Paul Winkler: Welcome to “The Investor Coaching Show.” I’m Paul Winkler talking about the world of money and investing.
Trading Strategies
Several things came up in the news regarding investing that I found interesting. One of them was the growth of index investing. It’s no threat to market efficiency, one study says.
So if we invest in markets, let’s say that we have large U.S. stocks. We might be investing in the area of the market that would be called the S&P 500. There is also the Dow and the Nasdaq, which is a trading exchange.
The Nasdaq was a computerized exchange. It used to be that everything was traded by hand and people ran around the floor of the exchange waving their hands like crazy trading stocks and bidding.
All these terms come from a lot of the trading strategies. The S&P 500 is large U.S. stocks, 500 of the biggest companies.
If I look at that group of companies, I may go, “Hey, I think I’m going to buy this company. I like this company. I don’t like that company. I think this company’s better than this one. It has more potential.”
Fund managers will go in and try to see which companies are better than others. That’s called active management, which is something that I’ve talked against for many, many years because the evidence is that it just doesn’t work.
You can beat markets over the short run, not the long run.
And then what happens is people say, “Hey, look at our skill. We beat the market.” And then they don’t beat the market next time. Matter of fact, they underperform.
You’ll find that the ones that perform the best in one period of time don’t go on to repeat. That’s why star ratings are just really, in my humble opinion, kind of a waste of time. There are very few areas where star ratings are somewhat repeatable, for example, if a fund is a one-star fund, it typically tends to stay down in the bottom of the barrel as far as future performance.
Well, why? Because typically it got its one-star rating because its expenses were outlandish or something like that. If you really have really high expenses, it’s going to be a really bad thing going forward as well.
Sometimes people use star ratings to choose funds, but the top-rated funds don’t go on to repeat. There is all kinds of research on this.
Index Trading
So what happens? A lot of people go to indexing. Now, this is something that I’ve often talked about. I don’t use indexes in most asset categories when I’m looking at funds and trying to invest, unless it’s somebody’s 401(k).
In most 401(k)s, it’s very rare to see great options. So I’ll typically use an index just because I don’t have to watch it all the time.
Funds will change all the time.
It’s called style drift. Style drift is going from one area of the market, like large growth companies to large value companies.
Stock picking is going to be a turnover ratio, looking at how often they changed the stocks. What happens anytime you try to pick the best of the best is the funds will change. With 401(k)s, they often change the whole lineup, and that is going to be something that’s really hard to keep track of.
Now, with indexes, at least I know that the Russell 2000 will remain to be somewhat the 2000 smallest of the 3000 biggest companies. So they’ll take the 3000 companies that are biggest in the United States, and they’ll lop off the thousand biggest and then 2000 are left. That’s the Russell 2000.
Last year, the Russell 2000 went down 20%. If you look at small cap stocks, the area, if it was a more concentrated fund that captured the return of that area of the market…
So if you looked at a fund that did not index and held the bottom 20% of the market, you might have $1.2 billion companies, whereas the Russell will be bigger companies on average because of the cap weighting. And then you look at the Russell 2000 value. It went down 14%. Well, small value stocks did go down, but they only went down 3%.
That’s a big difference, about 11% difference in return when you have that. So indexing is talked about an awful lot, but I don’t use it for just a couple areas of the market, like large U.S. growth companies and international large, because you don’t find anything that’s much better.
Market Efficiency
And since that is the area that most American investors put all their money in, that’s why they do that. Well, this study said something that I said years ago, because people said, “Well, wait a minute. What if everybody just buys and hangs onto stocks? And what if they don’t try to stock pick and move money around and market time and you don’t have all that trading going on? Would markets no longer be efficient?”
What that means is if there are mispricings in the stock market then could we therefore go and take advantage of them? Could we go out and find companies that are selling for $50 a share and nobody’s traded this stock in a long time and it’s really worth $60? And because nobody’s traded in a long time, it’s not sitting at its proper price.
When we’re looking at market efficiency, it works because you have a buyer on one side of the trade and you have a seller on the other side of the trade.
The buyer does not want to pay a dime more than they have to for the stock based on the earnings of the company. So they will watch that company, they’ll look at that company, they’ll look at the earnings, they’ll look at the sales projections, they’ll look at the economy, they’ll look at what’s going on geopolitically and determine, “Hey, what is the true value as best I can tell for this particular stock? I don’t want to pay any more than that.”
