Tag Archives: stock indices

Combining Stock Picking and Stock Indices

In A Random Walk Down Wall Street, Burton Malkiel suggests owning stock indices as the best way to trade in the market. He writes, “Indexing is the strategy I most highly recommend for individuals and institutions” (402). An exchange traded fund (ETF) trades like a stock, but consists of more than one stock (i.e. a fund). For example, the SPDR S&P 500 (ticker: SPY) is an ETF that tracks the Standard & Poor’s 500-Stock Index. Malkiel highly recommends purchasing a portfolio of all companies in an index such as the S&P 500 because you avoid the challenges of identifying between winners and losers, which might actually be impossible. According to Malkiel,

The logic behind this strategy is the logic of the efficient-market hypothesis. But even if markets were not efficient, indexing would still be a very useful investment strategy. Since all the stocks in the market must be owned by someone, it follows that all the investors in the market will earn, on average, the market return. (391-192)

As a result, owning a stock index is a smart and effective way to invest in financial markets. If the efficient market hypothesis (EMH) is correct, then purchasing an index is the only sensible decision since there is no way to correctly pick winning stocks. If the EMH is not correct, then purchasing an index will still at least produce the market return.

Despite these wise words, many investors still wish to be stock pickers. According to the Wall Street Journal, “Here’s the latest evidence that stock picking is back: Investors are buying and selling fewer exchange-traded funds… The data suggests that investors are increasingly favoring trades in individual stocks”. The article suggests that investors’ preference for ETFs is dependent upon the predominance of macroeconomic headlines. When macroeconomic issues dominate the news, then the correlation among stocks increases. Macroeconomic data contributes to systematic risk, which is something that all stocks are exposed to. According to Malkiel,

Now, the important thing to realize is that systematic risk cannot be eliminated by diversification. It is precisely because all stocks move more or less in tandem (a large share of their variability is systematic) that even diversified stock portfolios are risky. (217)

When positive macroeconomic data is released, then all stocks will likely rise. When negative macroeconomic data is released, then all stocks will likely fall. As a result, investing in an ETF is an effective way to increase your exposure to systematic risk and diversify away unsystematic risk (i.e. factors particular to an individual company). And when macroeconomic issues become less prevalent, then investors would rather conduct stock picking.

Although Malkiel much prefers investing in indices, he understands that not all investors will always prefer investing in indices and offers four rules as a guide for selecting individual stocks. According to Malkiel, “Rule 1: Confine stock purchases to companies that appear able to sustain above average earnings growth for at least five years” (403). Following this rule will help investors select stocks with potential for future earnings growth. If the investor is successful, then the stock will increase earnings and the stock’s multiple might increase as well. According to Malkiel, “Rule 2: Never pay more for a stock than can reasonably be justified by a firm foundation of value” (403). Although Malkiel believes that it is impossible to calculate the exact intrinsic value of a stock, he does believe one can assess whether a stock is reasonably priced using the price-to-earnings (P/E) multiple. If a stock is trading at a P/E multiple that is significantly above the market average and the company’s growth prospects are not significantly above average, then that stock is overpriced and an investor should not but it. According to Malkiel, “Rule 3: It helps to buy stocks with the kinds of stories of anticipated growth on which investors can build castles in the air” (404). Due to the importance of psychological elements in determining stock prices, stock prices can skyrocket as investors’ expectations about future growth increase. Although predicting the expectations of investors in the future is inherently challenging, it is still a worthwhile pursuit. According to Malkiel, “Rule 4: Trade as little as possible” (404). Transaction costs such as broker fees and taxes can erode the profit from any investment strategy. In short, investors must resist the urge to trade frequently.

Although I am a strong believer in using ETFs to invest in entire indices, I also think there is a place and a time for picking individual stocks. After an investor has a well diversified portfolio, I believe an investor can take the risk and choose individual stocks. If an investor follows Malkiel’s  four rules, then I think stock picking can supplement ETFs.

