Hayek, spontaneous order and index funds

If I can use a picture of Salma to get one to click on this post and read a little about Friedrich's ideas, I have achieved a small victory in educating the masses. 


This is a re-post in a new package.

"in the study of such complex phenomena as the market, which depend on the actions of many individuals, all the circumstances which will determine the outcome of a process… will hardly ever be fully known or measurable."

The above quote is from the 1972 Nobel prize lecture of Austrian economist Friedrich Hayek who wrote brilliant works that explained the errors of fascism and socialism. He taught that the modern economy has too many variables for one person, or organization, to efficiently allocate its resources. Hayek argued that the price system does a better job of allocating resources than a government controlled system. Hayek's observations are part of his reflections on spontaneous order - which is the idea that order comes out of chaos when many self interested individuals are involved. This idea is played out in many areas. A recent example of spontaneous order is the open architecture software - Linux, which is written by programmers from all over the world who, in their spare time, add to the code. Linux now operates some of the fastest computers in the world and is the operating systems that runs many devices that we use in our daily life.

So how does this apply to investing?

The investing world is divided by those that believe they can predict economic and investment trends - the active managers, they believe they can predict which stocks to pick for your portfolio or mutual fund. Then there are those that believe that the stock market is too complex to make those decisions accurately on a consistent basis (the indexers). The indexers argue that the collective wisdom of all the investors in the world will average out to the best answer. The indexers, one could say, are Hayekian in their thinking. They would argue that if Wal Mart makes up 2% of the stock market, then an individual investor should own 2% of Wal Mart.

What is the collective wisdom of all investors in the investing world? Answer: index funds.

What is the record of index funds? Answer: Over time, they outperform active managers. Yes, year to year some active managers outperform the average. But it is not the same ones on a regular basis.

Spontaneous order seems to play out in stock funds. It explains why index funds outperform active managers. The collective wisdom of the many results in better investment performance than that of one or a few.

What does this mean for the average investor. It means that the best course of action has been to hold a well diversified, risk appropriate portfolio of the global stock and bond market, fund it with index funds, and rebalance annually.

For an analogous column, see Russ Roberts's 2004 Business Week column : "The Bagel and the Index Fund,"

http://www.businessweek.com/bwdaily/dnflash/jan2004/nf20040120_6180.htm

I recommend Russ Roberts's podcast: Econtalk, his blog: Cafe Hayek, and his books: "The Choice", "The invisible Heart", and "The Price of Everything."

Roberts is a professor of Economics at George Mason University

In another related article, see Jason Zweig's January 8, 2011 Wall Street Journal Column, in which he also cites Hayek in his explanation on why forecasters rarely get forecasts correct:

http://online.wsj.com/article/SB10001424052748703675904576064320900295678.html?mod=ITP_businessandfinan

Is There A Choice???

I read a short article this morning on saving for retirement. The article references a 35 year old saving for retirement and it explored his saving options: saving in a 60% stock portfolio vs. 80%  in stocks. And I thought: as we sit in an environment where the economy is shaky, personal and government debts are high,  the media and some investing advisers telling people "this time its different." What is one to do? Should one invest in the stock market? Is this advice still valid?

I believe it is.

I think one has to invest at some level in the global stock market. Your other option is keep your nest egg in cash or in a bank- earning nothing and actually losing value through inflation - that is a risk concern in itself..
But if capitalism,  and thus our economy implodes, then it wont matter if you held cash - banks will have failed and your Federal Reserve Note will be worthless.
So, one needs to take the leap of faith: that, over the long haul, capital markets will provide positive returns that exceed inflation. If they dont, as I said, it means that our economy has collapsed and then nothing you have has value.

I know, someone is sure to mention gold. But when the economic apocalypse occurs, one can take their gold too Wal Mart, unfortunately nobody will be there to exchange your gold for goods and the shelves will have been looted dry. As the economist Nouriel Roubin has said, forget gold, one will want Spam when the economic apocalypse arrives.

I maintain the old rules hold: one must invest in a mix of cash, bonds, stocks that are appropriate for the investors risk tolerance and time horizons.

A final thought: as many have rushed into US Treasury Bonds, ask yourself, who generally manages their finances better: governments or the majority of public companies? Congress or Wal Mart, GE, Apple, Microsoft etc?

I referenced this idea in a prior post: "REM, Pascals Wager and The Stock Market"

Survival Bias-Another Great Reason to Invest in Index Funds

This is a re-post from one of my favorite investing bloggers - "The White Coat Investor" - a young physician who decided to take investing into his own hands. He is very similar to the brilliant William Bernstein MD: author of "The Four Pillars of Investing"

In this post, Rick Ferri's new book is referenced. I highly recommend Ferri's books and blogs.

Survival Bias-Another Great Reason to Invest in Index Funds

Posted on November 16, 2011 by White Coat Investor

Survival Bias-Another Great Reason to Invest in Index Funds

Survival bias is what happens when some of the data that should be in a data set is deleted. The “surviving” data paints the picture as being better than it actually is. This is a real concern when you look at actively managed mutual funds.  Rick Ferri, in his new book, The Power of Passive Investing, displays this chart (used with permission.)

