Why do people buy mutual funds or individual stocks?

This puzzles many people. The evidence is fairly incontrovertible that stock-picking and fund-picking are very, very expensive hobbies. So why do people do it? A fellow alum of the Chicago GSB once pointed out how many of our classmates, having spent $100K to learn that they can't beat the market, are now in the money management business. "I'm not sure," he said meditatively, "but I think maybe they should be in jail."

Why do people do this to themselves? My tenative answer is that you can't hit a home run with an index fund. You may get rich, eventually; but you will never get richer than everybody else. People investing in the stock market are buying the fantasy of the quick score. And like everyone else looking for a painless way to get rich, they're easy marks for the unscrupulous.

Comments

I don't want to get rich. I don't want to eat cat food when I retire.

Posted by Klug | December 11, 2007 5:23 PM

You know, cat food is all the rage here in NYC. Three cat food restuarant's just opened up in Soho. I personally enjoyed the Pate de Friskies at Le chat de fantaisie même. I'm not sure about the dog food restuarant however, too avant guarde.

Playing the stock market to get rich is like playing any game in Vegas, the only way to win consistantly is to gain the system. But it is possible to become very comfortable with a conservative investment approach.

But when you get right down to it, it's all luck.

Posted by Kate | December 11, 2007 5:29 PM

More importantly, why aren't 401k's required to have an index fund in each category? :-(

Another thing: It's going too far to say *everyone* should buy an index fund. How does the index get priced? People have to be looking for underpriced companies *that they might want to take over* in order for the stock market to fill its role.

Posted by Person | December 11, 2007 5:38 PM

I play two ways:

1. The Dilbert Method. Google it. Don't beat the market, be the market.

2. I buy individual stocks of companies in the industry that I work in, that have people I know working for them, doing things that I think are cool and useful. That has done pretty well for me. Not perfect, but better-than-market.

Posted by Donut | December 11, 2007 5:42 PM

While we're at it, what do people think of targeted retirement funds? They're new and fashionable, but I'm concerned that they have bad fundamentals.

Posted by Klug | December 11, 2007 5:42 PM

Warren Buffett on Efficient Markets:

"I'd be a bum on the street with a tin cup if the markets were always efficient."

"The professors who taught Efficient Market Theory said that someone throwing darts at the stock tables could select stock portfolio having prospects just as good as one selected by the brightest, most hard-working securities analyst. Observing correctly that the market was frequently efficient, they went on to conclude incorrectly that it was always efficient."

I think Warren Buffett probably has a better understanding of markets than the backers of the EMH here. His investment ideas are rooted in the basic ideas of beahvioral finance: people sometimes act irrationally. Thus, markets are prone to excesses of greed and fear.

Thise who are willing to study the fundamentals patiently, and to go against the crowd, can make a great deal of money. The efficient markets people are the worst kind of dogmatists. They refuse to admit the empirical evidence against their theory, or its inherent logical weaknesses.

And they do not ususally even try to make an argument for their position. Like religious fanatics, in the face of opposition they just repeat it with increasing fervor.

Posted by rwe | December 11, 2007 5:46 PM

Yes, but, I'm not Warren Buffett. Neither are most people investing for retirement. Respecting generally efficient markets and Warren's ability to outsmart them are completely compatible.

Posted by Bud Fox | December 11, 2007 6:00 PM

Target-date funds are a total scam. Jim Cramer's new book (and mine) explains why (Stay Mad For Life).

Sorry for the plug.

Basically target-date funds charge higher than average fees, and their asset allocation is way too conservative. There's a lot of variation among different ones, but you'll find plenty of target-date funds that give you 30% bonds if you plan on retiring in 40 years, and that's just nuts.

Also, bond funds tend to have lower fees than stock funds. So if you want to "be" your own target-date fund, figure out what percentage mix of stocks and bonds you want as you get older, and just adjust your asset allocation the way you want to as you age.

Target-date funds are marketed as easy because you don't need to do any thinking at all after you invest in them. That's crazy. It's not hard to say: I want 10% bonds when I'm 25, 30% when I'm 35, 40% when I'm 45, 50% when I'm 55, 60% when I'm 65, or whatever you want, and just allocate accordingly between equities and fixed income as you get older. And you save yourself a bundle on fees because you're not paying the higher than average target-date fees for your equities or your bonds, where the target-date fees are outrageous compared to the fees on most bond funds.

Posted by Cliff Mason | December 11, 2007 6:03 PM

Bud, if you are arguing that markets are pretty efficient and that most people would be better off investing in index funds, then you and I agree.

But if you are saying that it takes some divine gift, some almost superuman inteligence, to beat the market, then you and I disagree. And, perhaps more importantly, you and Warren Buffett disagree. For, as he also said,

You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ."

