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Ask HN: Models for investing in the stock market...

8 points by adsyoung ↗ HN
For much of early life I hadn't paid much attention to the world of finance and the markets as it seemed very difficult to know who was worth listening to and who was full of it, so I largely dismissed it as an insider's game.

But recent events have sparked my interest I guess and I've started doing a bit of reading and playing catch up.

So far I think I've identified 3 models for investing in the stock market that make some sense to me and everything else I've heard so far seems either a crazy temporary hack, pure luck or some combination of the two. At the risk of sparking a flame war, I'm curious as to whether people here disagree with my perhaps fairly naive understanding of this world or if you have other reasonable models to add etc...

The models are...

1. The Warren Buffet Berkshire Hathaway model: Place very few bets. Work really hard and be very disciplined in finding the rare opportunity and insight and then bet heavily when you do. As described by Charlie Munger in the second part of this talk http://www.paladinvest.com/pifiles/MungersWorldlyWisdom.htm.

2. Index fund model: Stop taking on risk in trying to beat the market all the time, an unlikely feat, and just go along for the ride. It will be bumpy (very bumpy perhaps) but have some faith that in the long run the market tends to go up as the human race goes about creating more wealth in the world (real wealth hopefully in the future).

3. The Nassim Nicholas Taleb Black Swan model: The world is dominated by large unexpected events (like the recent one) some are positive and some are negative. Limit your exposure to the negative ones by putting the vast majority of your money in extremely secure things like T Bills and then gamble with the remainder hoping to find a large positive event (like the next google). Anyone who thinks they can be exposed to the large negative events and effectively manage that risk is nuts.

Depending on an individuals particular appetite for hard work, risk, emotional rollercoasters and the like I could imagine any of these 3 being argued as a reasonable strategy.

Any thoughts to help me along would be greatly appreciated.

Cheers

15 comments

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Rod
Those aren't models. Those are investing philosophies. And they're so general and vague that I really don't understand what point you're trying to make. You asked no concrete question, and you will get no concrete answer.

If you want to educate yourself, don't ask HN, do your homework and read Harris' book: http://www-rcf.usc.edu/~lharris/Trading/Book

adsyoung
Point taken, they are absolutely philosophies. That was a sloppy question, it's getting late here.

I was curious if people more knowledgeable than myself on this topic took genuine exception to these philosophies and had others to add to the list. Part of doing your homework is asking other smart people questions. Perhaps not the best site for this one but what can I say, I respect the people here more than elsewhere.

Rod
If you're interested in Finance, I suggest you read / follow Nuclear Phynance ( http://www.nuclearphynance.com ), a rather smart forum. Just make sure you don't post questions like this on NP, because those guys will eat you alive if you do.
adsyoung
Thanks, I'll check it out. I was deliberately trying to avoid the land of acronymns and unnecessary complexity though.

I find it interesting that almost all of the most truly interesting and valueable things I have read were written in plain english by people that strive to keep it as simple as possible. It's far too rare unfortunately.

abc3
I think the question is a good one, and I think it's clear you did a fair amount of research before writing your post. There are several other philosophies you could have included but didn't, and the three you chose are the only ones that I believe make sense.

I suggest a broader approach to "The Warren Buffet Berkshire Hathaway model." Buffett is a value investor, and frequently cites other value investors who have started with similar assumptions (based on Benjamin Graham's work) but who don't necessarily place few bets (Buffett credits Philip Fisher, and also Munger, with making him a believer in concentrated portfolios).

The value investors I recommend reading, in addition to Buffett, Graham, Fisher, and Munger, are Martin Whitman, Seth Klarman, and Christopher Browne. Browne's letters and studies are available for free on the Tweedy, Browne website, Klarman's book (Margin of Safety) can be found as a pirated PDF, and Whitman's books are relatively inexpensive (and his letters to shareholders are free). Also, in addition to reading shareholder letters by Buffett and Munger, be sure to check out Lowenstein's Buffett biography (and The Snowball, though it's not nearly as good; Janet Lowe's Munger bio is a waste of paper).

blurry
Your best bet is to set up several virtual trading portfolios and see which strategy actually works for you. You will learn much quicker and make your first mistakes with fake instead of real money.