(Revised) The Best Time to Start Investing For Retirement Is Now

While it may be a long ways away for the students in the monetary and financial policy class, financial wisdom states that now is the time for us to start saving for retirement. As many of us approach graduation and graduate school or our first full-time jobs, we’ll be soon required to answer questions like: “Roth or traditional?” or “mutual funds or ETFs?” when starting our savings. Common sense financial knowledge suggests that one should redistribute one’s investment account from stocks to bonds as one ages. This is often formalized in the investing heuristic where one should subtract their age from 100 to determine the proper allocation of stock in their portfolio. However, many financial researchers have had a change of heart and have begun to take a much greater liking to investing in stocks leading up to and during retirement.

Kelly Greene from the Wall Street Journal explains in her article “How Much Stock Should You Own in Retirement?,” that investment researchers have concluded that individuals should adopt a “U-shaped” pattern in which they invest mostly in stocks until they near retirement, upon which they dial back their stock holdings to between 20% and 50% of their portfolio at the start of retirement, and then begin to increase their stock holdings by around one percentage point per year throughout retirement. After examining 10,000 simulations with assumed average annual returns of 6.5% for stocks and 2.4% for bonds, the authors explain that those that instead keep 60% of their portfolio in stocks throughout retirement are likely to run out of money after 28 years in the worst case scenario. According to Professor Wade Pfau, a retirement-income professor at American College who was one of the researchers involved,

“You want to have the lowest stock allocation when your portfolio is largest, and that’s going to be right before and after retirement. That’s when you’re most vulnerable to losing wealth. Once you transition into retirement, you no longer have as much ability to change your plans and make it back up.”

In this case, retirees can reduce their risk at the beginning of retirement when they are most risk averse, and slowly dial up their risk as they age, thus increasing the odds that they’ll have enough money throughout their life.

This is perhaps useful advice for those who are nearing retirement and worried about their savings, but a more practical factor to consider, especially if you have a long ways until retirement, is how early can you start investing. After inflationary effects, you might want to start earlier than you once thought. In order to illustrate, I ran a short MATLAB analysis of the S&P 500 returns from 1947 (post-WWII) to 2013 using data from the website of Robert Shiller (Nobel Winning Economics Professor at Yale). To obtain the real price level of the S&P 500 index, I first converted the historical S&P500 prices to prices in 2013 dollars using the Consumer Price Index obtained from the Federal Reserve Economic Database (FRED). Here we use the following equation to put all prices in 2013 dollars.

Screen Shot 2014-03-10 at 2.42.18 PM

If you plot the real prices alongside the nominal prices, you get something that looks like this:

S&P 500 Nominal and Real Prices

It’s pretty obvious that inflation eats away at your return. If you invested in 1947 and cashed out in 2013 you would have had only around an 803.8% return over this 66-year period after inflation, rather than the 9633.1% return you’d expect nominally. We can back out the compounded annual percent return by rearranging the equation:

Screen Shot 2014-03-10 at 2.42.30 PM

Using this equation we find that the annual nominal return over this period excluding dividends is ~ 7% and the real annual return is only around 3.35% (see my code for calculations). Therefore, holding on to a few shares of stocks isn’t going to make you as rich (as quickly) as you might think, so it’s even more important to start saving as early as possible. No wonder why Brett Arends of the Wall Street Journal thinks that a lot of amateur investors don’t understand how large their long-term annual returns are likely to be.

It’s also easy to see that when you buy matters. If you bought the S&P in 1973 and sold in 1983 you would have lost roughly a third to a half of your real purchasing power. You would find similar results if you bought in 1999 and sold in 2009, so timing and luck do matter. It also important to take into consideration what you buy. The only ways around this scenario is to a) be patient and don’t sell in a panic, and b) invest in a portfolio that’s diversified across many different markets so that if one market sinks, your entire portfolio isn’t washed away. As Professor Miles Kimball mentions in his blog post “Why My Retirement Savings Accounts are Currently 100% in the Stock Market,” this can be done by investing in a low-cost international index fund that diversifies not only across industries but across international markets.

Overall, despite all the popular investing tips that are thrown around by professionals and pundits, it appears that there’s no time like today to start intelligently planning and investing for the future.