It didn't take a genius to see that Nasdaq 5000 was too high. Nor did it take a genius to see some opportunity when the market swooned in 2001 and again in 2003. If you are willing to bet against the herd, you can make a lot of money on mispriced securities. Warren Buffett has (and so have I, though not quite as much as the master).

Posted by rwe | December 11, 2007 6:17 PM

The Dilbert Method (or Megan's for that matter) might sell better as "Zen Investing".

Posted by PaulJC | December 11, 2007 6:24 PM

There are considerable tax advantages to buying a diversified portfolio of individual stocks. To match index returns, you'll need 20-50k to start and a discount broker.

Then buy a randomized set of stocks chosen from all major industries and company capitalizations.

When you sell your losers as their capitalizations drop, be sure to match them against winners to make the losses maximally deductible.

When you sell winners, match them to your own lower income years (sabbaticals, retirement).

You'll beat the tax treatment of an index fund by 1-10% over your lifetime (not annually). It's not a lot of money and it requires some effort but it does have a return.

Posted by Brian | December 11, 2007 6:25 PM

I for one am glad that people avoid index funds and pick their own stocks. If every individual investor pushed money into index funds and ignored their monthly statements, how could the market remain efficient? Wouldn't it just keep pushing money into companies regardless of their success and failure?

Posted by Joe Magarac | December 11, 2007 6:33 PM

"Investing is not a game where the guy with the 160 IQ beats the guy with the 130 IQ."

This is an excellent quote. Given what I've heard about how emotion drives the market (I'm not much of an investor myself), it might be that a high EQ beats a high IQ. Unfortunately I don't think you can measure EQ.

Posted by Derek Scruggs | December 11, 2007 6:40 PM

if investing is the stock market is so costly, how can it be a "painless way to get rich"?

Posted by Kathleen | December 11, 2007 6:49 PM

I accept a weak version of the EMH. I believe that while it may be possible to beat the market, it is very difficult, and cannot be done by most professional managers. And for me, that the key point rather than more technical measures. As a practical matter, it's all but impossible to select stocks that will outperform the market ona risk adjusted basis. It's also all but impossible to select someone who can beat the market on a consistent basis.

The important thing - the main thing that drives the differences in performance of real life portfolios, is what asset classes are invested in. The single biggest mistake is to invest too conservatively, leaving money in treasuries or cash, especially when young.

Posted by wph | December 11, 2007 7:06 PM

In the following excerpt from anNPR interview">Mitlon Friedman rejects the EMH:

Friedman: I have believed for some time that the stock market was in a bubble, and that bubble just burst. And it's a good thing to have bubbles burst, because you cannot sustain a bubble indefinitely. And if the bubble goes too far, the bursting has very serious consequences. The best example of that is Japan, where the bubble went too far in the late 1980s, and when it burst in 1990 Japan took action which led to, by now, eight years of seriously depressed conditions.

NR: What accounted for our bubble?

Friedman: A tendency for people to extrapolate the past too far. What accounted for the tulip bubble in the Netherlands some centuries back? What accounted for the Florida land bubble, the Japanese bubble? Bubbles occur because there's a mass psychology that develops and that tends to project what's going on and thinks it will always continue to go on.

As it turned out, Friedman was right about stock prices, as all but the most purblind efficien market fanatics now admit.

Posted by rwe | December 11, 2007 7:07 PM

The first one didn't work, so here is the link again:

Friedman on Bubbles

Posted by rwe | December 11, 2007 7:10 PM

An easy answer to your question...

You have better odds than the lottery and casinos, and it's just as much fun as that sort of gambling.

Posted by Xmas | December 11, 2007 7:38 PM

If you "tithe" to yourself consistently, over time, you will do well.

Could you have done better? Maybe. (I guess you could have been Warren Buffett.)

Could you have done worse? Certainly. (You could have been invested in Social Security.)

Will you be able to retire comfortably and dispassionately analyze your successes and failures while sipping a mint julep an the veranda? Yup!

The "perfect" need not ever be the enemy of the "good".

Drink up!

Posted by Ed Reid | December 11, 2007 8:01 PM

I think one big reason people stock-pick is that the financial services industry has a very strong incentive to encourage people to do so.

Posted by fling93 | December 11, 2007 8:04 PM

I'm a stock investor; Berkshire Hathaway. I don't see a problem with that. Should I be switching to an index fund?

Posted by JR | December 11, 2007 9:06 PM

One point on tech bubble.

It is obvoius now that it was a bubble (at least that is the narrative that has been attached to it and one that I believe), but if it was so obvious then why did people not short. There were lots of ways even average investors could get short. Buy puts, buy bear fund on the Nasdaq, sell calls, sell the S&P mini futures contract etc.

