It is an interesting anomaly.
Investors are confronted with two choices: They can capture market returns (minus low transaction costs) with 100% certainty, or they can pursue the quest for higher returns, with the probability that they will underperform the markets.
You would think that the choice would be clear. Yet the majority of investors opt to ignore the data and try to "beat the markets."
This week, I deal with several methods frequently used by investors to try to accomplish this elusive goal. None of them work. I suspect the reason investors keep trying relates more to behavioral finance than to a dispassionate examination of the data.
Thanks for your much appreciated comments and questions. Please keep them coming.
Question: You are always recommending index funds. How risky are they?
Answer: Any investment in the stock or bond markets carries risk. The higher the percentage of stocks in your portfolio--whether in actively managed funds or in index funds--the greater the risk.
My recommendation of index funds is intended for investors who can tolerate market risk. Investors who have a time horizon of less than four years should not be exposed to any market risk--even in a very conservative portfolio consisting primarily of bonds. The time horizon increases to as much as twelve years for investors whose portfolios consist primarily of stocks.
Investors who cannot tolerate any market risk should invest in FDIC insured Certificates of Deposit or Treasury Bills. While these investments are typically called "risk free", that is somewhat misleading because they still carry a small amount of risk.
Question: Do you recommend using Exchange Traded Funds to buy sectors of the market?
Answer: No. Because I have no way of determining which sectors of the market will outperform other sectors. The technology and telecom sectors were very hot before they crashed in 2001. The financial sector was booming until the recent sub-prime debacle. Sector picking is no more reliable than stock picking.
Question: Are stock markets efficient? What does that mean?
Answer: The efficient markets theory holds that stocks in developed markets are correctly priced because the price reflects all public information about the stock. An excellent summary of the data supporting this theory can be found on the web page of Dimensional Fund Advisors here.
While I find this data convincing, others do not. However, I believe the debate over whether markets are, or are not, efficient misses the point.
I have yet to find any data supporting any methodology that investors can follow to exploit perceived inefficiencies in the market. Therefore, the debate seems moot.
Dr. Mark Rubenstein summarized the issue in an article in the Financial Analysts Journal, stating:
"...for a single investor (in the absence of inside information) to believe that prices are significantly in error is almost always folly. Public information should already be embedded in prices."
The next time your broker or advisor scoffs at the notion that markets are efficient, ask her to show you data indicating any methodology that consistently outperformed the markets, without taking more risk.
Don't worry about being overwhelmed by her response.
Question: Do you recommend buying high dividend stocks? Aren't they just like bonds, but with higher returns?
Answer: The reader whose comment stimulated this question used Provident Energy Trust (PVX) as an example of this strategy. He noted that "[I]t's an energy trust from Canada that pays like 12% dividends and the price barely moves. What I'm getting at is this: are you completely, 100% against owning any stocks? Surely, a wise investor like you wouldn't be totally against owning stable, slow, boring, dividend paying stocks. It's almost like having a supercharged savings account or CD."
Sounds good. Great return, little risk. Is there really a free lunch?
Of course not. Let's examine the data.
The three year weighted standard deviation of PVX as of December 2007 was 20.60 vs. a standard deviation of the S&P 500 of 7.74. This means that PVX is almost three times as volatile as the S & P 500. A portfolio consisting solely of an S & P 500 index fund would be too volatile for almost all investors. This stock is almost 300% more volatile! Does that sound like it is "stable", "slow", and "boring" to you?
Higher returns, whether in the form of dividends or total returns, always come with a price tag: higher risk.
Instead of engaging in the fruitless search for high returns with low risk, investors would be far better served by determining an appropriate asset allocation for their investment objective and tolerance for risk and investing in a globally diversified portfolio of low cost index or passively managed funds.
The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein.