperformed the market and index funds by dint of superior rationality, but most people are not qualified to judge which money managers are rational enough to be better than index funds.
I don’t have a good explanation for why value investing works. The most charitable and plausible one I know is “most investors look for short-term mispricings instead of long-term mispricings, and so there are more opportunities where less people are looking.”
Who do you think consistently does well, and what data do you use to support that view?
I don’t know. I am not even sure what is the classification you have in mind when you ask this question—are you talking about what kind of people do well? What kind of investment strategies? Are you talking about US or the whole world? Do you have in mind the last 20 years or the last 200 years?
what does “average” mean to you?
An arithmetic mean. Is this a trick question?
Buffet has famously outperformed the market and index funds by dint of superior rationality
Really? And how do you establish that particular causality?
Buffet has a specific investment approach. It clearly worked for him, it also clearly did not work for many other people who tried it. And if you posit the existence of Buffet’s wealth as evidence that “value investing works”, I can posit the existence of Soros’ wealth as evidence that currency speculation works.
I don’t know. I am not even sure what is the classification you have in mind when you ask this question
My interpretation of this comment is that you’re not asking an object-level question of me (why I think value investing is better for the modern American individual investor than technical analysis, for example) but the meta question of why I think that some investment strategies are better than other investment strategies. I’m afraid I don’t find that question interesting enough to give it a good answer, and I don’t think you would find a quick answer satisfying.
An arithmetic mean. Is this a trick question?
Are you making the comment that “market capitalization-weighted average returns on stocks” would have been more accurate than “average return on capital”, or what am I missing here?
And how do you establish that particular causality?
I used my judgment and publicly available information. You might be interested in this speech by Munger, this short summary of highlights from him, this book. I’ve mostly linked to Munger, since I’ve found his writings on rationality to be more useful, but any biography of Buffett will clarify the link between the two, and Buffett’s letters will make obvious that he thinks in similar ways.
Buffet has a specific investment approach.
I should comment that I think a critical part of Buffett’s approach is the “only invest in sure deals” component, which I don’t think is a widely followed rule in value investment as a whole.
Re arithmetic mean: an “average” return presupposes some set that you’re averaging. It could be the set of all investors (or the set of US investors, or the set of retail investors, etc.). It could be the set of all investments (or the set of US equties, or mutual funds, etc.). I don’t understand how investing in an index fund provides “average” returns.
If, by any chance, you mean that an investment in a portfolio of securities provides a weighted average of the returns of the assets included in the portfolio, why, this is a property of any basket of investments. In that sense a portfolio composed of, say, currency derivatives and interest-rate swaps will provide an “average” return as well, just like any portfolio at all.
Re Buffet: I am well aware of the claims made about him. I don’t take them at face value and don’t recommend that you do (and yes, I know who Munger is). People who have been successful through luck have just as compelling narratives how some feature of their {method/mind/character/upbringing/etc.} made their success inevitable. Hindsight, after all, provides perfect vision :-/
an “average” return presupposes some set that you’re averaging.
Okay. The set I’m imagining is the set of investments that meet some criteria, like “US stocks listed on the NYSE” or “US large cap stocks” or even “home robotics stocks.” It seems meaningful to me to state that indexing across that set will provide “average” returns in the sense that it will provide low-variance returns centered around the set mean, relative to a picking a portfolio based on personal taste from stocks in that set. For investors as a whole, the effects of their personal taste must average out to the mean (once weighted by participation in that set), and so unless you have special knowledge you should expect your returns to be centered around the set mean, but with higher variance. For risk-averse investors, higher variance is a bad thing. Justifying the expectation that your returns will be higher than the set mean requires a statement like “I can pick home robotics stocks better than the market as a whole,” or the less questionable “I can pick industries better than the market as a whole”, but the safest is probably “I can’t pick better than the market as a whole,” which suggests indexing across all industries (and, barring legal barriers, across all countries).
People who have been successful through luck have just as compelling narratives how some feature of their {method/mind/character/upbringing/etc.} made their success inevitable.