The reason is that there was quite a bit of uncertainty about if it was a bubble or not and how long it might last. I thought stocks were overpriced but I didn't believe it strongly enough to short the market. So at the end of the day I can'r really say I knew it was over valued because I didn't do anything about it.

Posted by eccdogg | December 11, 2007 9:09 PM

There's good evidence that investor behavior exhibits several classic decision-making biases that result in a systematic departure from what the rational choice model would predict. Of particular relevance here is the “overconfidence bias”; i.e., the belief that good things are more likely than average to happen to us and bad things are less likely than average to happen to us. See http://www.stephenbainbridge.com/punditry/comments/megan_mcardle_on_investing_decisions/

Posted by Steve Bainbridge | December 11, 2007 9:28 PM

"Yes, but, I'm not Warren Buffett. Neither are most people investing for retirement. Respecting generally efficient markets and Warren's ability to outsmart them are completely compatible."

Buffett addressed this 23 years ago in a lecture at Columbia: "The Superinvestors of Graham-and-Doddsville". As Buffett pointed out, he wasn't the only one who had beaten the market consistently -- so had Bill Ruane, Walter Schloss, Tom Knapp, etc. -- all value investors who were influenced by Buffett's mentor, Benjamin Graham.

Since then, there has been a new generation of great value investors who have consistently beaten the market. Some, like Joel Greenblatt, have wracked up their returns at hedge funds, but others, like Bruce Berkowitz have done so running open-ended mutual funds. Berkowitz's Fairholme Fund has clobbered the S&P since inception. It's one thing to beat the market during bull markets, but Berkowitz's bear market performance has been even more impressive. If you'd rather put your money in an index fund than in shares of FAIRX, BRK-B, etc., that's your choice, but it's a heavy price to pay for fealty to EMH orthodoxy.

Posted by Fred | December 11, 2007 9:30 PM

cross-post

For an 'Economics' weblog, I'm always amazed at MM's, near-singular, focus on Finance.

Seeing as we're in 'Election Season', it may behoove us to consider that it's Always Election Season.

Our 'dollars' are mere Ballots. Each day we elect, through our decisions on how to spend and/or invest, the 'morrow we trod.

Our votes, always and everywhere, have a Financial value and an Economic impact.

It is hardly unknown that two classes of shares, one with and one without voting rights, trade at different prices. Shares without such rights, trading at discounts.

What MutFund and Index Fund buyers should ask themselves is: "Where's my proxy dividend?"

EMH is yet another smoke-screen to tell People that their too stoopid to figure out what's right for themselves.

Buffet, and Lynch, are telling you the truth when they acclaim that 'one doesn't need to be a rocket scientist', just observant.

Posted by MEH | December 11, 2007 9:35 PM

Posted by Mark E Hoffer | December 11, 2007 9:39 PM

Fred, you say that "Berkowitz's bear market performance has been even more impressive" as if he had anything more going for him. In the last two years he's done a little better than a Vanguard 500 Index fund. And the Vanguard fund has an expense ratio of .18%.

Any fund manager can beat the market in the short term. In fact, a good chunk of them will, just from random selection. You need more than 3 good years to make a claim for genius.

Posted by Henry | December 11, 2007 9:55 PM

Has Megan (or anyone else) ever wrote a post regarding on whether one should contribute to your Roth IRA or 401K.

Right now I'm investing into a Roth IRA. But that's more of an overall guess. I'm trying to do the math right now on excel. And I have a monster headach...

Posted by thehova | December 11, 2007 10:04 PM

Here's what puzzles me:

Why the legions of people who now support investing in index funds (this is an overwhelming majority among the chattering class and NOT at all the consensus view of economics who study the market, who are indeed separate from the efficient markets people) are so smug about it?

There are many reasons why a person might hold a certain position, but I have to believe that index funds have become so popular, at least as something to talk about (let's face it, the idea has been around for three decades--this is still controversial?) because it allows its proponents to feel superior to an enormous number of people, including those who make spectacularly more money than the rest of us.

Obviously there are good reasons for most investors to seek the comfort of index funds, mostly because they allow you to perform decently without being at all informed about any macro or micro economic issues.

Know nothing and still beat the vast majority of people most of the time, sounds too good to be true!

And it is. The reason so many people prefer individual stock picking is that with the right mix of easily acquired skills and hard work you will in fact have no trouble beating the benchmarks. I do not have a theory like the efficient markets hypothesis behind me, but like all economics this hypothesis relates to a model that is intended to help us better understand reality. If we embrace the hypothesis as reality we are doing it a disservice, and doing ourselves one at the same time.

