Better Index Funds
Better Index Funds
May 12, 2009
A stock index fund buys stock in every company that is a member of some defined index, such as the S&P 500. The idea is that if you own, for example, a little bit of 500 different companies, you’ll be well diversified and generally do better than the professional stock pickers, thanks in part to lower fees and lower taxes.
The reason index funds are so popular is that it’s hard to pick individual stocks that will outperform the average. But I wonder if it is just as hard to identify stocks that will surely NOT be stars in the next year. In other words, could you have the best of all worlds by starting with, for example, the S&P 500 stocks and subtracting the ones that have no realistic chance of being stars?
Much of the growth in an index fund comes from about 20 percent of its stocks. It’s hard to know in advance which stocks will be in the top 20 percent next year. But is it just as hard to forecast which stocks will NOT be in the top 20 percent? On the surface, that seems easier.
So called short sellers make money betting stocks will go down. As a group, and over time, they don’t do better than the people betting which stocks will go up. That might tell you that identifying the stocks that will go down is just as hard as identifying the ones that will go up. But for my hypothetical index fund you don’t need to identify the stocks likely to go down a lot, which is where short sellers make their money. You simply need to identify stocks that are unlikely to be top performers on the up side. Isn’t that a relatively easy target?
The quick answer is “no.” If it were that easy there would already be such funds and everyone would be rushing to invest in them. A big reason the economy is in such a mess is that lots of investment ideas seem like obvious winners but aren’t. I laugh every time I see a commercial on CNBC for some product or brokerage service that boasts it will help you use your own excellent theories to invest your money. What the world really needs is a product that will prevent people from using their own dumbass ideas to invest.