Bernstein 3

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JWR1945
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Bernstein 3

Post by JWR1945 »

These comments refer to Chapter 3 of our currently featured book The Four Pillars of Investing by William Bernstein.

I was very disappointed with this chapter. I think that John Bogle did a much better job in Common Sense on Mutual Funds and I think that the discussion about timing in Dynamic Portfolio Theory and Management is far superior.

[I do not recommend Dynamic Portfolio Theory and Management since it differs radically from my own investment approach. In terms of certain factual discussions, however, it is excellent. It advocates extremely active trading (once per month). I extracted some key observations in my book review.]
http://nofeeboards.com/boards/viewtopic.php?t=2725

There is one section that I consider misleading. Other sections are OK if you keep in mind that William Bernstein is comparing actively managed mutual funds and index funds.

The section Why Can't I Just Buy and Hold Stocks on My Own? is on pages 99-102. William Bernstein compares owning the Market with owning randomly selected portfolios of 15, 30 and 60 stocks.

Exactly what constitutes the Market is not clear. It is identified as being at the 50th percentile of returns (page 100) and as being the S&P500 index (Figure 3-6 on page 101). I know of no reason that the market should be the 50th percentile absent assumptions (about the symmetry of returns) that I would consider questionable.

My best guess is that the graph is normalized to the return of the S&P500 index, but not necessarily at the 50th percentile.

The next issue is how the portfolios are weighted. The S&P500 index is weighted by capitalization. Presumably, the randomly selected stocks are equally weighted. (They could be weighted by an equal number of shares or weighted by equal dollar amounts. My best guess is that it is by equal dollar amounts.)

This means that we are comparing oranges and pears.

The outrage is how individual stocks are selected: completely at random! There are none of the standard guidelines such as investing across different industries. There is not even a minimal effort to eliminate the very worst companies. There is no screening, such as by value.

What William Bernstein actually shows is how a portfolio containing a limited number of stocks selected entirely at random compares with the market as a whole. He shows that it can do better or it can do worse.

The apples to apples comparison is this: individuals cannot do any better than hypothetical chimpanzees when picking stocks entirely at random.

Most of the chapter is much, much better. Still, I prefer alternative sources.

Have fun.

John R.
unclemick
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Post by unclemick »

I give Bernstein an o.k. - but I'd previously read 'The 15 Stock Diversification Myth' on the Efficient Frontier website(use his search option) - interestingly his conclusion is exactly opposite of mine - individual stocks are worth a shot for at least some of "my money in my individual circumstances." Four Pillars write up states his case - but having read other guys notibly Ben Graham - I doubt that I'll ever give up taking a flyer at individual value type stocks from time to time.
hocus2004
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Post by hocus2004 »

"I doubt that I'll ever give up taking a flyer at individual value type stocks from time to time."

I see both pros and cons to indexing.

A benefit of picking individual stocks is that you tend to educate yourself more as to the companies involved. Investing in just a few stocks is like having all of your eggs in one basket rather than in lots of different baskets--it's generally riskier but the risk is countered to some extent by an inclination to watch that basket very carefully.

The big benefit of indexing is that you lock in the return of the overall market. Since the return of the overall market is generally a pretty darn good return, there is a significant benefit to locking it in and not needing to worry any more as to whether you actually will match it or not. When overall market returns are likely to be good enough for you to meet your goals, I question whether it makes sense to give up the certainty that indexing provides in a quest for higher returns which brings with it a risk of earning lower returns instead.

The logic breaks down at times of extreme overvaluation. When valuations go high enough, the expected returns from the overall market are no longer appealing. In those sorts of circumstances, you either need to find an alternate asset class or invest in ways that provide you a reasonable expectation of earning a better return from stocks than you can reasonably expect by investing in index funds.

Index funds are not risk-free. Their primary benefit is that they permit a lock-in of market returns. At times when the lock-in all but guarantees a return that is not adequate for realization of your investment goals, the lock-in feature is a negative rather than a positive.

I see little appeal to index funds at today's valuation levels. But it is possible that smart investors might be able to find particular individual stocks that will provide satisfactory long-term returns. So we are now in the sort of investing environment in which the merits of indexing should be subject to serious questioning, in my view.
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