I'm not talking about mutual funds here which are institutionally crippled because they make their money by raising more assets, not by giving their investors gains--except early on obviously to grow the asset base (not a great incentive to do a good job, by the way).

I don't know how to conduct a study of individual investors who do the right amount of homework, but in my role on Mad Money I hear from and read emails from thousands of people who are beating the benchmarks and have done so consistently by following a set of straightforward rules. This is all anecdotal, but the assumption of rational markets does require rational investors. To take the attitude that even the weakest version of the efficient markets hypothesis holds, but investors are afflicted with so many biases that they might as well be considered non-rational, seems convenient for those who want to feel good about their decision not to invest, but not particularly consistent.

Though I am a leftist, I do try hard not to assume that most people are idiots and not fit to make their own economic decisions. Which is why it screams out to me whenever someone else does it, and I'd say that happens pretty much every time someone writes an article or a blog post about how stupid and lucky those billionaire stock pickers are and how much smarter it obviously is to just buy some index funds.

Megan, you're stuff is pretty great, but at the very least you're pandering to ressentiment if not necessarily being guided by it yourself.

If you want to see a real example of what I'm talking about, check out fraudster Henry Blodget's articles in slate advocating this approach. The envy there is palpable. On second thought, I don't want to plug his work, so don't read it.

Posted by Cliff Mason | December 11, 2007 11:01 PM

Henry,

If you think this outperformance of Vanguard's S&P index fund is something to scoff at, you are parading your ignorance. The two year comparison of FAIRX to VFNIX may not look as dramatic as the eight year comparison, but if you'd rather pay 82 basis points less in fees every year to underperform Berkowitz and have greater downside risk, then stick with the index fund. Had you invested $10k in that index fund 8 years ago, it would be worth about $12k now; had you invested it in the Fairholme fund, it would be worth about $36k.

Bogleheads are often penny-wise and pound-foolish.

Posted by Fred | December 11, 2007 11:05 PM

For the uninitiated, Cliff Mason (assuming the poster above is him) is Jim Cramer's nephew and junior writing collaborator.

Posted by Fred | December 11, 2007 11:09 PM

"I'm a stock investor; Berkshire Hathaway. I don't see a problem with that. Should I be switching to an index fund?"

JR, don't switch. Berkshire is my largest position, and I've been handsomely rewarded for my confidence in Mr. Buffett's ability to beat the indexes. Let the Efficient Market Flat Earthers have their index funds.

The people here who have backed the EMH have offered little or no argument for it. It is, for them, an article of faith.

P. S.: Say high to Sue Ellen.

Posted by rwe | December 11, 2007 11:37 PM

Annualized returns over the last 10 years (according to Morningstar):

Berkshire: 12.7%

S&P 500: 4.6%

You people who've been indexing rather than buying Berkshire are a lot poorer for it. If you go back further than 10 years the differences become even more dramatic.

Indexing is not the worst strategy in the world, mind you. But it is far from the best.

Posted by rwe | December 11, 2007 11:46 PM

Think you can pick stocks? Try picking a money market fund. Read this from the Wall Street Journal. The key words:

Last month, Bank of America disclosed that it would provide support of up to $300 million for an institutional cash fund, and a similar amount to a separate group of money-market funds that own troubled securities.

The article says that the institutional fund has failed, causing substantial losses. The other funds mentioned are apparently the money market funds your bank accounts are swept into overnight. The cause of the collapse? Asset backed commercial paper. Check the portfolio of the money market fund you own and see if you can figure out if it is safe.

I've read enough here from the host and the commenters to see that you all think you know how to manage your money, so this should be a good test.

Posted by masaccio | December 11, 2007 11:55 PM

masaccio-

"...now in the money management business. "I'm not sure," he said meditatively, "but I think maybe they should be in jail."

to your point/query

Posted by MEH | December 11, 2007 11:59 PM

Thanks for the intro and full disclosure Fred. In this case I may be toeing the Cramer party line, but we're a very contentious family.

Obviously I have an interest in seeing people try to pick their own stocks, but it's not like sufficiently large numbers of people will be convinced to flee individual stocks now if the last thirty years of index evangelizing hasn't already convinced them.

And what I said is true, the idea that when you win it's luck and when you lose its luck is always going to be inherently more appealing to the losers than the winners. The idea isn't entirely wrong, but anyone with experience actually running a portfolio in a serious, well informed manner, can tell you that there's a lot more to it than luck.

Wall Street doesn't make money (granted, this is not a great time to make this argument, but Goldman is still printing money. They've been shorting CDOs and CMOs backed by subprime debt for the last six months: was that luck or skill and intelligence?) because they're scamming the gullible or taking advantage of market opportunities that only they can exploit.

