First counter-question: why should an individual investor care? Unless you perceive yourself to be in some sort of ranked competition (which is actually the case for professional money managers), why would you care about beating the market?
On a purely rational basis, you have a universe of investment opportunities. You evaluate, to the best of your ability, the future probability distributions of returns from all of them and some kind of a dependency structure (in the simple case, a covariance matrix). From these, you form a portfolio that best matches your risk-return preferences.
If you just want to “beat the market”, the simplest answer is leverage. Assuming you believe that the expectation for the equity market is positive, open a margin brokerage account and invest into a diversified equity portfolio on the margin. In the US the equity margin is limited by law to 2:1 (in most cases). Your expectation of return would be the double of the market return. The price that you pay is doubled volatility.
In the context of the US equity market another simple answer is high-beta stocks. Invest in a portfolio of such stocks and if the market return is positive your expected return would be higher. The price that you pay is again, increased volatility.
First counter-question: why should an individual investor care?
If I had $1 billion, even microscopic improvements in the yield of my investment would dominate any income I could hope to earn through wages. If I had $1, my investment yields wouldn’t matter—doubling my principle would be less remunerative than working a minimum wage job for 15 minutes. Somewhere in between owning $1 and $1 billion there is a net worth where it becomes worth it to switch from a generic roughly age appropriate portfolio to something more finely tuned. I had estimated that cutoff to be many times a person’s annual income. If the cutoff is lower than my estimate, then a lot more people should be learning modern portfolio theory.
You’re forgetting about the utility function. If you had a billion dollars, there’s no reason for you to care about the return of your investments at all, much less about microscopic improvements. On the other hand, if you’re retired and you’re living on the income from, say, a $100,000 portfolio, any additional percent that you can eke out is meaningful to you.
The real question is why do you consider the market portfolio (which, again, most of US residents understand as an S&P500-based index) to be the default?
For historical context, it certainly wasn’t the default for saving money for retirement, say, 50 years ago.
If you had a billion dollars, there’s no reason for you to care about the return of your investments at all, much less about microscopic improvements.
I don’t agree—if you have $1 billion, the marginal utility of an additional dollar is smaller than if you are normal individual investor, but the utility is still positive. More importantly, the second derivative of utility—the rate at which the marginal of utility diminishes—is much larger for an individual investor than for a billionaire. $10 million is about twice as good as $5 million for Bill Gates, but not for me. This implies, to me, that individual investors should be more risk-averse than larger investors, which supports the statement “It is never going to be worthwhile for a personal investor to attempt to beat the market”.
Could you give some specific and realistic scenarios where it would be rational for an individual investor, with at most a few hundred thousand dollars in capital, to attempt to beat the market? That’s what I’d like to discuss.
The real question is why do you consider the market portfolio (which, again, most of US residents understand as an S&P500-based index) to be the default? For historical context, it certainly wasn’t the default for saving money for retirement, say, 50 years ago.
I was under the impression that historically most were more concerned with safety than they are now, and less concerned with “beating the market”.
I’m laboring over the phrase “beat the market” so much because I believe that (1) many people think that they can do better (2) most can’t, even if they are smart (3) you shouldn’t try.
This implies, to me, that individual investors should be more risk-averse than larger investors, which supports the statement “It is never going to be worthwhile for a personal investor to attempt to beat the market”.
And, if an individual is able to (predictably) beat the market for whatever reason then it is overwhelmingly unlikely that their optimal strategy is to invest their own capital but nothing beyond that.
A relative of mine does predictably beat the market, and he would agree with you that he would make more money in the long run by investing the money of others. But he would disagree that this is an optimal strategy: his (economic) goal is to make enough money to live comfortably while doing a minimum of work. He reports a fair number of likeminded people among his acquaintances, some more successful at this than others.
First counter-question: why should an individual investor care? Unless you perceive yourself to be in some sort of ranked competition (which is actually the case for professional money managers), why would you care about beating the market?
On a purely rational basis, you have a universe of investment opportunities. You evaluate, to the best of your ability, the future probability distributions of returns from all of them and some kind of a dependency structure (in the simple case, a covariance matrix). From these, you form a portfolio that best matches your risk-return preferences.
If you just want to “beat the market”, the simplest answer is leverage. Assuming you believe that the expectation for the equity market is positive, open a margin brokerage account and invest into a diversified equity portfolio on the margin. In the US the equity margin is limited by law to 2:1 (in most cases). Your expectation of return would be the double of the market return. The price that you pay is doubled volatility.
In the context of the US equity market another simple answer is high-beta stocks. Invest in a portfolio of such stocks and if the market return is positive your expected return would be higher. The price that you pay is again, increased volatility.
If I had $1 billion, even microscopic improvements in the yield of my investment would dominate any income I could hope to earn through wages. If I had $1, my investment yields wouldn’t matter—doubling my principle would be less remunerative than working a minimum wage job for 15 minutes. Somewhere in between owning $1 and $1 billion there is a net worth where it becomes worth it to switch from a generic roughly age appropriate portfolio to something more finely tuned. I had estimated that cutoff to be many times a person’s annual income. If the cutoff is lower than my estimate, then a lot more people should be learning modern portfolio theory.
You’re forgetting about the utility function. If you had a billion dollars, there’s no reason for you to care about the return of your investments at all, much less about microscopic improvements. On the other hand, if you’re retired and you’re living on the income from, say, a $100,000 portfolio, any additional percent that you can eke out is meaningful to you.
The real question is why do you consider the market portfolio (which, again, most of US residents understand as an S&P500-based index) to be the default?
For historical context, it certainly wasn’t the default for saving money for retirement, say, 50 years ago.
I don’t agree—if you have $1 billion, the marginal utility of an additional dollar is smaller than if you are normal individual investor, but the utility is still positive. More importantly, the second derivative of utility—the rate at which the marginal of utility diminishes—is much larger for an individual investor than for a billionaire. $10 million is about twice as good as $5 million for Bill Gates, but not for me. This implies, to me, that individual investors should be more risk-averse than larger investors, which supports the statement “It is never going to be worthwhile for a personal investor to attempt to beat the market”.
Could you give some specific and realistic scenarios where it would be rational for an individual investor, with at most a few hundred thousand dollars in capital, to attempt to beat the market? That’s what I’d like to discuss.
I was under the impression that historically most were more concerned with safety than they are now, and less concerned with “beating the market”.
I’m laboring over the phrase “beat the market” so much because I believe that (1) many people think that they can do better (2) most can’t, even if they are smart (3) you shouldn’t try.
And, if an individual is able to (predictably) beat the market for whatever reason then it is overwhelmingly unlikely that their optimal strategy is to invest their own capital but nothing beyond that.
A relative of mine does predictably beat the market, and he would agree with you that he would make more money in the long run by investing the money of others. But he would disagree that this is an optimal strategy: his (economic) goal is to make enough money to live comfortably while doing a minimum of work. He reports a fair number of likeminded people among his acquaintances, some more successful at this than others.
Sorry, leaving on a trip in about an hour so I have to bow out of this discussion. But I’m sure it will come up again on LW… :-)
Aww. Well, it was fun while it lasted :-)