Google virtual stock portfolios or virtual investments - there are lots of websites that offer fantasy trading. One of your goals should be to simply find out how much time you can devote to your portfolio... most people find that its' a job and go back to index/mutual fund investments.

adsyoung
It's a good suggestion but not so applicable to the strategies I listed for the average investor above I think. These are all long term strategies. Finding the next Google or working hard to find the rare highly valueable opportunity, something which perhaps there is only a handful of great ones in a lifetime doesn't lend well to testing. Starting out with fake money is a great idea though.
viggity
I just found a Forbes article about a guy who started a small fund that invests in the SP 500 Index while congress is out of session and moves everything to T-Bills when they're in session. He joked about it for a while until he ran some numbers and found that historically the SP returns ~16% while congress is out of session, and sub 1% while in session.

The markets don't like uncertainty, and nothing is more uncertain that the idiocy that congress brings when in session.

anamax
> 2. Index fund model:

Which index fund model? Weighted by market cap or some other measure?

Weighted by market cap means that you buy a given stock as the underlying company's market cap increases relative to the market as a whole and sell it as said market cap decreases relative to the market as a whole.

Can you do better?

Femur
Index funds based on Dividends are available but are not yet mainstream.

The main purpose of an index funds is that it "aims to replicate the movements of an index of a specific financial market"(http://en.wikipedia.org/wiki/Index_fund). Since markets are themselves naturally weighted by the largest players in the market, it makes the best sense to weigh the indexes the same way. Example: Swings of Exxon stock will change the market much more than "Jack's Tools."

Index funds capture the market, not beat it. To try to beat the market violates the Efficient Market Hypothesis (http://en.wikipedia.org/wiki/Market_efficiency)

Femur
I am an adherent to the Efficient Market Hypothesis (http://en.wikipedia.org/wiki/Market_efficiency) and thus try to capture the market (through index funds) and minimize cost.

Ideally, the best way to do this is own multiple non-correlated indexes (Example: Gold and the S&P500 are negatively correlated). I own my indexes through Vanguard.

A well diversified portfolio that owns stocks (of all capitalization both foreign and domestic), bonds (treasuries and corporate foreign and domestic), real estate, commodities (Gold, Silver etc) and Cash (multiple currencies) will generally provide positive stable returns continually.

In my opinion the big "to-do" with most peoples 401ks is that they are VERY poorly diversified and way to heavy in stocks.

Femur
I forgot to mention the benefits of Indexing from a personal perspective. It is:

-Cheap (low cost) -Easy (Set it and forget it with occasional rebalancing) -Safe (As long as you are properly diversified) -Low Stress (Some portions may have wild swings, but the negatively correlated holdings swing the other way) -Good returns (Your investments will never perform below-average)

adsyoung
Do you believe it to be truly efficient or just the most effective hypothesis? For example perhaps where it is inefficient this is indistinguishable and highly random therefore not terribly useful?
Femur
I do not believe it to be truly efficient as that would require perfect information for all parties that participate in the market. (discussion of that topic is here: http://en.wikipedia.org/wiki/Perfect_information)

I do believe that it is efficient enough that the model works.

adsyoung
Is there anyone who doesn't believe that it works though? i.e. It won't lead to a reasonable positive return?

Believing that it works means simply accepting the average return of the market through index funds as you said, which sounds reasonable to me, but it is admitting defeat that you can't beat the market in the long run.

Seems to me everyone would agree it works in general and the trouble starts when you try and do better than it.

Is your reason for not looking for inefficiencies to exploit and do better the fact that it takes more time than you have to devote to it, don't believe its possible in the long run (i.e. largely luck), you require some special insight other people don't have, other?