Monday, July 25, 2011

Indexing Looking Forward and Looking Back

An interesting thing about indexing is that it is never the best investing strategy when we look back in time. There is always some other strategy that would have been better if only we had known to make the right decisions.

If only I had known the stock crash of 2008 and 2009 was coming. I could have sold out of stocks in advance and bought back at the bottom. But I didn’t know and I rode stocks down and back up again. Unfortunately, we can’t invest to make past returns. We can only invest and accept whatever the market brings in the future.

A common human failing is the tendency to think that past events were predictable. We don’t know what will happen over the next month, but after it happens we tend to think that it was obvious that things would unfold as they did. But it was not obvious beforehand.

For those who look back, there is always a strategy that beats indexing. But for those who look forward, the best bet for the vast majority of investors is investing in inexpensive broad indexes.


  1. Bets can still be hedged with options. That plan creates less volatile portfolios, earning less in strongly rising markets and losing less in strongly falling markets.

    Depending on the specific hedge chosen, the overall effect can be to earn less over time (collars) with a guarantee of zero disasters, or slight out-performance over time (covered call writing) that gives up earning a ton during the boom years.

    Michael: I understand that we are not on the same page with this idea. Just sharing my thoughts.


  2. @Mark: Based on informal discussions with friends and acquaintenances, most users of options make wild bets with call options until they lose enough money that they quit using options entirely. This says to me that maybe a minority of investors might be able to use options responsibly, but most cannot. And as I've said before, I've never been able to find specific option trades to make a collar work sensibly. It always comes out with almost no upside, but a significant downside. Maybe I'm doing it incorrectly somehow.

  3. Michael said: "If only I had known the stock crash of 2008 and 2009 was coming. I could have sold out of stocks in advance and bought back at the bottom."

    This is exactly what I did Michael. I sold half my stocks before the market crash and went on a buying spree picking up $500k of stocks on margin at the bottom. BMO InvestorLine was charging me 2.25% on the loans back then (3.00% now) so it was a no brainer.

    I should mention that I spend my days following economics so I can see what is going to happen before it happens. Its like when I was younger, I was always mystified by how the Bank of Canada sets interest rates. Now that I understand that they are simply reacting to measures like the output gap, unemployment rate, inflation indicators, etc., I just watch what they watch and can predict what they are going to do in advance with reasonable certainty.

    BTW, the reason I knew the crash was coming was because of a single economic indicator flashing red, the savings rate. It had declined from about a historical range of 8%-15% and had hit a low of -0.5%. Consumers had replaced savings with the rise in equity in their homes. Some idiot economists even went along with this idea that rising home equity could negate the need to save for retirement. We all know how that played out.

  4. @Ahmed: How do you know, at any given time, that you're not the "idiot economist" yourself? :-)

  5. @ Patrick,

    I retired into investing at the age of 29. And no, I was not born with a silver spoon in my mouth, actually was close to being on welfare twice in my life. Wife helped out in the first few years as I studied investing and learned the craft. I'm a value investor who follows the methods of Benjamin Graham and Warren Buffett.

    I've been a successful investor for about twenty years now, so I guess my record speaks for itself. Or maybe I'm just lucky like a monkey that flips a coin and gets heads one hundred times in a row. (That was a bone for those of you who subscribe to the Efficient Market Hypothesis (EMH)).

    Anyway, I believe the secret to success in investing is to move ahead of the crowd. As Buffett says, "What the wise man does today, the fool does tomorrow". Most people get their information from the media, by which time it has already been discounted. Read annual and industry reports, keep an eye on economic indicators and political events, and invest accordingly, you can do well.

    And in those few cases where you mess up, that's what diversification is for. Even Warren Buffett makes mistakes.

  6. @Ahmed: Your recipe for investing success sounds quite simple:

    "Read annual and industry reports, keep an eye on economic indicators and political events, and invest accordingly, you can do well."

    I tried to do these things but largely failed. If you wish to convince more people to try, perhaps you should consider announcing your moves just after you make them. This wouldn't hurt your results and when people see that you made accurate predictions in advance, they will be convinced. You could do this by forming your won blog or by simply making comments here.

  7. @ Michael,

    Sorry if I haven't convinced you that value investing can beat the market, but the method is well known. Buy stocks at a 30% discount to intrinsic value and wait for value to out. The skill is in calculating the intrinsic value which is the method taught by Benjamin Graham and David L. Dodd in the classic book titled Security Analysis. It is a learned skill but it is not rocket science. No one who has followed this method has had cause to complain.

    In answer to the second part of your post, I am currently fully invested using margin trades. I believe with reasonable certainty that we are in for a long period of low interest rates. I always aim for a 10% return and with a margin cost of 3%, I can earn a 7% spread, my own version of a carry trade as Garth Turner calls it. That means that I can earn $7k on each $100k I borrow. In addition I get a $3k interest write-off on the debt which helps to reduce taxes. What could go wrong? Well interest rates could rise but that would sink the Canadian economy considering the amount of mortgage debt Canadians are carrying so the Bank of Canada would step in and lower them again. So no worries there. Maybe I don't earn the 10% if the economy stagnates. Well, say I earn 7%, not an unreasonable assumption. So I earn a 4% spread. I'm still happy as it's not my money.

    I hope I answered your questions Michael. I enjoy reading your posts and am saddened that you have gone over to the passive side of investing. The thing with active investing is that no one stands over your shoulder and tells you if your doing it wrong. And when you get poor results, it tells you that you were doing it wrong but not in what way. Even good results can fool you as they could be simply a result of a rising market, dumb luck, or being right for the wrong reasons.

  8. Always easy to look back, doesn't matter what kind of investor you are :) Good post Michael.