Monday, October 31, 2011

Real Investors Lag Indices by 6%










Anonymous said...

When you say the "average investor" do you mean the median investor?

The average investor earned the market return minus transaction costs no?

Jim Glass said...

The average investor earned the market return minus transaction costs no?

No. A great many investors enter the market after it starts rising, missing part of the rise, chasing returns -- then stay in it after it starts falling, catching the fall from the start until they finally bail. Then they are out when it turns back up ... repeat. So their final return is much lower than the market's. The amount invested in mutual funds lags the market, so there's more invested in them when the market turns down than when it turns up.

Many do the same thing within different market sectors, moving between them while buying high and selling low repeatedly, with much the same result.

And of course they pay commissions and fees on all these in-and-out decisions.

The joy of market timing.

J said...

What the losing investors lose, the winning investors must win. At the end of the year the difference must be equal to what the index did.

There must be some explanation. Let wait till Falken explains it to us.

Eric Falkenstein said...

indiv investor returns equal the index minus transaction costs, adverse timing. The index assumes transaction costs, and adverse timing effects, are zero. This simply isn't true. Now, one can make them very nearly zero, but in practice, people don't.

zby said...

But what is adverse timing for some investors is perfect timing for their counter-parties, what the first lose the others gain. So do you mean that the counter parties that gain on the poor timing are not investors but rather those who create the initial stocks?

Eric Falkenstein said...

adverse timing is measured corporate distributions (dividends, bankruptcies) and offerings (IPOs, SEOs).This does not wash out. See Ilia Dichev's work.

Matt R said...

The difference is between individual investors (401(k)'s) and professional investors, right? It's sad to think that all of Wall Streets' profits above and beyond the normal stock growth and dividend payments come from individual investors dumb investing decisions. The pension model wasn't perfect, but 401(k)'s are far from perfect, too.

revelo said...

I didn't read the report, so I'm not sure what is meant by "stocks". But the SP500 index definitely takes into account creation and destruction of stocks. That is, whenever the index changes, the index must sell some stocks that are currently in the index to buy new stocks entering the index. Thus for every dollar that market-times SPY and loses, another dollar must market-time SPY and win. If "average" investors are losing big by market-timing, someone out there is winning big by taking the other side of these losing trades. I cannot believe that all of the loses come from the bid-ask spreads, which are negligible with SPY. Someone must be market-timing SPY so as to get very high returns.

Eric Falkenstein said...

S&P stocks changes in capitalization over time, independent of its change in market value: distributions and issuances. Further, the average spread is much much greater than that for the SPY, which is a very small fraction of the equity market investors actively trade in. You can't assume that the SPY is 'the' market, because it isn't: many investors own specific stocks.

Jim Glass said...

What the losing investors lose, the winning investors must win.

Investing is not a zero-sum game. This is as true on the downside as on the upside.

revelo said...

SPY tracks the SP500 pretty well. It certainly isn't lagging by 6%. Nor is VTI, the Vanguard total stock market index, lagging the Wilshire 5000 by that much.

French did an analysis ( of the costs of active investing and concluded the cost was about .67% per year for the market as a whole.

Unless this dumb money in 401k is a very small part of the market, so that the 6% they are losing is fully accounted for by the .67% the active investors as a whole lose, then some smart people out there must be making money market-timing. A fact you don't seem to want to admit because it conflicts with your ideology that no one can be smart money.

revelo said...

As an aside: note that Madoff is in the list of people who aided French is compiling data for his study!

SRSFinance said...

@Jim Glass "Investing is not a zero-sum game."

Because credit expands market size?

Anonymous said...

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David said...

Very interesting idea of the average equity investor being way behind the index return. Like Jim Glass, I can't quite wrap my mind around that.

Using a really simple example, suppose the stock market index is worth $1000 at time 0, $2000 at end of year 1, and $2000 at end of year 2. All the gains in the first year, second year trading flat.

Investor 1 buys the whole market in time 0 for $1000. He sells $500 of that at end of year 1 to investor 2 for $1000, and keeps that in cash.

Return of the index = 100% over 2 years or 42% a year.

Return of investor 1 = 100% over 2 years (he has $1000 in cash and $1000 in stock at the end) or 42% a year.

Return of investor 2 = 0% over 1 year.

So the average return is way under the index return? Because investor 2 missed out on the big first year and only jumped in the flat years? While investor 1 didn't gain much from his timely sale because he doesn't have much of a choice other than hold cash (buying back into stock market would have gained him the same 0% return in the 2nd year)?

Where did the "implied" money go then? It's kind of a mathematical illusion.

David said...

Also, another thing that has never been completely clear to me is how much these annualized Dow or S&P 500 returns properly account for survivorship bias. There are companies in the index who have completely gone of business during the study period. Also, new companies have been added in.

Does the return in the index take into account the loss of value in owning shares of those defunct companies? And what price do new companies buy into the index at? Or is the index a weighted average of the price of X companies at a particular time, where X gradually changes over time.

Jim Glass said...


Jim Glass has no problem wrapping his mind about it at all.

... Where did the "implied" money go then? It's kind of a mathematical illusion.

You are missing the point that people enter and leave the market. E.g., mutual funds issue and redeem shares. People chase returns, so there are fewer investors and shares issued at a market low after people have sold out during a fall, and more at a market high after people have bought in during a rise.

So at a market bottom there are say 20x investors who enjoy the ride up to the high, at which point there are say 30x investors who enjoy the ride back down back to the original point. The mutual fund's price returns to its point of origin at which its price change is $0 net. But as there were more investors going down in it than there were going up, the average investor in the fund during the time period has suffered a loss.

This occurs not only as people go into and out of the market, but also as they run from one specialty mutual fund to another, chasing after returns by buying hot market segments high and selling them low, repeat.

Etaoin Shrdlu said...

The results obtained by 401(k) investors are not at all necessarily equal to those of all investors. Fees and fund expenses are relatively high, and disclosure is disfunctional. The participants are typically quite ignorant of how to invest. Market timing and performance chasing, you name it, it's all over. There are people who spend most of their careers with their money in stable value funds. It is a wonder people do as well as they do.