If you’ve been following along so far, you surely have noted the influence I’ve received toward no-load index fund investing. Everything I read suggests this strategy for the majority of investors, with names such as Warren Buffet and Jack Bogle lending their wisdom. There are however a certain group of people, known as value investors, that note an inherent flaw with how the big index funds, like the S&P 500, are structured. Before you dismiss this group of investors you should understand that the father of value investing, Benjamin Graham, wrote what is now often referred to as “the bible for anyone serious about investing.” He was also the teacher of Warren Buffet.
That’s right, Warren Buffet, who I have quoted as stating that the majority of people will gain the most from index funds, does not actually feel this is the best sort of investment. Warren Buffet is a value investor. Now before you call shenanigans, I believe the reason he is quoted being pro-index funds is that it is a very simple way of investing that requires very little committed time. Therefore, for the majority of people, it is the ideal investment vehicle. That doesn’t mean it will produce the best returns, but it is most appropriate considering the lifestyle of the masses.
So what is this flaw in the big index funds?
The S&P 500, Russell 1000, the NASDAQ Composite, are all known as Capitalization-weighted Indexes. This means that each stock in the index is not weighted equally, but rather based on how large their market capitalization is. In effect, the largest twenty companies in the S&P 500 only account for 4% of the number of companies, but represent about one third of the market value of the index. Therefore, the index is influenced much more by any of these twenty companies than by any of the other 480.
In fact, the indexes are efficient in that the weighting of any company will automatically increase when their stock price increases, and the weighting will decrease when the stock price drops.
But why can this be bad?
By now we understand that the price of a stock doesn’t always reflect the actual value of that stock. In fact, it often represents the emotions of the investors more than the value. You may have put two and two together that when these over-valued stocks increase in price due to hype or emotions, their weighting in the capitalization-weighted indexes rise. The index is then faced with greater influence by these overpriced stocks. If you were invested in the NASDAQ bubble in 2000, I don’t have to tell you why this is a problem. How well does an index that is full of over priced internet stocks do when the bubble bursts? Only now is the NASDAQ recovering to it’s original value, and that’s more than 10 years later.
By their structure, the S&P 500, Russel 1000, the NASDAQ Composite, etc. will be composed of more over priced stocks and less under priced stocks, and will therefore be innately inferior.
Instead, value investors suggest that you buy shares that appear under priced, or in other words are priced less than their intrinsic value. This obviously requires much more work and expertise than simply investing in the S&P, which is why it’s probably not the best route for the masses. However, if done correctly the returns can be much greater, so it is definitely worth a look.
It should be said that not everybody agrees with value investing. It would be wise to check out some of the criticism on both sides (you can find the basics on Wikipedia) and make up your own mind about what makes sense to you.
If you want to know more about value investing, check out “The Intelligent Investor” by Benjamin Graham, or the book I just read: “The Big Secret for the Small Investor” by Joel Greenblatt or his website
No comments:
Post a Comment