I understand the outside view that most successful people are likely to be highly lucky, and are unlikely to have public correct causal models of their success. (It’s very unlikely that a boy band star or male actor would admit to having sex with a gay talent agent in order to land a position, for example, even if that’s the primary differentiator between them and their competition that did not go on to become famous.)
That said, as someone who formally studies good decision-making, I think I have a strong inside view of what works about Buffett’s decision-making, and it seems likely to me that it actually is a causal factor in his success. I have no doubt that luck played a role in Buffett making his way to the top, rather than just doing well for himself. (There are other residents of Graham-Doddsville, many of whom have also gotten rich, but none of whom have gotten as rich as Buffett.)
Well, let’s try to sort this out a little better. There’s a general superset of all investment opportunities. That’s too much to chew on, so let’s limit ourselves to a semi-arbitrary subset. As an example let’s take the standard large-cap US equity and define it as members of the S&P500 index. There is a variety of tradeable instruments (mutual funds, ETFs, futures, etc.) which will allow you to buy the S&P500.
indexing across that set will provide “average” returns in the sense that it will provide low-variance returns centered around the set mean
That is not correct. Owning an index security will provide returns similar to the set mean (defined appropriately, here the mean is cap-weighted), but these returns will not be low-variance. Provided the security that you chose is run competently, your tracking error with respect to the the index will be small and so low-variance, but the returns themselves can be as high-variance as they like.
If you pick a portfolio from the same set based on personal taste, the tracking error will be much greater, but the variance of the portfolio returns themselves might be greater or might be smaller. For example, if your taste runs to low-beta stocks, the variance of your personal-taste portfolio is likely to be less than the variance of the S&P500 index.
so unless you have special knowledge you should expect your returns to be centered around the set mean, but with higher variance
Again, this is not true. Indices are not homogenous, my personal taste will affect the variance of my portfolio. It might end up higher than the index or it might end up lower. Similarly, my personal taste will affect the expected returns as well.
higher variance is a bad thing
Given everything else equal, which it never is. If investors were only interested in expected variance, why even invest? Holding cash has zero variance in nominal terms. And, of course, different investors have different risk tolerances.
Let me also point out again that investing is a much broader field than just picking stocks and choosing a subset to invest in often has more significant consequences than deciding which securities from that subset to pick. The advice to “index” tells me nothing whether I should have municipal bonds in my portfolio, for example. Or any bonds. Or any equities. Or, actually, anything in particular.
Re Buffet, I fully agree that he possesses superior decision-making abilities. He’s probably better than 99.9% of the population. However his wealth is far beyond the average wealth of the top 0.1% best decision makers. More importantly, I am not sure how the superiority of Buffet’s personal abilities translates to believing that value investment can “beat the market”.
Provided the security that you chose is run competently, your tracking error with respect to the the index will be small and so low-variance, but the returns themselves can be as high-variance as they like.
This is what what I meant by “low variance centered on the set mean,” as I assumed the set mean was a stochastic object (with the variance that implies). Similarly, you can read “high variance” about the personal taste portfolio as “high tracking error variance,” which as you point out may be the result of low absolute variance in returns. Holding cash has a high-variance tracking error relative to the S&P 500, even though cash is zero nominal variance.
Given everything else equal, which it never is.
What does it add to the conversation to point this out?
I don’t get the impression that this conversation is productive. I think if someone doesn’t want to become proficient at finance, their best way to invest money is to set aside part of their salary* and buy into VTSMX every month. I don’t think they need to know what “dollar cost averaging” is, or why index funds are better than actively managed funds, and I think that crude heuristic arguments (“on average, money managers subtract value, you should expect to be average”) are the right way to convince them to invest this way.
As of yet, I don’t think I’ve seen you make a positive recommendation, which strikes me as worse than useless for a PSA thread. If finance is hard, then what?
*I feel the need to point out that I understand not everyone has a salary.
I’ve said it before—my point is that there are no good general-purpose universally-applicable recommendations for personal investing. They do not exist.
