Socrates would have opted for index funds
Almost a year ago I posted on GameStop. I’m reluctant to revisit that post, as I’m almost certain to be misunderstood. But . . . when has that ever stopped me before?
Here’s what I said on January 29, 2021:
In the early 2010s, I had no idea what was going on with Bitcoin, and still don’t really understand the investment. But I think I at least understand that I don’t understand it. You say nothing “fundamental” has changed with GameStop in the past week? OK, maybe, but are you sure? Does becoming 10 times more famous and developing a strong emotional connection to many millennials have zero value to a retailer? I don’t even play computer games, so I have absolutely no opinion on this stock. But how confident are you in your opinion?
This is why it’s so hard to test the EMH. The collapse of what looks like speculative bubbles seems like evidence against the EMH, but in fact the theory predicts that the vast majority of speculative “bubbles” will collapse, in order that the expected rate of return on portfolios that include Bitcoin, Amazon and Tesla is consistent with the risk-adjusted rate of return on other portfolios. The statement “speculative stock X is very likely to be lower in a couple years” is not at all equivalent to “speculative stock X is a bad investment.”
I’m surprised to see GameStop used as an example here. It closed today more than 14 times the pre-social movement high, which started a bit over two weeks ago.
Could the company cash in on this extra capital? Yes, though it hasn’t done so yet. Could millennial affection help permanently boost prospects for earnings? Yes, but 14 fold, for a retailer that still mostly depends on buying and selling increasingly obsolete products in many increasingly obsolete retail spaces, like malls?
In less than a year, GameStop has moved from obsolete malls to NFTs:
The day started hot for video game retailer GameStop (NYSE:GME) after the company announced an NFT marketplace. Shares jumped 22.3% at the start of trading but started losing that bounce quickly and were trading 8% higher at 10:40 a.m. ET.
The Wall Street Journal reported after the market closed on Thursday that GameStop is building a non-fungible token (NFT) marketplace and partnerships in the cryptocurrency business. About two dozen people have already been hired for the project, and management thinks it can translate the brand to a valuable position in the market.
Translate the brand to a valuable position? Interesting idea . . .
My fear is that readers will view this as a buy recommendation for GameStop. Nothing could be further from the truth. (It still seems like one of those long shots–like Bitcoin.) I invest in index funds because I believe in the EMH. I believe that I don’t know anything about individual stocks.
Where does Socrates come into the picture?
I know that I know nothing.
Socrates would have invested in index funds.
Tags:
7. January 2022 at 12:29
I hereby publicly state that I was (most likely) wrong about GME on 2/1/21. From my 2/1/21 post:
“Any believers in the strong version of EMH willing to back up their beliefs with a bet?
I believe Gamestop is overvalued at its current price of $325. I am willing to back up this belief with a bet:
Gamestop will sell for less than $100 per share on February 1, 2022.
I am giving long odds. For you to win the bet, Gamestop only has to preserve 32% of its current market value.
We can bet money if you want, but the true prize will be to have your convictions documented in the comments of TheMoneyIllusion.
Any takers?”
(Although we haven’t yet reached 2/1/22; I still hold out hope)
7. January 2022 at 12:56
Todd, Well at least you would have made money shorting GameStop.
7. January 2022 at 13:00
At the time you conceded to Eliezer in comments that the short squeeze explanation was better than yours. You shouldn’t have conceded that. You were right the first time: it was fundamentals.
7. January 2022 at 13:25
Hi Todd—I don’t think you need any of Scott’s readers to bet—or am I missing something? I know nothing about individual stocks either-because I don’t pay any attention to them. But if I did pay attention them, I would know a lot more—-but not whether they would “hold 32% of their value” the next 3 weeks. I really do not get the anti EMH guys. Perhaps if there were persuasive empirical data showing the non-index guys outperforming, it would one thing—but it shows the opposite. It is a probability game—you might be right on Gamestop—and the next 2 or 3—but I bet you were wrong about Amazon (or Apple)–and your whole portfolio—not because you are not smart—one cannot consistently win—although who knows– maybe there are some who can–but I never heard of them.