Figure 1: Twenty Years of Active Equity Funds (based on 100 funds)

If you do not account for survival bias, YOU’RE MISSING HALF THE DATA.  That’s such a huge effect.  Over 20 years, it appears that 17/50 (34%) of actively managed funds significantly outperformed their respective index.  but if you look at ALL the data, that number quickly shrinks to 17/100 (17%).  More depressingly, if you only consider those that significantly outperformed the index, that number is down to 6%.  I don’t know about you, but I’m humble enough to realize that the odds of me picking the 1 fund out of 20 that will significantly outperform is too low to justify the activity.  I’d be doing well to pick one that survived for 20 years.

There was another study done in 2006 by Savant Capital Management looking at the Morningstar database.  Basically, they inserted all the now-extinct funds back into the database to determine how much worse that would make the average actively managed fund look compared to the indexes.  They examined the time period 1995-2004 and found that survivor bias accounted for an additional performance gap of 1.3% per year.  Add that on to the already significant performance gap (heavily influenced by additional costs) and you have a real uphill battle for active managers.  1.3% a year is huge.  Consider two portfolios, one which grows at 4.7% real a year and one that grows at 6% real a year.  If you add $30K to the portfolio each year for 30 years, the one growing at 6%/year is worth 25% more, or nearly a half million bucks.  I don’t know about you, but I can think of a lot of things I could do with an extra half mil.

A Mathematician Explains the Paradox of The Efficient Market Hypothesis

I came across this article this morning. I had stuck it in the pages of Paulos's book "A Mathematician Plays The Stock Market"
It is a good short summary of the "efficient market hypothesis"

WALL STREET JOURNAL, SEPTEMBER 2, 2003 OpEdAll Investors Are LiarsBy JOHN ALLEN PAULOS

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As an author of a recently published book, I've noticed an odd inefficiency in the book market. Online booksellers often charge different amounts for the same book even though a couple of clicks worth of comparison shopping can reveal the disparity. This seems to violate the Efficient Market Hypothesis, which, applied to the stock market, maintains that at any given time a stock's price reflects all relevant information about the stock and hence is the same on every exchange. Despite its centrality and its exceptions, it's not widely appreciated that the hypothesis is a rather paradoxical one.First, let me note that the hypothesis comes in various strengths, depending on what information is assumed to be reflected in the stock price. The weakest form maintains that all information about past market prices is already reflected in the stock price. A consequence of this is that all of the rules and charts of technical analysis are useless. A stronger version maintains that all publicly available information about a company is already reflected in its stock price. A consequence of this version is that the earnings, interest and other elements of fundamental analysis are useless. The strongest version maintains that all information of all sorts is already reflected in the stock price. A consequence of this is that even inside information is useless.
It was probably this last version of the hypothesis that prompted the old joke about the two efficient market theorists walking down the street: They spot a $100 bill on the sidewalk and pass it by, reasoning that if it were real, it would have been picked up already. An even more ludicrous version lay behind the recent idea of a futures market in terrorism.

Adherents of all versions of the hypothesis tend to believe in passive investments such as broad-gauged index funds, which attempt to track a given market index such as the S&P 500. Opportunities, so the story continues, to make an excess profit by utilizing arcane rules or analyses, are at best evanescent since, even if some strategy seems to work for a bit, other investors will quickly jump in and arbitrage away the advantage. Once again, it's not that subscribers to technical charting, fundamental analysis or tea-leaf approaches won't make money; they generally will. They just won't make more than, say, the S&P 500.  (emphasis is mine)

So to what degree is the hypothesis true? The answer is surprising. The hypothesis, it turns out, has a rather anomalous logical status reminiscent of Epimenides the Cretan, who exclaimed, "All Cretans are liars." More specifically, the Efficient Market Hypothesis is true to the extent that a sufficient number (sometimes relatively small) of investors believe it to be false.
Why is this? If investors believe the hypothesis to be false, they will employ all sorts of strategies to take advantage of suspected opportunities. They will sniff out and pounce upon any tidbit of information even remotely relevant to a company's stock price, quickly driving it up or down. The result: By their exertions these investors will ensure that the market rapidly responds to the new information and becomes efficient.
On the other hand, if investors believe the market to be efficient, they won't bother. They will leave their assets in the same stocks or funds for long periods of times. The result: By their inaction these investors will help bring about a less responsive, less efficient market.
Thus we have an answer to the question of the market's efficiency. Since it's likely that most investors believe the market to be inefficient, it is, in fact, largely efficient. However, its degree of efficiency varies with the stock, the market and investors' beliefs.
The paradox of the Efficient Market Hypothesis is that its truth derives from enough people disbelieving it. How's that for a contrarian Cretan conclusion?
Mr. Paulos, a professor of mathematics at Temple University, is the author, most recently, of "A Mathematician Plays the Stock Market" (Basic Books, 2003).