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A Hypothetical Conversation Between a Stock Picker and an Indexer
By JLP | July 13, 2010
I saw this hypothetical conversation between a stock picker and an indexer by Larry Swedroe in the book I mentioned last night: Mutual Funds: Portfolio Structures, Analysis, Management, and Stewardship (Robert W. Kolb Series)
Steve: I just bought a 1,000 shares of Intel.
Sherman: Why did you buy Intel?
Steve: I became interest when I heard a fund manager on CNBC yesterday recommend the stock. He gave a solid explanation for the purchase. So I went home and did my own research. I don’t just rely on the recommendations of others. What I found was that the company has a stream of new products in the pipeline that are expected to drive the growth in earning to a much higher rate. In addition, they have worked off the excess inventories that had developed. The stock, relative to the market, is also trading at a P/E multiple that is below its historic relationship. And, finally, the company’s balance sheet is very strong. This is a great company that had some hard times, but it’s poised for a turnaround.
Sherman: Those facts sound like good reason for buying the stock. However, in the end, the only logical reason for your purchasing that particular stock was that you believed that it would outperform the market. This must be so because owning just that one stock is taking more risk, because of the lack of diversification, than if you had purchased a total stock market index fund. Isn’t this correct?
Steve: I guess that is so, if you look at it that way.
Sherman: But that is the only way to look at it. At least the only correct way. Now, Steve, where did you get those shares?
Steve: I bought them through a brokerage firm, of course.
Sherman: That is not what I meant. What I meant was, from where did the shares you purchased come? They did not come out of thin air. Someone had to sell them to you. We can break up the market into two types of investors, individuals like you and me and institutional investors like pension funds, mutual funds, and hedge funds. Do you believe that the seller was more likely to be another individual investor like you? Or was the seller more likely to be one of those institutional investor I mentioned?
Steve: I would guess that the seller was another individual investor.
Sherman: That is incorrect. Since institutional investors do as much as 90 percent of all trading, there is as much as a 90 percent chance that the seller was an institution. Since we no agree that while the underlying reason you bought the stock was that you believed that it would outperform the market, we can also agree that the underlying reason that the institutional investor sold the stock was because it believed it would underperform the market. If this were not the case, the investor would have continued to hold that stock. Correct?
Steve: I guess so.
Sherman: Okay. So you believed it would outperform the market and the institutional investor believed it would underperform. How many of you can be correct?
Steve: Just one.
Sherman: Being perfectly honest with yourself, who do you believe had more knowledge about the company, you or the institutional investor?
Steve: I would have to say the institutional investor.
Sherman: I agree. Thus, all the reasons you gave me for buying Intel were also known by the institutional investor. What you thought was knowledge was really nothing more than information that other, more sophisticated investor also had. Yet they decided to sell the stock. So the logical question is: Why did you buy the stock knowing that there could only be one winner in the trade and you were likely to be the loser?
Steve: I never thought of it that way.
Sherman: Again, that is the only way to think about it. You are playing a game where there4 can only be one winner and you are playing that game with a competitive disadvantage. The most likely way to avoid losing that type of game is to not play. Consider the following. What I believe is the most interesting part of this game of trying to beat the market lies in the answer to this question: Who is the likely seller when one institutional investor buys? Is it an individual investor or another institution?
Steve: Well, since institutions do as much as 90 percent of the trading, the logical answer must be that when one institution is buying, the seller is likely to be another institutional investor.
Sherman: Correct. One institution bought, say, one of Merrill Lynch’s mutual funds, because it thought it would outperform, while the other institution sold, say, one of Morgan Stanley’s mutual funds, because it thought Morgan Stanley would underperform. How many of them can be right?
Steve: Obviously, only one.
Sherman: Now, how many of them are spending your money, in the form of the operating expense ratio, commissions, and other trading costs in the effort to outperform the market?
Steve: Both of them are.
Sherman: This is why active management is a loser’s game. Since outperforming the market must be a zero-sum game before the expenses of the effort, in aggregate, after expenses, it must be a loser’s game for investors. Collectively, active investors must underperform the market by the total of all of their expenses. And since most of the competition is between very sophisticated institutional investors to find enough victims, meaning people like you and me, to exploit in order for them to overcome the hurdle of their expenses. So, Steve, with your newfound insight, would you still have done that trade?
Steve: I see why it really doesn’t make sense. I see that it is likely that I will only “discover” information that these institutional investors already know. Therefore, that information is already built into the current price.
Sherman: Now you see why I never buy any individual stocks. I don’t like playing a game where the odds are stacked against me. And, more important, I have far more important things to do with my time than doing research on stocks—like spending time with my family.
Steve: Well, I know my wife would agree with you on that.
Notice Swedroe is not saying that some stocks can’t be undervalued. Rather, he is saying that they are hard to find. One thing he doesn’t mention is that sometimes mutual funds are forced to sell stocks due to redemptions. So, they may like a particular stock but have to sell it in order to meet investor redemptions. I do think that with the invention of the computer and the internet, it is a lot more difficult to find undervalued stocks.
Anyway, I thought this conversation was interesting. Thoughts?
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Topics: Index Funds, Investing | 19 Comments »
July 13th, 2010 at 5:52 pm
Many are wary of the Wall St casino these days:
” The public has been told that the way to wealth is investing. The way to invest, Ph.D. economists tell the public, is to allocate your portfolio between stocks and bonds.
Which stocks ? An index of American stocks, preferably the S&P 500. Buy a no-load fund. Same with bonds: a mix of mid-term and long-term AAA-rated corporate and Treasury bonds.