7. January 2022 at 16:43
That quote there was from me, and I made some quick money buying puts on a couple of these Wall Streets bets stocks. I was right, but for the wrong reason, which is another way of saying I was wrong and got lucky. I really only profited because the stocks were so volatile, in retrospect. The EMH seemed to apply here much more than I thought.
7. January 2022 at 17:40
Glad to be like Socrates.
Just index funds for me too.
7. January 2022 at 20:50
How did you make money buying puts on GameStop?
Vol was insane in GameStop. Timing outs would need to be perfect. The trade was selling vol which has huge tail risks but when gme was at 320 atm calls were over 200.
I’d be nervous of index funds going forward. The quant funds etc are getting good at gaming index inclusions etc and I believe that’s going to cause a lot of performance drag going forward and into the long term where cash flows drive performance.
7. January 2022 at 21:53
I do believe in a weak form of the EMH and the vast majority of my portfolio is in index funds. One thing I’ve never understood though is that if the EMH is true picking individual stocks should have the same expected return (excluding transaction costs and taxes) as index funds. So why is it widely condemned by the personal finance community?
You hear things like “To time the market you have to be right twice: when to buy and when to sell”. But then if everything has the same expected returns (holding beta constant), you can’t actually “buy high” or “sell low” ex-ante. Every stock is equally a good investment.
Yes, there is a diversification benefit of buying 5000 instead of 100 stocks. If you’re smart about transaction costs and taxes though then buying enough individual stocks should roughly equal an index fund. Maybe the advice needs to exist just to prevent people from only holding a few stocks.
Personally, I think it makes sense to hold a small portion of individual stocks for things like tax-loss harvesting.
7. January 2022 at 23:30
Sean,
I was going to buy a put on GameStop, but after studying all the stocks the Wall Street Bets crowd was pumping, I decided to buy puts on Express and Sundial Growers instead. Sundial’s price did collapse as I expected, but I can’t say I was right about it, because I thought most, if not all of these stocks would likewise crash.
Lately, I’ve made money on my US Dollar/Turkish Lira bet, and with stocks like Tesla.
I always keep in mind that though a pretty strong version of the EMH is true, there have to be arbitrage opportunities to provide the motivation to keep market efficient.
7. January 2022 at 23:46
But, Socrates, how can you be sure about that?
8. January 2022 at 01:52
Sean, if you are worried about the gaming of index inclusion, then just stay away from eg S&P 500 and stick to broader indices likes those underlying VT or VWRA.
They are so broad, that the index inclusion/exclusion only happens to stocks with really small market capitalisation.
Another thing: what kinds of ‘gaming’ are you worried about?
Eg if enough hedge funds know about an index addition in advance, they will just compete with each other to offer good prices to the relevant index funds.
Similarly for exclusions. Coming exclusions are especially interesting, because index funds are typically very keen on renting out their inventory to short sellers.
And that’s a good thing, because it means that their inventory is well priced.
8. January 2022 at 02:15
Yes, markets are only efficient in some asymptomatic sense.
Or in another sense: markets are as inefficient as they need to be in order to attract enough arbitrageurs and speculators to keep them at their equilibrium levels of efficiency.
More practically, if you are speculating in something as mainstream as Tesla stocks or foreign exchange, you should ask yourself what you know that hedge funds and investment banks don’t know?
8. January 2022 at 07:26
Markets are efficient so long as no one knows markets are efficient and people actually pick up the $20 bills on the sidewalk.
Why shouldn’t you participate in the market process of price discovery? Unless you think price discovery is impossible without insider trading?
8. January 2022 at 07:36
Something I never understood about index funds, like I have money in the S&P 500 index. But people claim thats being passive and just owning every stock … but I dont own every stock. I am making a bet, that, broadly speaking, American stocks will beat other countries, and that the top 500 companies will continue to outperform everyone else. That is an active decision.
