Demoralizing Realization that I can't beat an Index Fund

[huxley]

“ If most investors used index funds what would happen to the share broking industry?”

My guess is they would be a leaner industry, but there would probably be opportunities to out perform the passive money anyway . If no one is doing any research how will values be established? The majority of fund managers will just be allocating capital based on the weighting, so if SKT is 2% if the market, we put 2% into SKT, never mind the business model is a bit broken and the stock is arguably a value trap :/

[Snoopy]

How can an individual out perform an index when active management cannot over the long term. They have staff employed full time analysing balance sheets.

There is a 'small cap premium' that has been positively identified by those studying the investment world. Put simply it is much easier for a company with $20m in sales to grow profits by by 100% than it is for a company with $2,000m in sales to do the same. The problem is that if an investment fund tries to chase the small caps, then their very act of buying and selling moves the share price up or down to the extent that the small cap premium cannot be realised.

An advantage for the small investor in NZ is that sharebrokers very rarely cover companies outside the NZX50. So we small investors are not competing with sharebrokers full time analysts to try and out smart them, because such full time analysts are completely absent from the NZX small cap market.

As a Mum and Dad investor without millions to invest, you can invest in small caps without moving the price around too much. However, if you go entirely by broker advice the small cap premium will also likely evaporate, because lost of Mums and Dads acting together can push a share price around. Yet if you keep it small and do your own thinking then some of these small cap premiums can be realized, at least in my experience.

SNOOPY

[Investor]

interesting posts. If most investors used index funds what would happen to the share broking industry?
I looked at my returns on the ASX AND i have failed to beat the index over the last 3 years. How can an individual out perform an index when active management cannot over the long term. They have staff employed full time analysing balance sheets. it must come down to luck.

Well.. in my opinion the main problems with managed funds are: over-diversifying, high transaction fees because of too many investments & having to invest new cash all the time and generally having fairly high weightings in low performing asset classes to avoid upsetting investors who are risk averse and don't like volatility.

[James108]

There is a 'small cap premium' that has been positively identified by those studying the investment world. Put simply it is much easier for a company with $20m in sales to grow profits by by 100% than it is for a company with $2,000m in sales to do the same. The problem is that if an investment fund tries to chase the small caps, then their very act of buying and selling moves the share price up or down to the extent that the small cap premium cannot be realised.

An advantage for the small investor in NZ is that sharebrokers very rarely cover companies outside the NZX50. So we small investors are not competing with sharebrokers full time analysts to try and out smart them, because such full time analysts are completely absent from the NZX small cap market.

As a Mum and Dad investor without millions to invest, you can invest in small caps without moving the price around too much. However, if you go entirely by broker advice the small cap premium will also likely evaporate, because lost of Mums and Dads acting together can push a share price around. Yet if you keep it small and do your own thinking then some of these small cap premiums can be realized, at least in my experience.

SNOOPY

Your right, it's a lot easier to be the smartest person in an empty room.

[Snoopy]

How can an individual out perform an index when active management cannot over the long term. They have staff employed full time analysing balance sheets.

One more pearl of experience to drop on this subject. I will leave it to others to decide if it qualifies as 'wisdom'.

The sharebroking industry is by self reflected customer demand, working with a short term time horizon. Most brokers come up with a list of 'picks for the coming year' in December. Yet if you look at how many managers of NZX50 corporations set out manage their businesses on a year to year basis, I would venture to suggest the answer is none. If you look ten years out, you may get a very different answer to those that the brokers recommend, even though the valuation techniques you use are the same. My specific case in point is the gentailers, a sector in which I held three players: Contact, Mercury and Genesis.

My valuation of the former two includes the contribution from a future power station that will eventually be built by each, using their existing capital structure. I am probably the only dog to value the companies in this way. But if you have a ten year time horizon, valuing the snapshot power picture that is presented today does not make sense. By contrast, the ten year picture for Genesis Energy, in my view, looks pretty dire. Kupe will be virtually extinct. To keep the existing gas infrastructure going will require importation of LNG and all the associated infrastructure for that must be paid for. Big money will be required to replace or seriously upgrade Huntly within ten years. Or will Genesis simply cede their role as a significant generator to other industry players? On a short term basis I see Genesis as well run, and I think many brokers would concur. But I am frightened by the long term headwinds, hence my decision to sell out, albeit at a nice profit, in 2017.

I still hold my positions in Contact and Mercury Energy.

SNOOPY

[Stranger_Danger]

So as above if the majority agree it’s difficult to beat the market and put 90% into index funds and ‘play’ with the rest, why are you doing it? Purely because you enjoy the process of stock picking as more of a hobby? One that’s lined your pocket rather than emptying it?