Now, the seller would love to sell it for more. If let’s say that the stock is selling for a high price and actually news comes out and says, “Hey, it’s actually worth less.” A buyer won’t be willing to pay that much.
Because you have two entities of their own volition coming together to A, one person buying that stock, and B, the other person selling it, they come to an agreement as to what the person is willing to sell it for, the lowest price that they’re willing to sell it for, and the highest price that the buyer is willing to buy it for.
Proper Prices
So you have this supply demand curve kind of a thing going on. And with the supply demand curve, you have the X and Y-axis and then you have an X in the middle of the chart. And as the price goes up, more people are willing to produce things. Well, it works as well.
And then vice versa, if the price is lower, they’re not willing to produce as much. If the price is higher, the buyer’s not willing to buy as much. And vice versa. So what happens if the price is lower? They’re willing to buy more. Well, the same thing works in stock trading.
So what happens is that with market efficiency, the idea that the prices are proper is what the concept’s based on. But the idea was if people aren’t trading anymore, then we really don’t know the price.
This is what happens in real estate, by the way. If we look at the real estate markets, we can look at that and say, “It’s not as efficient as the stock market.” Why? Because each house is a little bit different.
If I’m looking at one share of Coca-Cola stock, it’s the same as another share of Coca-Cola stock. I’m indifferent between the two. I’m not indifferent between two houses.
So what happens is because the location’s different, the house is a little different, the condition in the house is a little bit different, you’ll have more inefficiencies. And because your house is over on Jones Lane or whatever is not traded all the time, you have less efficiency.
Now with the stock, it’s traded all the time. And why? The reason that this study showed what I’ve been talking about for years and I wasn’t the one that came up with it.
Markets wouldn’t become inefficient if everyone indexed.
One time I asked Eugene Fama, “So would markets become inefficient if everybody indexed?” And he said, “No.” And I said, “Why?”
He said, “Well, because somebody’s going to be doing trading. People are always putting money into their 401(k)s or taking their money out of their 401(k)s, so there are always trades taking place. Or they’re putting money in their investment account or taking their money out of their investment account.”
Dollar Cost Averaging
So it’s just interesting that now there is research showing that what he said so many years ago was dead on correct. Okay, these types of stories kind of lead us all over the place.
There was an article saying that only 401(k) savers didn’t lose money in the past year. It was a rough year in the stock market for most people. For most people, because they have most of their money in large U.S. stocks, which went down 20%, it was a rough year.
Whereas some areas in the market, like I said, only went down a small value. I was just talking about it only going down 3%. Most people lost a lot more.
The only people that did not lose money were who? It was beginners. It was young investor Gen Z savers. And why didn’t they lose money? Because they had small balances and they were putting money in.
There’s an interesting lesson to be learned for why they didn’t lose money because it goes deeper than what I just said. The reason is that what happened last year was an interesting year, and this is a lesson in dollar cost averaging for you investors that put money into something on a regular basis.
Dollar cost averaging is putting a set amount of money in on a regular basis throughout a year.
What will happen is that each time that you buy, you’re buying at a different share price based on what the market did just recently.
Then what happens is that if the market is down, you are buying more shares. So let’s say that the share price is $5 and you’re putting in $100, so you’re going to buy 20 shares.
Now, if the price jumps to $10, you will buy only 10 shares. You’ll buy half the number of shares because the share price has doubled. That’s dollar cost averaging.
So if the price drops down to $2 let’s say, then you’re going to buy 50 shares. So what happens is that as the price drops, you’ll buy more shares. So fooling yourself into playing the market correctly is the idea behind dollar cost averaging.
A Look at 2022
Well, what happened last year is that the market started up in 2022, but it lasted a very, very short period of time. Then it went down, down, down, down, down, down. And then about mid-year later on in the year, the market started back up again.
So if you think about it, if you had a young investor that was putting money in in the early part of the year, they were buying more and more shares with each dollar that they invested because the market happened to have gone down in the beginning of the year. By the time the later part of the year started where the market actually jumped up, they owned more shares and therefore that is why they did well.
Some young investors did well by accident, not by beating the market.
Now, anybody that hadn’t accumulated a balance, because most people invested in large U.S. stocks, like I said, and that area of the market got hit the worst. That accumulated balance going down more than made up for any contributions they made throughout the year.
So it wasn’t rocket science. I just don’t think it was really worth an article. But it may confuse people thinking that there was a group of people that was really smart and they figured out how to beat the market. Not exactly.
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