That isn’t necessarily a rational decision either. People generally tend to own stocks from their individual countries … or maybe it is rational. Maybe people also have more information of their individual countries (on that basis the UK should invest in America, The Economist seems to understand this country better than we do!) But in either respect there is a bias which I am exploiting, its not an entirely passive decision.
One of Bogles argument isn’t that you don’t know anything, but that index already does a good enough job of “picking” stocks. The ipo process should, in theory, filter out obvious scams. Stocks within the index are efficient, perhaps, but the index already picked decent stocks to begin with.
I can invest into the new Vanguard total world index, but if you compare trading strategies against that … suddenly everyone looks better.
8. January 2022 at 09:00
Aladdin, The cost of price discovery for 99.9% of people exceeds the benefit.
8. January 2022 at 09:47
Honestly asking here, not trolling. I’m looking for anyone’s thoughtful answers, but please don’t troll me back.
Is the prediction of EMH that individual stock pickers cannot outperform RISK-ADJUSTED returns of broad market indexes?
Does it therefore follow that individual stock pickers CAN outperform ABSOLUTE returns of broad market indexes, if the individual stock pickers accept higher levels of risk?
A second line of inquiry:
Is “risk” in EMH theory generally defined as excess standard deviation of price swings, relative to a “risk-free” investment?
Is that calculation ex-ante,based upon the price swings prior to purchase of the security, or ex-post, knowable only in hindsight?
If ex-post, wouldn’t a security that outperforms have large relative price changes, by definition, thereby increasing the measured “risk”?
Thanks to anyone who takes the time to leave thoughtful responses!
8. January 2022 at 11:26
Todd Ramsey,
You asked:
1. “Is the prediction of EMH that individual stock pickers cannot outperform RISK-ADJUSTED returns of broad market indexes?”
I think most subscribe to a weaker version of the EMH than that. I think it’s more like that it’s very difficult to outperform risk-adjusted returns of broad market indexes.
2. “Does it therefore follow that individual stock pickers CAN outperform ABSOLUTE returns of broad market indexes, if the individual stock pickers accept higher levels of risk?”
Yes, but if they consistently take on more risk, they’re unlikely to outperform markets for very long.
3. “Is “risk” in EMH theory generally defined as excess standard deviation of price swings, relative to a “risk-free” investment?”
No. Fama published some papers in the 80s that revealed that CAPM theory, which claimed excess risk was reflected in excess volatility doesn’t fit the data well. Volatility is a measure of risk, but not the only one.
4. “Is that calculation ex-ante,based upon the price swings prior to purchase of the security, or ex-post, knowable only in hindsight?”
There are ex-ante calculations which actually drive investment, but ex-post is obviously better. Broad market guesses are still guesses, but just better guesses than those from smaller groups of investors, on average.
5. “If ex-post, wouldn’t a security that outperforms have large relative price changes, by definition, thereby increasing the measured “risk”?”
The reason for volatility is important. Is the volatility due to the particular exposure of a given company’s earnings to particular risks, with relatively low liquidity and solvency risks, or is solvency the primary concern?
The primary risk for relatively safe outperforming stocks, such as Alphabet or Apple, comes more from the lack of diversification than anything else. Their prices are very highly correlated with the S&P 500, but have had a lot more upside in recent years. They are much safer than other stocks, on average, due in part to huge cash/cash equivalent hoards on balance sheets, and they even seem to be treated somewhat as safe assets.
8. January 2022 at 16:09
global thug summy sumtard and his accomplice Klaus Schwab is afraid of Djokovich.
Doesn’t want a healthy man to compete and crush his vaccine commie Americans.
https://edition.cnn.com/2022/01/08/tennis/novak-djokovic-covid-australia-intl-spt/index.html
8. January 2022 at 19:11
Nick, honestly all of you non tennis fans who are suddenly supporting Djokovic because of his anti vaxxer stance is really annoying me. As a professed tennis fanatic and Djokovic fan (from the beginning, at the Murray Djokovic game, instead of all these bandwagoner), please stop.
It is frustrating he seems willing to throw away his chance at making tennis history, but ah well.