The fact is, all these money managers, especially at hedge funds (where you do not continue to succeed if you don't perform. the idea that a hedge fund that lags for five years will still be in business after that period of time is just absurd. the fund of funds guys would pull their money out immediately and crush the fund with redemptions, which is what happened to a lot of underperforming funds this summer), make tons of money because the stock market is a great place to get really rich if you know what you're doing.

Occam's razor, anyone?

Posted by Cliff Mason | December 11, 2007 11:59 PM

"And what I said is true, the idea that when you win it's luck and when you lose its luck is always going to be inherently more appealing to the losers than the winners."-Cliff Mason

Cliff has it exactly right. A lot of academic economists were pretty poor investors (as several of my own economics professors noted over the years). They felt rather embarassed about this, since stock markets were supposed to be their expertise. So they embraced a theory that said "hey look, all those guys like Buffett who are beating us are just lucky--5 sigma events. It's not our fault we can't beat the market. No one can beat the market consistently." And so, a falttering myth was born. And the academics taught their myth to credulous students, like M. McCardle apparently, and the students have gone on believing it.

Behavioral economics is pushing the EMH into the ash heap, but those who were taught it in business school and have been out of academia a while go on clinging, pathetically, to an outmoded teaching.

Posted by rwe | December 12, 2007 12:21 AM

rwe, even if you weren't buds with hdt, you'd still be right on.

Posted by MEH | December 12, 2007 12:35 AM

"It is obvoius now that it was a bubble (at least that is the narrative that has been attached to it and one that I believe), but if it was so obvious then why did people not short."

It isn't enough to know a stock is overpriced. If it continues to be overpriced, and even increases because others refuse to see the light, you're screwed. As I said on a different blog today, "the market can remain irrational longer than you can remain solvent".

Posted by Njorl | December 12, 2007 12:56 AM

Financial planners jumped onto the EMH bandwagon for similar reasons as the econ professors. Rigorous fundamental securities analysis is hard, and involves qualitative assessments as well as quantitative ones. In short, it involves some thinking, and thinking is hard work. Far easier to pretend it's all useless and throw their clients into index funds, and focus on "adding value" with Suze Orman-style admonitions about skipping the lattes at Starbucks.

Modern Portfolio Theory and its related pretensions are the incense in the temple of EMH.

Posted by Fred | December 12, 2007 12:59 AM

Hey Donut! I just Googled "The Dilbert Method"

The first two hits were for "Ruby on Rails" programming pages, and the third was your comment. Those Google bots are scary fast.

Do you have link?

Posted by JP | December 12, 2007 1:07 AM

"Thanks for the intro and full disclosure Fred."

No problem, Cliff. Nice work on the show, by the way. Perhaps you can pass a question along to your uncle though: How does he reconcile his constant praise for Goldman Sachs with his dismissal of Fortress Investment Group? Doesn't he know where Fortress's hybrid hedge fund head Peter Briger came from? He seems like a guy with the perfect background to find values among the wreckage of today's credit environment.

"As I said on a different blog today, "the market can remain irrational longer than you can remain solvent"."

That's true for shorts and those who go long on margin. For patient, un-leveraged long investors, it's not an issue. As Graham wrote, "In the short term, the market is a voting machine; in the long term it's a weighing machine".

Posted by Fred | December 12, 2007 1:10 AM

Annualized returns over the last 10 years (according to Morningstar):

Berkshire: 12.7%

S&P 500: 4.6%

You people who've been indexing rather than buying Berkshire are a lot poorer for it. If you go back further than 10 years the differences become even more dramatic.

So, you invest purely on faith in Warren Buffet. If he is that good, then he is charging below market prices for his wisdom. If he isn't that good, then there is probably a "Buffet Bubble", inflated by people who overvalue his wisdom based on past performance.

Posted by Njorl | December 12, 2007 1:19 AM

Grrrr.

Italics never work right over multiple paragraphs.

Posted by Njorl | December 12, 2007 1:20 AM

Cliff Mason: "Though I am a leftist, I do try hard not to assume that most people are idiots and not fit to make their own economic decisions."

Wow. Thanks for verifying my beliefs about leftist ideology.

Posted by JP | December 12, 2007 1:27 AM

Isn't there some argument to be made that all these people desperately trying to buy good stocks and sell bad ones are actually what makes the market efficient? And that if people started just buying indexes, then the market might stop doing such a good job of evaluating the worth of stocks, and you'd start to see more irrational or inaccurate prices? Which might in turn fuel less energetic behavior by businesses subject to less stringent evaluation from stock buyers?

Or maybe the way market index funds are structured isn't actually like that, so it wouldn't have that effect?