Certainly there are not-horrible recommendations. Investing in VTSMX is one of them. Putting your money into T-bills is another one. Putting it into TIPS is yet another one. Putting it into a 50-50 mix of high-grade corporate bonds and Russel 3000 is yet another one. Etc., etc.
All of these are not horrible. But none of them is particularly good or a good fit for everyone.
It’s like asking “what kind of food should I eat?” There are many not-horrible answers to it, starting with “follow the US government’s food pyramid”. But it’s not a particularly good answer and there is no single universal answer. People are too different for that. Same with investing—no generic answer is good enough.
However I agree that this particular chain of exchanges got too long. Your arguments seem incoherent to me and, no doubt, mine seem obtuse to you. If I get to writing a post on introduction to thinking about investing this conversation might continue...
True.
Not true. Or at least much more complicated.
The first problem (minor) is with the concept of an “index fund”. Most people read it as an S&P500 index fund, that is, a fund that passively invests into US large-cap equity. At this point it’s reasonable to ask, why US large-cap equity? Why not a US equity + US bonds passive fund? Why not add European stocks or bonds? Why not add emerging markets? Why not add commodities or real estate? The answer to what kind of a mix of asset classes do you want to hold is… complicated.
The second problem (major) is with the concept of “best return”. It’s pretty meaningless to talk about best returns without involving uncertainty, volatility, and individual risk tolerance. I don’t think asserting that the risk-return profile of the S&P500 (again, US large cap equity) is just perfect for everyone is a defensible position.
Finance is a hard problem. There’s no easy universal answer to “what should I do with my money”—the answer is it depends. Sure, compared to investing in S&P500 there are a lot of worse things you can do—but that doesn’t mean buying the Vanguard index fund is the optimal choice.
The argument is that the added value of the “it depends” answer doesn’t pay for the additional cost in calculating what it depends on. With perfect knowledge, not everyone would go for the Vanguard index fund, but that’s not the situation we have, and with imperfect knowledge it’s a solid choice for nearly every situation. Having it as a default choice (that you possibly move away from after doing research) is much better than not having it as a default choice.
I see no reason to believe so. Do you have evidence or arguments to support this naked assertion? What other choices are you comparing it against?
From Index Fund Advisors:
They have several recommendations by Nobel laureates on that page, and have a index of papers here. As a general comment, the Efficient Markets Hypothesis is relevant: unless your money manager is insider trading (and if you, as a customer, know about that, then probably so does the SEC), you should not expect them to do significantly better than the market as a whole. The EMH has holes; Buffet has famously outperformed the market and index funds by dint of superior rationality, but most people are not qualified to judge which money managers are rational enough to be better than index funds.
You don’t think they might be a bit, um… biased? :-)
Marketing BS is not evidence.
And before we get into the EMH mess (by the way, how strong a version are you arguing for?) let me ask you, which market? There are a whole bunch of different markets—what makes large-cap US equity special?
Possibly. I linked them because they’re convenient. I know enough economics that index funds being optimal for investors without special knowledge is obvious to me; you can find more on wikipedia or Motley Fool.
I personally recommend VTSMX for investors in the US, because there are a handful of reasons to prefer investing in domestic funds (especially if you live in the US). There is advice out there targeted at low-load funds if you’re interested in putting more thought into the choice. If you live elsewhere, there may be tax considerations that make other funds superior (google ‘index fund [your country]’, and you should probably find some useful advice), but if you live in a particularly small country investing only in domestic stocks will probably increase your volatility significantly over an American only investing in US stocks.
I suspect I know more economics than you and that optimality is not obvious to me at all.
Let me ask you again the question which you sidestepped—which market? An “index fund” is a shortcut for “passively managed diversified portfolio” and that’s a very large territory.
Let’s even assume market efficiency. First, investors are different. Let’s take a few: a 25-year-old grad student in Singapore with $5,000; a 65-year old Canadian with about $5m saved for retirement; a 40-year-old Indian who has ten lakhs rupees with which he intends to open a business in a couple of years. None of them have “special knowledge”—is the same investment vehicle optimal for all of them?
Second, I’ve still seen no argument as to why large-cap US equity (aka S&P500) is the best. Why is it better than a stock-and-bond mix, for example? Should you throw emerging market equity in there, too? it will increase diversification. And what about commodities? Strategy-based ETFs? They are all different and they will all increase the diversification of your portfolio—under the EMH assumptions that’s the only way you can win. Theoretically your portfolio should consist of all investable assets available and yet the usual recommendation is to invest in the S&P500-based index fund? That doesn’t look optimal to me at all.
Third, what about leverage? I can easily double my leverage or halve it (by leaving half of my money in cash). What’s the optimal leverage? Why would you consider the default leverage of 1 to be optimal?
Finance is hard.
How is recommending a specific fund sidestepping the question? If you mean that I sidestepped the meta question of “which method do you use for selecting which market?”, then yes, I did. I don’t think the value gained from researching that sort of topic is very high once you subtract the costs of researching. I also don’t think the question of how much of one’s wealth should be invested is very sensitive to the asset class that you choose to invest in for most investors. (Yes, lower wealth investors should be more risk averse, and older investors should be more risk averse. But, for older investors at least, that suggests a passively managed fund with a targeted retirement date which they use to adjust their allocation between stocks and bonds, which still falls in the recommended class of index funds!)
Indeed, it might be better to treat the claim “invest in index funds” as a consequence of the broader claim that “treating finance as hard is a mistake.” It looks to me like there are two sorts of people that consistently do well in personal finance:
Finance is impossible. This group believes the EMH and invests in passively managed funds, which seek to get average returns on capital without losing money to financial services.
Finance is easy. This group carefully prices assets, waiting until there is a significant difference between their price of the asset and the market’s price, and then buying (or shorting) with that significant margin of safety. If they don’t see mispricings, they don’t act. (I’m calling this group “finance is easy” because of Buffet: “There seems to be a perverse human characteristic that likes to make easy things difficult”.)
The people that believe that finance is hard do not seem to consistently do well, and seem to be easy prey for financial parasites.
It’s not clear to me what advice you’re giving with the statement “Finance is hard.” Is that a “become a financial advisor” or “hire a financial advisor”? If so, how do you square that with acknowledging that most of the industry is parasitic or deluded? On average, people have average financial advisors.
We seem to have a baseline disconnect with respect to how one goes about picking what to invest in, so I’ll let the subject drop and not get into line-by-line argument.
However let’s take a look at the broader claim “treating finance as hard is a mistake”.
Um, evidence? It does not look to me like that, so where’s the data?
The “finance is impossible” group is better known as passive long-only investors. They don’t get “average” return on capital in any meaningful sense of the word “average”—they are just willing to accept whatever returns the basket of assets (index) they chose will generate. And they still have to make decisions—very meaningful decisions—about which index to pick and how much leverage to deploy.
The “finance is easy” group is usually called value investors. Note that they are active investors, not passive. Given this I am not sure why do you think they consistently do well—this seems to contradict your acceptance of EMH earlier. And, of course, “pricing assets” is very very hard.
The advice is: there are no good one-size-fits-all solutions. Investments should be custom-tailored to individual circumstances which include things like risk tolerance, expected use, expected time horizon, etc. That custom-tailoring is complex and there are no obvious ways to make it simple. Simple solutions exist but are typically sub-optimal. Generic advice (other than “don’t fall for scams”) is pretty worthless.
Who do you think consistently does well, and what data do you use to support that view? That’ll help me determine if I have evidence you’ll find convincing.
Similarly, what does “average” mean to you?
I said earlier:
I don’t have a good explanation for why value investing works. The most charitable and plausible one I know is “most investors look for short-term mispricings instead of long-term mispricings, and so there are more opportunities where less people are looking.”
I don’t know. I am not even sure what is the classification you have in mind when you ask this question—are you talking about what kind of people do well? What kind of investment strategies? Are you talking about US or the whole world? Do you have in mind the last 20 years or the last 200 years?