8. January 2022 at 19:27
Aladdin, knowing your own country better is as much an argument in favour of shorting stocks form your country as it is an argument in favour of going long them.
Your argument about the S&P500 being an active bet on American large cap stocks is true in theory. In practice, broader equity indices like those below VT and VWRA move essentially in lockstep with the S&P500. The correlation is pretty close to 1.
You get a bit more diversification with them, but at the cost of higher fees.
So in practice the S&P500 is close enough to a bet on global stock markets.
Your critique is more valid, if you look into other asset classes like eg government bonds.
If you are an individual, you probably don’t want your portfolio’s proportion of government bonds to equities to mirror the market portfolio, because much demand for government bonds is driven by regulatory requirements on banks.
8. January 2022 at 19:36
Todd, you have some great technical questions. The exact details depend on the exact version of EMH under discussion.
And empirically, the details of the answer depend on the market in question. In general, stock markets have gotten more efficient over time, so the answers for the American stock market in the 1920s are different from the answers for the American stock market in the 2020s, or the answers for collectible Lego sets in the 1990s.
The general underlying principle is that the act of exploiting mispricings tends to also correct them. All the technical details follow.
The bit about adjusting for risk is to take into account the general tendency for (reasonably) leveraged portfolios to be able to outperform plain portfolios. That’s broadly because the average investor seems risk averse.
All the results for individual stock pickers perhaps being able to systematically take riskier stocks and make money off that, is a corollary to make everything consistent.
Compare also the strategy of writing (ie selling) out of the money put options.
That’s a reliable money spinner in normal times, but completely tanks your portfolio when the market goes down.
9. January 2022 at 06:42
The analogy doesn’t make any sense.
When Socrates spoke of knowing nothing, he was referring to the quantity of knowledge in the marketplace and his recognition that such knowledge could not be learned in a short life time. In other words, he recognized he could never know everything.
If one dedicates their life to reading financial statements and, more importantly, have the ability to meet and interview executives of the companies they invest in, a valuable advantage for mutual fund managers with billions in assets, then they can certainly “beat the market”.
Socrates would not invest in an index fund if he was an expert investor, because it would be a low return on investment.
Taking his statement about knowledge, and applying it anachronistically to modern day investments, is simply not logical.
9. January 2022 at 06:57
“Your critique is more valid, if you look into other asset classes like eg government bonds.”
– And this response is precisely why our investment firm doesn’t hire economists.
Think about that statement for a moment. The arrogance coming from the lips of this moron is palpable. This person has never managed a fund in his life. He has absolutely no practical experience whatsoever, yet he has the audacity to tell another gentlemen that their critique is wrong.
I’m averaging 23.4% per year, over the last twenty five years. Over that same time period, the average market return is 10.5%.
Don’t tell me that arbitrage doesn’t exist. Yes, for you it doesn’t. But you are a nobody. You have no money to invest. The information you get is assymetrical, because you are the last to get it, lol. You cannot move markets with a measly half million, and I doubt you even have that.
You need to get a grip on reality….
Repeat “I’m a nobody” in front of the mirror if you have to. But lose the arrogance. It will serve you better in life.
9. January 2022 at 07:05
Michael D Sandifer:
Thank you! For your thoughtful responses. I have some follow up questions. Again, honest questions.
“Volatility is a measure of risk, but not the only one.” What are the other measures of risk in the context of EMH theory?
“Yes, but if they consistently take on more risk, they’re unlikely to outperform markets for very long.” Why? In particular, I am asking about diversification risk. In theory, why would a poorly diversified portfolio necessarily perform worse over the long run than a well-diversified portfolio?
Thanks for your help!
9. January 2022 at 07:15
Matthias:
Thanks for your thoughtful responses. A follow-up question about a couple of your statements:
“The general underlying principle is that the act of exploiting mispricings tends to also correct them.”
“In general, stock markets have gotten more efficient over time.”
