“It’s just fun to do the research, learn new stuff, and potentially have an impact on the way people are thinking about the world”- Kenneth R. French
When we look at investing, it can be broken down into two broad schools of thought. The more common and well known is of course stock picking or forecasting. This involves a ‘professional’ telling you what stocks they think will go up in the future and convincing you to buy it. The second method relies on market prices and academic research. The second method relies off data, research and long-term thinking.
So, how do you pick stocks?
You don’t.
A brief history of indexing
Investing in the broader market has been a concept for over 50 years. When Jack Bogle founded Vanguard in the 1970s he was mocked by his peers. Why would you invest in the market when you could ‘outperform’ by picking stocks…
As I am sure you are aware, Vanguard today is very successful. They have approx. $6 trillion in assets as of today, making it the largest asset manager in the world.
Forecasting
The conventional or most commonly used method until recently relies on forecasting or using a star fund manager who is promoted as having an amazing stock picking ability, or following the approach of another famous stock picker.
This style of investment has the following characteristics:
- Concentrated position’s, i.e. relatively few holdings or a focus on a certain industry or geographical area
- Higher costs
- High turnover
- Poor tax management
- Plenty of advertising
It’s a success story, but for end investors in the flagship fund returns have been worse than simply investing in the broader market.
Standard and Poor’s (S&P) measures the performance of fund managers, and year after year the numbers are similar.
Most managers don’t beat the benchmark
So why bother? Well, until now you did not have much choice. No one told you about the alternative.
The academic or evidence-based approach
The different way to invest is using science and research. This method relies on some common principles:
- A belief in markets
- Diversification
- Risk and return are related
- Very little or no reliance on forecasts
- Reasonable costs
- Fund survival is important
- Tax management
- Giving investors more peace of mind and less to worry about. Investors don’t need to know what is happening in markets to have a successful investment experience
If you want to be a long-term investor, using an investing strategy gives you a greater chance of success – and also less anxiety. It leads to a better understanding of where returns come from, better expectations, and better asset allocation decisions.
“My regular recommendation has been a low-cost S&P 500 index fund”- Warren Buffet wrote in his 2016 Berkshire Hathaway annual shareholder letter”
Summary
- Decades of data and academic research can point us in the right direction.
- Economists are unbiased and would be equally happy to prove that stock picking is a great wat to invest.
- There is an alternative way to invest.
- We can choose to use this information or ignore it.