Don’t try to beat the index, efficient market theory warns us. Buy and hold. All will be well.
For fund managers, yes. For investors, no. ”
{by Gary North}
http://www.lewrockwell.com/north/north864.html
July 13th, 2010 at 8:31 pm
I disagree when it comes to buy and hold of dividend-paying stocks.
The initial purchase may be done at a disadvantage, according to your assumptions. Since institutional investors have relatively short term outlooks when it comes to stock price, their turnover rate is necessarily much, much higher than a dividend investor.
A dividend investor is looking for increasing dividends to drive a stock price up, unlike the institutional investor that looks primarily for stock growth.
July 13th, 2010 at 9:54 pm
Or you could do one better and get out of the market. We’re in a secular bear market. The bubbles have burst, people and governments are loaded with debt, and there are no drivers for jobs. From a technical and fundamental perspective, equities are overpriced.
My saying going forward:
Return OF investment is more important than return on investment.
July 13th, 2010 at 10:50 pm
JT, seems like paying down a mortgage is the best deal around
JLP, did I get your attention?!!
July 14th, 2010 at 6:48 am
I tend to agree but there has to be a carrot dangling to keep retail investors in the game. Otherwise, there’s only going to be the institutions left and how can they ‘make’ money if there’s noone left to take it from?
I think there are always opportunities in the market. I’ve seen a stock go from $5 to $3 then back to $5 in the manner of a two week period. If the institutions were so smart, the selling in the first place never would have happened to drive it down to the low levels, since it was to rise back up anyways. If you, as an individual investor, could have come in around the lows, you could have ‘won’ that particular trade.
I think most of it is luck, but then again, you make your own luck.
July 14th, 2010 at 11:19 am
This doesn’t seem to apply to IPOs either. At some point, shares do have to come “out of thin air.”
July 14th, 2010 at 4:25 pm
Your argument assumes that institutional investors are ‘smarter’ than the individual investor. That is far from the case, is it not?
July 14th, 2010 at 6:16 pm
At lower levels of wealth, I would agree with your conclusions, because it is not cost-effective to diversify on one’s own. At higher levels, however, a buy-and-hold strategy with 20+ stocks saves the annual fees, and saves capital gains taxes. (Even index funds sell to re-align their portfolios, and so incur capital gains taxes, even if the owner does not sell his shares of the fund.)
July 14th, 2010 at 6:17 pm
Courtey, even IPOs are sales of privately-owned shares.
July 14th, 2010 at 8:55 pm
Jack, yes and no – the company has the option to create new shares during the initial public offering (and often does). “When a company lists its shares on a public exchange, it will almost invariably look to issue additional new shares in order at the same time…The existing shareholders will see their shareholdings diluted as a proportion of the company’s shares. However, they hope that the capital investment will make their shareholdings more valuable in absolute terms. In addition, once a company is listed, it will be able to issue further shares via a rights issue, thereby again providing itself with capital for expansion without incurring any debt.” (Wikipedia)
July 15th, 2010 at 11:45 am
The company cannot “create new shares.” It must split the existing shares.
Example: I own my own company, and I have all 100 shares. If I decide to go IPO, and sell 900 shares and keep 100, I have in reality split those 100 shares 10 to 1.
The owners of a private company must sell some of their ownership, some of their “share” in the company, in an IPO.
July 15th, 2010 at 1:15 pm
One common conclusion is when Steve and Sherman agrees that only one part in the transaction can be right. One winner and one loser.
I totally disagree with this. If the two parts reached their decision to buy/sell with (very) different time horizons on their minds they could BOTH be right.
July 15th, 2010 at 1:19 pm
Good point, Magnus.
July 15th, 2010 at 4:06 pm
“What I meant was, from where did the shares you purchased come? They did not come out of thin air. Someone had to sell them to you.” My point, Jack, is that sometimes (especially with IPOs), shares ARE coming ‘out of thin air’ – that is, someone is not selling you a share that they currently own; it is being created. Which is contrary to the point that the dialogue is making, in that an institutional investor who is much wiser than you is selling the share that you’re buying.
July 15th, 2010 at 9:40 pm
I’m sorry, Courtney, but you are dead wrong here. IPO shares do not come out of thin air, but are sold by the current owners of the company. I have been through an IPO with a company that was once employee-owned. The employees were allowed to sell their shares into the IPO.
A “share” is just that — part of a company. The total number of shares adds up to 100% of the company, whether there are 100 shares or 100 million.
July 16th, 2010 at 7:16 am
Again, Jack, in the context of this article, the hypothesis is that when you buy a share there is a 90% chance that an institutional investor with far more knowledge than you is selling you the share that you’re buying. In an IPO, there is a 0% chance that is true. For the purposes of the *public market* that share is being created. It didn’t exist on the public market before the IPO.
July 16th, 2010 at 4:14 pm
Right. In an IPO, it is the PRIVATE owners who are selling. You know, the people who know the MOST about the company, because they started it!
Now, they are usually selling to raise capital for investment, but they may be selling to cash out before the crash.
July 16th, 2010 at 7:45 pm
You seem to only equate IPOs with small companies that some dude started in his spare bedroom. Six of the ten largest (in terms of sales) privately owned US companies have over 50,000 employees. You think the shelf stockers at Meijer or the janitor at Price Waterhouse Cooper either started those respective companies or knows much about them? Or have any influence over the operations of the company?
July 16th, 2010 at 9:25 pm
Not at all. The shelf stockers and janitors may not know anything about the company, but neither are they the ones selling their stocks in the IPO. It is, by definition, the owners who are selling into the IPO, and they know more about the company and its prospects than anyone else does.