I understand and agree with these statements. I don’t understand why, even if those statements are true, there cannot remain some market inefficiencies to exploit. Or does EMH say that there might still be inefficiencies to exploit, but they will decrease over time as those investment strategies become more generally accepted?
Thanks for your help!
9. January 2022 at 10:01
Todd, You said:
“Is the prediction of EMH that individual stock pickers cannot outperform RISK-ADJUSTED returns of broad market indexes?”
No, the claim is that they won’t do so on average.
9. January 2022 at 10:56
Ouch, the GME puts I recommended Todd buy have more than doubled in price since I made my suggestion. Wish I had bought some!
9. January 2022 at 12:46
Tacticus, Similarly, I wish I had bought Bitcoin when it was $2, and called a bubble.
https://marginalrevolution.com/marginalrevolution/2011/04/is-bitcoin-a-bubble.html
9. January 2022 at 13:04
Didn’t GME raise capital with an issuance at a pretty elevated stock price? I’m not sure I understand what the EMH is even supposed to mean in a context where investors are determining the cost of capital to firms.
I guess part of my problem is that I’m not even sure what the EMH is supposed to prove. Professional investors are clearly able to earn above market returns in ways that are statistically provable not to be just luck. But, yeah, you can’t just call bubbles from your armchair and the government should be very hesitant about interfering in capital markets. But that doesn’t mean they should never interfere.
What are the actual stakes of the EMH debate?
9. January 2022 at 18:05
Ridiculous. Sumner opines on Greek politics and now on Greek philosophy, which even I, a speaker of Greek, don’t try and do. Here’s the original statement by (Plato) Socrates: “That said, in the Apology, Plato relates that Socrates accounts for his seeming wiser than any other person because he does not imagine that he knows what he does not know.[7] … ἔοικα γοῦν τούτου γε σμικρῷ τινι αὐτῷ τούτῳ σοφώτερος εἶναι, ὅτι ἃ μὴ οἶδα οὐδὲ οἴομαι εἰδέναι.” (loosely, “I know that I don’t know, unlike some other fellows”).
So does Sumner know that monetarism doesn’t work? Far from it. Despite his fake modesty by quoting Socrates, Sumner pretends to know what a 25 basis points rise in the interest rate will do to a $20+T economy. The height of hubris, another Greek concept.
9. January 2022 at 23:31
Todd,
You asked:
“What are the other measures of risk in the context of EMH theory?”
The most useful approach is probably to look at the lognormal distribution for a stock or stock index. Here’s a nice video about how to do that: https://www.youtube.com/watch?v=OmRpIB54svs
You also asked:
In theory, why would a poorly diversified portfolio necessarily perform worse over the long run than a well-diversified portfolio?
A poorly diversified portfolio doesn’t necessarily perform worse over the long run, but does underperform, on average. There are some who get lucky with their less diversified approaches, and a smaller number still who actually know what they’re doing.
10. January 2022 at 07:31
I know nothing and I know that I know nothing, but sometimes I forget.
Anyone do any “prop” trading?
10. January 2022 at 17:16
Scott, I’ve said this before (and you agreed), but you don’t seem to have internalized it, so I’ll say it again.
The efficient market hypothesis only says (roughly) that you can’t predict whether the value of a stock will go up or down. It says NOTHING about whether the stock price is equal to time-discounted expected future dividends.
Gold pays no dividends, yet people still value it, because they believe others will value it in the future. Bitcoin is the same: it has near-zero “fundamental” value, and is only valuable because of the belief that others will value it.
This is a sustainable equilibrium! I’m not predicting gold will crash; I’m not predicting bitcoin will crash. I believe in the efficient market hypothesis, and I only buy index funds. But that doesn’t mean bitcoin is secretly useful or anything.
Same with GameStop: there do not need to be ANY FUNDAMENTALS. All you need is a belief that others will continue to value GameStop stocks, same as they value gold. That’s it, that’s all there is to it. Looking for fundamentals will only confuse you.
11. January 2022 at 07:14
mpowell, You claimed:
“Professional investors are clearly able to earn above market returns in ways that are statistically provable not to be just luck.”