An arithmetic mean. Is this a trick question?
Really? And how do you establish that particular causality?
Buffet has a specific investment approach. It clearly worked for him, it also clearly did not work for many other people who tried it. And if you posit the existence of Buffet’s wealth as evidence that “value investing works”, I can posit the existence of Soros’ wealth as evidence that currency speculation works.
My interpretation of this comment is that you’re not asking an object-level question of me (why I think value investing is better for the modern American individual investor than technical analysis, for example) but the meta question of why I think that some investment strategies are better than other investment strategies. I’m afraid I don’t find that question interesting enough to give it a good answer, and I don’t think you would find a quick answer satisfying.
Are you making the comment that “market capitalization-weighted average returns on stocks” would have been more accurate than “average return on capital”, or what am I missing here?
I used my judgment and publicly available information. You might be interested in this speech by Munger, this short summary of highlights from him, this book. I’ve mostly linked to Munger, since I’ve found his writings on rationality to be more useful, but any biography of Buffett will clarify the link between the two, and Buffett’s letters will make obvious that he thinks in similar ways.
I should comment that I think a critical part of Buffett’s approach is the “only invest in sure deals” component, which I don’t think is a widely followed rule in value investment as a whole.
Re arithmetic mean: an “average” return presupposes some set that you’re averaging. It could be the set of all investors (or the set of US investors, or the set of retail investors, etc.). It could be the set of all investments (or the set of US equties, or mutual funds, etc.). I don’t understand how investing in an index fund provides “average” returns.
If, by any chance, you mean that an investment in a portfolio of securities provides a weighted average of the returns of the assets included in the portfolio, why, this is a property of any basket of investments. In that sense a portfolio composed of, say, currency derivatives and interest-rate swaps will provide an “average” return as well, just like any portfolio at all.
Re Buffet: I am well aware of the claims made about him. I don’t take them at face value and don’t recommend that you do (and yes, I know who Munger is). People who have been successful through luck have just as compelling narratives how some feature of their {method/mind/character/upbringing/etc.} made their success inevitable. Hindsight, after all, provides perfect vision :-/
Okay. The set I’m imagining is the set of investments that meet some criteria, like “US stocks listed on the NYSE” or “US large cap stocks” or even “home robotics stocks.” It seems meaningful to me to state that indexing across that set will provide “average” returns in the sense that it will provide low-variance returns centered around the set mean, relative to a picking a portfolio based on personal taste from stocks in that set. For investors as a whole, the effects of their personal taste must average out to the mean (once weighted by participation in that set), and so unless you have special knowledge you should expect your returns to be centered around the set mean, but with higher variance. For risk-averse investors, higher variance is a bad thing. Justifying the expectation that your returns will be higher than the set mean requires a statement like “I can pick home robotics stocks better than the market as a whole,” or the less questionable “I can pick industries better than the market as a whole”, but the safest is probably “I can’t pick better than the market as a whole,” which suggests indexing across all industries (and, barring legal barriers, across all countries).
I understand the outside view that most successful people are likely to be highly lucky, and are unlikely to have public correct causal models of their success. (It’s very unlikely that a boy band star or male actor would admit to having sex with a gay talent agent in order to land a position, for example, even if that’s the primary differentiator between them and their competition that did not go on to become famous.)
That said, as someone who formally studies good decision-making, I think I have a strong inside view of what works about Buffett’s decision-making, and it seems likely to me that it actually is a causal factor in his success. I have no doubt that luck played a role in Buffett making his way to the top, rather than just doing well for himself. (There are other residents of Graham-Doddsville, many of whom have also gotten rich, but none of whom have gotten as rich as Buffett.)
Well, let’s try to sort this out a little better. There’s a general superset of all investment opportunities. That’s too much to chew on, so let’s limit ourselves to a semi-arbitrary subset. As an example let’s take the standard large-cap US equity and define it as members of the S&P500 index. There is a variety of tradeable instruments (mutual funds, ETFs, futures, etc.) which will allow you to buy the S&P500.
