David Dreman, author of several books focused on contrarian investing, was quoted in one of his books as saying something to the affect of, nobody beats the market, except for the people that do. And yes, there are people that do (like Seth Klarman).
Some people are still very resistant to that idea. If you read Burton Malkiel‘s, A Random Walk Down Wall Street, for instance, it’s easy enough to believe that anyone that beats the market is just doing so by random chance.* If you do, in fact believe that, there’s an alternative that takes some of the gamble out of the equation. The answer, of course, is one that you already know: indexing.
*While at one time the most dominant theory in academic circles, the efficient market hypothesis has lost some of its credibility to the rise and prevalence of value investing. Warren Buffett has been among the most vocal critics…but he has plenty of company, including people like Klarman and Dreman. The people that have beaten the market by the largest margins over time don’t believe that their life’s work is nothing more than random chance. I don’t believe it either.
Index investing is the brain child Vanguard founder and former CEO Jack Bogle. I honestly think Jack Bogle is a great man. He personally strove for things that actually helped the individual investor succeed. Vanguard’s roots were about low minimums and very low management fees. I think they’re moving away from that somewhat – but that was Mr. Bogle’s vision. It was one that changed the entire investment industry. Investing wasn’t just for rich people anymore. If you’ve read any of Mr. Bogle’s work (or heard him speak), I think you’d agree that he makes a pretty compelling case for indexing.**
**You’re probably familiar with the idea of indexing. If you are, feel free to skip this section. If you aren’t, you’re about to be! Indexing is, basically, the idea that because it’s so difficult to beat the market, the most important thing to manage is costs. With an index fund, you’ll never beat the market, because essentially, you are the market. You’re copying the market’s performance. You’re controlling one of the few things you can control, which is cost, by paying lower fees than you would if you invested in a mutual fund with a manager that has no better than a 50/50 chance of outperforming the market. An index fund copies the performance of a specific group of stocks. The S&P 500, for instance, is a common bench mark that mutual funds, pension funds and hedge funds measure themselves against. An index simply invests your money across the stocks in the S&P. Since these stocks are chosen according to a precise formula based on size, there is no decision making on the part of the manager. That’s why they can give you such low fees.
Not everyone is sold on indexing, though. Specifically, many famous value investors think it’s a bad idea. And why wouldn’t they? If you’ve beaten the market like a playground bully, indexing would seem quite unappealing. Seth Klarman points out that it’s essentially the opposite of contrarian investing, that is, instead of buying what’s out of favor, you set out to buy what’s popular. In his own words:
“I still believe indexing is a horrible idea. Stocks trade up when they’re added to the index so the index investor is paying up. I’m more likely to buy the companies kicked out of the index. For the average person, however, they don’t do enough research to own individual stocks. The idea of owning stocks for the long run is a disservice to investors, because many are not there for the long run. Many got out in 2008 when they should have been buying, because the entry point matters most. Transaction costs and Taxes don’t matter if the market goes nowhere. I’m very worried about another 10 years of zero or low returns since the market has run up so fast.”
Klarman is talking about an index with a finite amount of stocks in them, like the S&P. I think his quote ignores the fact that you’re perfectly capable of buying a Total Stock Market Index, that includes almost all the relevant publicly traded companies. Still, his point is a good one: if he had to buy every one of something, he’d rather be stuck with every stock kicked out of the index than every stock added to the index. A contrarian strategy.*** Buy when stocks are being sold indiscriminately, and sell when they are dear.
***The expression contrarian investing was popularized by David Dreman in his book Contrarian Investing.
My Roth IRA is invested completely in index funds. I think the strategy has value. It’s better than the alternative of choosing higher cost mutual funds that may or may not outperform. But I’m not a complete Boglehead. I also have a taxable account that I own individual securities in. In fact, I’ve been known to follow Klarman into some trades now and then.
In that taxable account, I attempt to practice value investing. The problem with value investing is, while the broad strokes of the concepts are simple, the approach requires a tremendous amount of time. I don’t have the requisite knowledge to understand many opportunities. In fact, many of the situations that Klarman invests in are complicated. In many (most, even) of these situations I have to pass on the opportunity because it’s outside my circle of competence.
It’s unlikely that your average investor is going to be able to produce success (over time – anyone can get lucky in the short term) on the level that Seth Klarman has. By definition, about half of all investors have to underperform the market. Index funds are a simple solution. You could spend hundred of hours studying and evaluating stocks…and still underperform the market. Or you could spend an hour rebalancing each year with index funds and pretty much tie the market.****
****Or, if you really want to automate things, a Target Date Retirement Fund does your rebalancing for you. Vanguard offers these funds of funds invested entirely in index funds.
Anyway, I’m always interested in anything that Klarman has to say. I thought I would share his comment about index investing here. It’s not necessarily my opinion, but Klarman knows what he’s talking about. If you’re only going to listen to one person about markets and investing, Klarman might be a good choice. Good luck and thanks for reading.
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