This is a dubious claim.
anon85, What makes you think I have not “internalized” that view?
11. January 2022 at 16:07
Scott, what makes me think you’ve not fully absorbed that view it is that you quote someone talking about GameStop’s “prospects for earnings”, and counter it with an example of how GameStop could attain a valuable position. All without mentioning that GameStop’s stock price *does not need to bear any relation* to its prospects for earnings, even under the efficient market hypothesis.
Maybe you know that “stock value” and “prospects for earnings” can be totally unrelated (even under EMH), but you keep talking like someone who doesn’t know this.
(Technically, under EMH, I guess time-discounted expected future dividends would still be a lower bound on the value of a stock, but there is not a corresponding upper bound.)
11. January 2022 at 16:44
EMH is oft misinterpeted as the OMH
but efficiency isn’t omniscience
sometimes the available information indicates rapidly rising prices
sometimes the available information changes rapidly
bubbles don’t need any more explanation than other price swings
long VFINX since ’95, outperformed large majority of professionals iirc
maybe someday the free ride for indexers will end someday (everyone can’t) but not today
12. January 2022 at 05:25
anon85, It’s pretty clear that I was responding to Michael’s argument. I am well aware of assets like Bitcoin having nonzero valuations.
Talldave, I agree about EMH and OMH.
12. January 2022 at 06:12
https://www.newswars.com/the-federal-reserve-keeps-buying-mortgages/
Monetary economists are a worse disease than covid.
I think we all have enough evidence to show that bubbles are not created by irrational exuberance, but rather by the Fed’s centralized planning.The fed is now subsdizing risk to the extent that banks will lend to anyone – dead or a live (no heartbeat necessary).
The Fed is like a microcosm of Mao’s China. If the Fed applied “I know what I don’t know” to their policy conclusions, then the Fed would cease to exist. Although, maybe these people do know. Maybe they just don’t care, because they are immoral.
Maybe they are a disease.
12. January 2022 at 08:03
Recently published inflation numbers are terrible. 7% YoY.
Biden admin = disaster.
12. January 2022 at 15:01
Index funds can only exist because there exist investments in the underlying individual stocks.
Index fund investors are relying upon the real world entrepreneurial activity taking place in the capital markets.
If everyone invested in index funds they’d cease to exist because the underlying individual company stock would have no investors, no demand, and thus no price.
Happily in the real business world, very few people listen to ignorant economists.
12. January 2022 at 18:20
Farrell, You said:
“Biden admin = disaster.”
Yes, what a disaster it was when Biden appointed Powell to head the Fed in 2018, and then spent 2 years complaining that Powell’s policy was not inflationary enough, that they should be even more stimulative.
13. January 2022 at 17:40
Does EMH discuss varying levels of efficiency? Was the market as efficient during the Depression as it was during subsequent periods? Or is this not a relevant or useful way to think about it?
From reading your MP book, it seems like the market could have been more efficient during certain periods.
I think I commented a while (few years maybe) back that I was certain Tesla was overvalued. Luckily my company has a policy that we can’t buy puts or short.
14. January 2022 at 10:46
Milljas, It could be that the market was slightly less efficient during the Great Depression. But my research convinced me that even then it was pretty efficient.
25. January 2022 at 08:43
I may have spoke too soon. The fat lady is still singing, for another week.
2. February 2022 at 07:59
GameStop stock closed 2/1/22 at $112. I publicly proclaimed it would close under $100, down from $345 on 2/1/21. So I guess my prediction was wrong.
However, the stock traded as low as $89 in the week before 2/1/22, so in that sense my prediction was right.
Sometimes stocks become so unhinged from fundamentals, usually because of herd emotions, that it’s possible to outpredict the market with enough frequency to make it profitable.
I “lost” the bet because I predicted the stock would fall 70% and it only fell 68%. I still feel pretty good about it.
I’m aware I could have shorted the stock rather than make claims on a blog. I never short stocks because stocks go up over the long run. However, I do make big bets on stocks going up, when it seems the market is overtaken with emotion.