The reason I do it is because the only upside one can get from owning an index is the return provided by that index.

By researching and owning stocks directly, one also gets the constant education that comes with needing to continually increase your knowledge.

I used to own a (non investing) business and I - and yes, this quote is pretty much stolen word for word from Warren Buffett - found that my experience in investing helped me in business, and that my experience in business helped me as an investor. A lot of people get trapped in the "widget making" aspects of their business, and I found my investing experience, on almost a daily basis, gave me a real advantage over those that were just making widgets by getting me to constantly look at the bigger picture, think more strategically, think of my private business entity as if it was a listed financial investment, and to run it accordingly.

On the other hand, my experience in business helped me a lot in investing. I think a lot of people forget these wiggly moving share price things are actually making widgets, and I found my business experience helped me remember that. Rather than just looking at a share price chart, it would force me to think about what things I could or would do to improve this business, are the current managers moving in that direction, how will I know when a rational plan is being followed by management, how will I measure it etc etc. Also, it helped me a lot when it came to understanding the (often underestimated) change in investor returns that can result from changes to competitive position or regulatory stances.

Bottom line is I found there were massive long term gains that resulted from direct sharemarket investment that simply couldn't have been achieved by turning off my brain and buying an index. While these gains were educational rather than financial, the application of business to investing, and then investing to business, eventually yielded a satisfactory financial outcome.

I'm "retired" now (ie no operating business) and just invest, but I have no problem at all if I spend more than 40 hours a week researching and managing investments. Truth is, I absolutely love it, don't regard it as a job, and prefer it to a wife any day (no offence, ladies!).

On the other hand, if investing is just a means to an end (ie you like money as a tool for acquiring toys and a lifestyle, but aren't intrinsically interested in growing it just for pure fun) and you have a job, a life, kids, a partner etc etc, then I can 100% understand not wanting to put in endless hours on investing.

With that mindset, it is totally rational to buy an index, and that is what I would recommend.

It's a bit like Kane Williamson liking cricket, and practicing and competing his whole life, and me kinda/sorta liking cricket, but really not having the time or caring that much.

If that is my mindset, I'm better buying an index (ie watching the "returns" others, namely the Black Caps, accrue on TV) rather than fooling myself that I could kinda/sorta spend 2 hours a week practicing my cut shot and suddenly wake up and be as good as Williamson. Not gonna happen.

Same with investing. If you love it, you have to do it with a FOCUS and do a lot of it. If you don't love it, stop kidding youself and buy an index.

[DarkHorse]

There is a 'small cap premium' that has been positively identified by those studying the investment world. Put simply it is much easier for a company with $20m in sales to grow profits by by 100% than it is for a company with $2,000m in sales to do the same. The problem is that if an investment fund tries to chase the small caps, then their very act of buying and selling moves the share price up or down to the extent that the small cap premium cannot be realised.

An advantage for the small investor in NZ is that sharebrokers very rarely cover companies outside the NZX50. So we small investors are not competing with sharebrokers full time analysts to try and out smart them, because such full time analysts are completely absent from the NZX small cap market.

As a Mum and Dad investor without millions to invest, you can invest in small caps without moving the price around too much. However, if you go entirely by broker advice the small cap premium will also likely evaporate, because lost of Mums and Dads acting together can push a share price around. Yet if you keep it small and do your own thinking then some of these small cap premiums can be realized, at least in my experience.

SNOOPY

Snoopy raises a key point. If you're talking about medium to large caps - which dominate "the index", at least a weak form of the efficient market hypothesis is common sense. All the information is widely available to professional analysts so it's tough to beat the market consistently.
But small companies are a different kettle of fish. Good companies fly under the radar, while unprofitable speculative stocks are often overpriced. The risk-reward equation goes out the window when, on average, things like low debt, high manager ownership and strong cashflow both reduce risk and increase reward.
So not only does investing part of your capital in small caps increase returns over time, but you're much better off either investing directly using appropriate filters, or via an active manager (eg LIC in Australia)who uses proven selection criteria.

[Valiant]

G'day all, can someone point me in the direction of a thread on managed funds, if there happens to be one? I've had a search around but haven't been able to spot..
Thanks in advance.

[Lawstudent05]

Unsure if there is one.

Not sure if your aware of Smartshares, good index passive investment. I do know Milford Asset Management do managed funds investment and Quay Street.

[sonny n share]

There is the ETF thread
https://www.sharetrader.co.nz/showthread.php?10835-ETF-s

You can compare NZ investment platforms and fees at:
https://thesmartandlazy.com/
https://www.moneyhub.co.nz/investing--saving.html

and learn about other people's stories at:
https://www.thehappysaver.com/

Good luck