Posted by brooksfoe | December 12, 2007 1:28 AM

Njorl,

Buffett doesn't charge investors in BRK any fees (unless you count his modest salary). I paid all of $7 to buy my shares of BRK-B at Scottrade @ $3600 per share last spring, and I got a $50 discount on my car insurance to boot (GEICO is a Berkshire holding, and shareholders get discounts there). Holding BRK in a taxable brokerage account is low cost and tax efficient.

As for a "Buffett Bubble", if anything, Berkshire is slightly under-valued. The break-up value would be considerably more than the book value, since acquisitions of its operating companies are booked at their purchase price and many are worth a lot more today.

Posted by Fred | December 12, 2007 1:34 AM

A:

People are not always efficient, and markets are people.

Monday markets rose in anticipation of a Fed rate cut, and fell after the cut today, and based on a 25 basis point difference in expectations. There is a ton of irrationality in there, because obviously all of those people selling were holding positions based entirely on an unknown outcome. Who, pray tell, will hold a position (that you are willing to sell if you are wrong) when the next day's outcome is unknown?

B:

The average person may not beat the market because the average person does not really care about beating the market. They are not at home studying after work, trying to learn anything about companies, economics, accounting, psychology, or Wall Street.

To say the average person doesn't beat the market is like saying the average woman does not excel at understanding football. It is statisically true, but meaningless on an individual basis, as any woman with the right interest can easily understand football.

Posted by Finn | December 12, 2007 1:51 AM

This is an excellent quote. Given what I've heard about how emotion drives the market (I'm not much of an investor myself), it might be that a high EQ beats a high IQ. Unfortunately I don't think you can measure EQ.

Actually, there was a study about this - they used a reference group of people with personality disorders. Specifically, brain damage in areas that governed emotions. Or, bluntly put, psychopaths. So you want a LOW EQ.

Found the link:

http://www.gsb.stanford.edu/news/research/finance_shiv_invesmtdecisions.shtml

apex

Posted by apex | December 12, 2007 2:07 AM

That Keynes quotation that people keep throwing around about the market staying irrational longer than you can stay solvent is a perfect illustration of what's wrong with the way we think about the market.

The market has no agency. It has no state of mind. The market is never irrational. Other investors might be irrational from your perspective, but they're hardly ever irrational from their own perspectives.

It's better for investors to focus on why other investors behave "irrationally" than to waste time looking at the sum of investor behavior, the market, in the hope that they'll learn something useful.

If you find yourself believing that the market is behaving irrationally, you've backed yourself into a corner. It lets you get off the hook without asking the right questions. So if you were short tech in 1998 and 1999 and then gave up because "the market was staying irrational longer than you could stay solvent," you never really thought the position through. The case for shorting these stocks was that they were overvalued, but that relies on the rationality of the market to sort things out. The case should have been: people are willing to pay ridiculous prices for these stocks, far more than conventional valuation metrics can possibly justify, but I think some event or set of events will cause these irrational investors to lose confidence in their overvalued tech stocks and sell them six ways from sunday.

The right approach is more sociological than economic. Different stocks have different shareholder constituencies, and the behavior of each of these groups is roughly rational given their assumptions about the right way to invest and the prospects of the company in question. The way we think about the market tends to obscure the fact that we're really just talking about the actions of other investors who think they have good reasons for behaving the way they do. It also lulls us into thinking of the investors who drive short-term moves as buffoons with poorly thought-out strategies. Both of these biases discourage us from taking the time to work out how other investors tick. This gets less important if you have a really long time horizon, but if you're only looking out as far as the next eighteen months then nothing matters more than how the other guys operate.

Just one example here. There's always someone willing to call Google overvalued in print or on air, but they never explain why the people who own or want to own the stock, with opinions based on the same information the naysayers have, will change their minds and start selling. They just call it expensive and assume the magical market will take it down a peg or two in spite of all the investors who believe in the stock. I have never heard anyone say anything along the lines of, "GOOG's shareholders are in it for the growth, but I expect its growth to slow dramatically more than anticipated over the next year and that will shake a lot of people out of the stock." People are betting at explaining why investors will buy, but even there you rarely hear someone connect a fact about the fundamentals with an argument that the fact in question will appeal to some group of investors and cause them to buy."

When you think in terms of the market rather than the people who make the market it's just way too easy to decide what a stock is worth and then assume away the problem of how it will get there.