That is not correct. Owning an index security will provide returns similar to the set mean (defined appropriately, here the mean is cap-weighted), but these returns will not be low-variance. Provided the security that you chose is run competently, your tracking error with respect to the the index will be small and so low-variance, but the returns themselves can be as high-variance as they like.
If you pick a portfolio from the same set based on personal taste, the tracking error will be much greater, but the variance of the portfolio returns themselves might be greater or might be smaller. For example, if your taste runs to low-beta stocks, the variance of your personal-taste portfolio is likely to be less than the variance of the S&P500 index.
Again, this is not true. Indices are not homogenous, my personal taste will affect the variance of my portfolio. It might end up higher than the index or it might end up lower. Similarly, my personal taste will affect the expected returns as well.
Given everything else equal, which it never is. If investors were only interested in expected variance, why even invest? Holding cash has zero variance in nominal terms. And, of course, different investors have different risk tolerances.
Let me also point out again that investing is a much broader field than just picking stocks and choosing a subset to invest in often has more significant consequences than deciding which securities from that subset to pick. The advice to “index” tells me nothing whether I should have municipal bonds in my portfolio, for example. Or any bonds. Or any equities. Or, actually, anything in particular.
Re Buffet, I fully agree that he possesses superior decision-making abilities. He’s probably better than 99.9% of the population. However his wealth is far beyond the average wealth of the top 0.1% best decision makers. More importantly, I am not sure how the superiority of Buffet’s personal abilities translates to believing that value investment can “beat the market”.
This is what what I meant by “low variance centered on the set mean,” as I assumed the set mean was a stochastic object (with the variance that implies). Similarly, you can read “high variance” about the personal taste portfolio as “high tracking error variance,” which as you point out may be the result of low absolute variance in returns. Holding cash has a high-variance tracking error relative to the S&P 500, even though cash is zero nominal variance.
What does it add to the conversation to point this out?
I don’t get the impression that this conversation is productive. I think if someone doesn’t want to become proficient at finance, their best way to invest money is to set aside part of their salary* and buy into VTSMX every month. I don’t think they need to know what “dollar cost averaging” is, or why index funds are better than actively managed funds, and I think that crude heuristic arguments (“on average, money managers subtract value, you should expect to be average”) are the right way to convince them to invest this way.
As of yet, I don’t think I’ve seen you make a positive recommendation, which strikes me as worse than useless for a PSA thread. If finance is hard, then what?
*I feel the need to point out that I understand not everyone has a salary.
I’ve said it before—my point is that there are no good general-purpose universally-applicable recommendations for personal investing. They do not exist.
Certainly there are not-horrible recommendations. Investing in VTSMX is one of them. Putting your money into T-bills is another one. Putting it into TIPS is yet another one. Putting it into a 50-50 mix of high-grade corporate bonds and Russel 3000 is yet another one. Etc., etc.
All of these are not horrible. But none of them is particularly good or a good fit for everyone.
It’s like asking “what kind of food should I eat?” There are many not-horrible answers to it, starting with “follow the US government’s food pyramid”. But it’s not a particularly good answer and there is no single universal answer. People are too different for that. Same with investing—no generic answer is good enough.
However I agree that this particular chain of exchanges got too long. Your arguments seem incoherent to me and, no doubt, mine seem obtuse to you. If I get to writing a post on introduction to thinking about investing this conversation might continue...
Is there a short list of fairly unrelated components that cover almost all of what it depends on?
Off the cuff, I’d guess:
Expected per-time income and expenditures—their approximate distributions (mean, variance, and shape?)
Current stored value—its expected change over time and the variance of that change
How much you care about beings in the future, especially those that will think of you as their past self
Where the major changes in your dUtility(expenditures per-time)/dExpenditures occur
The mean and variance and shape of what things you’re thinking about doing with what portions of your money
Tax, and I don’t know what to think about this
Any other broad category of consideration that I missed, or consolidation/elimination of those I listed?