Fred: thanks for the props. In the past Jim's main objection to FIG was that it was so much more expensive than Goldman with a lot more downside. He was negative on this one all the way down, so I can't fault him there. Now that the stock trades at 13.5 times next year's estimates it's a lot harder to prefer Goldman, at 9.5 times 2008 estimates, on valuation. My best guess here is that Fortress has done a terrible job delivering on earnings or propping its stock up since it came public. Your stock doesn't fall to three points above the 52-week low because the company wants it to be there. From what I've learned of Jim's methods I expect he'd want to see evidence of a real turn at Fortress, and by that I mean at least one strong quarter but probably two of them in a row. Until then the stock has been a real dud and Jim typically doesn't try to get in ahead of a turnaround story, he usually waits for it to pick up a bit of steam before he's willing to believe. Also, the market is being saturated with these hedge fund stocks and that's rarely a good sign. With Och-Ziff now public and Blackstone over the summer, Fortress went from being the only play on the business to one of three. Since there doesn't seem to be much demand for these stocks anyway that surely doesn't help. If you look at the most recent quarter too you'll see that FIG was down 1% on its own investments, which is not something you want to see in a money management firm.

Goldman on the other hand has been a real performer, it has a more diverse set of businesses , and that means its numbers are a lot more predictable and consistent than FIG's. GS has a track record of beating the earnings estimates while FIG has fallen short. It's also better at managing its own money than FIG has proven--witness their terrific results from shorting subprime paper last quarter.

Fred I'm not sure if these are Jim's opinions right now, but they're observations based on what he's said about both companies lately and his approach to stocks.

Posted by Cliff Mason | December 12, 2007 4:39 AM

As Person alluded to early in the thread, I haven't yet had an employer who had an index fund in their 401k. My current job is bad enough that we're just contributing enough to get the full match, and looking for a good account to put the remainder of our retirement money in.

Posted by Tom H. | December 12, 2007 8:32 AM

"Isn't there some argument to be made that all these people desperately trying to buy good stocks and sell bad ones are actually what makes the market efficient? And that if people started just buying indexes, then the market might stop doing such a good job of evaluating the worth of stocks, and you'd start to see more irrational or inaccurate prices?"-brooksfoe

Brooksfoe is right (as Joe was earlier). The funny thing about efficient market people is that their underlying assumption is rational, optimizing behavior on the part of investors. But then they say, "Hey, look how stupid all these investors are, picking stocks and actively managed funds when they ought to be indexing." And that's a contradiction.

If everyone were indexing, markets would be terribly inefficient, since companies would be able to attract capital reagrdless of their future prospects. Capital would be allocated very ineffeciently in that case and there would be lots of incentives to look at individual securities rather than indexing. Everyone indexing, then, is not a plausible market equilibrium.

Thus, even assuming perfectly rational behavior, stock-picking has to be sufficiently rewarding to entice some people to devote time to researching companies rather than merely indexing. Otherwise they wouldn't do it. So really, EMH falls apart logically, even under its own assumption of perfect rationality. Of course if you add in insights from psychology and behavioral economic about herd behavior, then EMH becomes even more obviously untenable.

I doubt the EMH Kool-Aid drinkers here will try to engage with me (or brooksfore or Joe) on this point, though. They just assert, they don't argue or present evidence.

Posted by rwe | December 12, 2007 9:29 AM

Okay, thanks, rwe, but now, arguing against that theory: when you buy an index fund, does that actually remove the incentive for the managers who run the index fund to try and buy winners and sell losers? Couldn't you set it up so that index funds simply guaranteed investors returns identical to the market as a whole, but let the fund managers keep whatever they make on top of that, or punish them for earning less? Thus preserving the incentives that keep the market itself pricing rationally?

Posted by brooksfoe | December 12, 2007 11:12 AM

If one is going to compare to an index, at least use the Vanguard Total Stock Market Index, not the S&P 500, which was NEVER "the market." Showing that a fund beat S&P 500 in the last few years is just saying that small stocks outperformed. And of course, a "true" index should include some foreign equities as well.

Me, I believe I can't beat the market whichever flavor of EMH holds. However, I wish that I knew what THE market REALLY is. Is it 40/30/30 US/Intl/Bonds or should I include REITS and TIPS? What about foreign small caps with really high expenses and high transactions costs? Commodities? Is my home equity part of my portfolio? Sadly, picking the right stock fund is a subset of the general problem of what a true TOTAL MARKET portfolio should look like, and academics have not fully calculated that [They haven't even solved the optimal solution with just stocks/bonds/real estate -- at least not in the papers I've read that noodle around the issue.]

Posted by chewie | December 12, 2007 11:12 AM

thehova: Has Megan (or anyone else) ever wrote a post regarding on whether one should contribute to your Roth IRA or 401K.

Er, why not max out both? That's what I do (or rather, what I did before I went back to school, anyway).

Cliff Mason: Here's what puzzles me: Why the legions of people who now support investing in index funds...are so smug about it?

I imagine people are smug about indexing because people are smug about almost any decision they've made that simply required some thought. Stock pickers who've beaten the market over just one or two years are smug about that. Stock pickers that underperform the market but who picked some stock before it got hot are smug about that.

Me, I tell folks I index because when the bubble burst, I realized that I'm not that good at stock picking. So I'm not smug about my strategy. I imagine if I'm smug about something, it's probably my savings rate. :)

Posted by fling93 | December 12, 2007 3:33 PM

Fred, my point was really much simpler -- you're looking at a small data set.

Posted by Henry | December 12, 2007 4:35 PM

Cliff,

Thanks for the opinions on GS and FIG. You're right that Goldman has historically done a great job of investing its own money. That's why I mentioned Peter Briger, because that was his role at Goldman, as co-head of Goldman's special situations group. A WSJ article last summer described this group as Goldman's "elite but opaque money-making machine that buys and sells eclectic assets including British power plants, Japanese golf courses and Thai auto loans." According to the article, this small group that bet the firm's own money around the world on distressed assets and debt, ended up generating 20% of the overall earnings for Goldman Sachs. It made bets during periods of uncertainty, for example, buying airplanes off of struggling airlines after 9/11, and selling them back years later when the travel industry took off. Goldman got more bang for its buck out of this unit than any other. Briger was essentially underpaid there, so went to Fortress and took an equity stake that has now made him a billionaire.

I liked the idea of getting a little piece of Briger's business for less than some insiders paid for it (my average cost is $17.02). I look at it like getting the best part of Goldman's business at pre-IPO prices.

Goldman's P/E ratio is lower (as it should be), but Fortress's PEG is .4. That's way too low for a company that has been growing assets under management at 50% year-over-year and nets 2% of those assets to its bottom line annually, on average.

Posted by Fred | December 12, 2007 5:10 PM

"If one is going to compare to an index, at least use the Vanguard Total Stock Market Index, not the S&P 500, which was NEVER "the market.""

Chewie,

Since both indexes are market-cap weighted, you won't find a whole lot of difference between those two.

Posted by Fred | December 12, 2007 7:39 PM

Fred,

A lot people have been using figures from the last few years, when the S&P500 noticeably underperformed the whole market. Of course, in the longer run, the two have very high correlation.

It is common to see funds with large shares in foreign equities and small caps being compared to the S&P 500. Well guess what? Foreign and small caps have done well since about 2002. But how well do these funds do when compared to indexes with equivalent weighting in these asset classes? Pfftt.

As I said, the real problem for a consumer like me (when interpreting the academic lit) is to decide what an "optimal" allocation across asset classes "should" be. All the lit on the efficient frontier seems non-helpful because you only know in hindsight what the true correlation across classes will be.

Posted by chewie | December 13, 2007 5:51 AM

Chewie,

Your definition of "the whole market" is different from Vanguards use of "Total Market". There can be (and has been) a lot divergence between international stock returns and domestic stock returns, and international returns can be broken down further by region, by developed or emerging markets, by market cap, etc. But none of that is covered by the Vanguard Total Stock Market Index Fund, which covers only US stocks. My point was that, since the total stock market index fund and the S&P 500 index fund are both market cap-weighted (i.e., a mega cap stock like Exxon has ~900x more impact on performance than a small cap like Heindrick & Struggles), there isn't a whole lot of divergence in returns between them.

It's true that a big failure of MPT and its efficient frontier concept is that it's entirely backward-looking, and so doesn't offer a lot of help with asset allocation with respect to international and domestic stocks. What I did a couple of years ago for international exposure was buy some DODFX for exposure primarily to developed countries and TREMX for exposure to emerging countries overseas (TREMX is actually limited to Eastern Europe, the Middle East, and North Africa, but it's done phenomenally well).

Posted by Fred | December 13, 2007 8:25 AM

As to the original question in Megan's post, her answer strikes me as correct - it's the same motivation that drives Lotto ticket sales and has put hig-stakes poker on ESPN. "The question you have to ask yourself is 'do I feel lucky?'"

Posted by ktel | December 13, 2007 1:06 PM

The problem with the EMH literature is that most of the studies compare the performance of a benchmark index with actively managed mutual funds, but that's a rigged game. Mutual funds are strangled by regulation, and are pretty much forced into closet indexing. They can't engaging in any short-selling strategies, and they can't leverage any of their positions. There is cap on the percentage stake they can take in a company, and there is a cap on how large of a percentage of their portfolio a single position can be. Thus, most hedge funds are diluted across hundreds of positions. A corollary of this fact is that they don't have an economic incentive to do real due diligence on any one of their positions because it makes up such a small percentage of their portfolio. Thus, they rely largely on issuer estimates and analyst estimates instead of trying to do real valuations of companies. To say that EMH is true simply because most mutual funds don't beat the market is simply unwarranted.

Posted by ECL | December 14, 2007 5:30 PM