4 Key Ideas for Successful investing

Pranesh Srinivasan
August 2018

Key Idea 0: Saving

Key Idea 1: The sophistication of Market Weighted Index Funds.

1A: Arithmetic of the average returns in the market
1B: The magic of low fees
1C: The magic of market weighted funds
1D: After tax return
1E: What if everyone indexed?

Key Idea 2: Staying the Course: The world’s worst market timer

Key Idea 3: Asset Allocation & Periodic Table of Returns

3A: The math of compounded returns
3B. Periodic Table of Investment Returns
3C. What’s a good asset allocation?
3D. Time diversification

Key Idea 4: Tax Loss Harvesting

Summary

Key Idea 0: Saving

The most important idea is to save money by spending less than you earn. Without saving, you
cannot build capital to apply the 4 Key Ideas. This is the basis for successful investing!

Key Idea 1: The sophistication of Market Weighted Index Funds.

Index Funds, also called passive indexing are treated as the loser’s choice by many in the
market. Unfortunately, this is far from the truth. Index Funds are highly sophisticated instruments
that allow you to beat nearly 90% of investors over a decade with little to no effort. Yes, you read
that right! You win by indexing.

To understand why indexing works, we need to understand three related concepts.

● Arithmetic of the average returns in the market.

● The magic of low fees.
● The magic of market weighted index funds.
● After tax return.
1A: Arithmetic of the average returns in the market
By definition, the average of return of all investors (weighted by their size) in the market has to
be equal to the markets return, R. This is because the market is a closed system. Sure, money
may flow in from bonds to equities (stocks) or from equities to real estate, but at the end of the
day, there is always a buyer for every seller and a seller for every buyer. This idea is illustrated
in the figure below:

Or, to put it in a simple equation:

R = Return of M arket = W eighted Average of returns all participants

To adjust for reality, we need to remember that (all) participants incur costs. Individual investors
incur costs through brokerage commissions and by crossing the spread with every purchase or
sale (estimated to be 2-3%). Mutual fund investors incur additional costs in paying their fund
managers (additional 1%). Index investors also incur costs, albeit far lower (of a few basis
points) - we’ll see why shortly.

Thus, the equation actually becomes

R = W eighted Average of returns all participants bef ore f ees

In the above equation what is the return of the market? It is simply the weighted return of all
stocks in the market, or:
 ΣS ∈stocks return(S) * market cap(S)
R = ΣS ∈stocks market cap(S)

In other words, it is the return one would obtain if they held each and every stock in the market
proportional to its size (market cap), or a slice of the market. This is exactly what market cap
weighted index funds do for very low costs.

Since the average non-indexed dollar pays higher costs than the average indexed dollar and the
aggregate returns have to be the same, it follows that:

R = M arket Cap Index Returns + low costs = Other participants + high costs

Or put simply:

M arket Cap Index Returns af ter f ees > Other participants returns af ter f ees

This is the magic that makes indexing work!

1B: The magic of low fees

How much exactly does the market cap indexer beat the average dollar (after fees) by?
Estimates put the average non-index investor incurs ~2% costs per year through commissions,
crossing the spread and expense ratios, compared to the indexed investor who pays a measly
fee (<0.2%). This difference of 1.8% by itself means that only about 40% of the investors in
the market can beat the index (after fees) in any given year (SPIVA, 1 (pdf), 2). Further, winners
don’t consistently outperform year over year. Markets tend to be mean reverting over investing
styles and returns, meaning that a winner over one period will likely lag over the next period.

The low cost index fund will never be in the top 10% of a market in any year, but it will never by
in the bottom 10% either. It will be in the ~60th-percentile each year. This slight advantage
compounds over a long period because of the way binomial distributions work.

Percentile of the index fund over an n-year period.

1-year 5-year 10-year 20-year 30-year

Percentile 60% 85% 89% 95%+ 99%+

One is virtually guaranteed to beat 99%+ of the market by buying the average market indexed
portfolio with very low costs! This may seem appear to be a surprising outcome in many fields,
but in investing buying the average with very low fees is winning. To digest this, consider the
following:
 ● Every source of edge discovered by an active investor is eventually eaten (arbitraged)
away by other enthusiastic active investors.
● As the average skill-level in a stochastic game rises, the luck factor plays a larger role.
Michael Mauboussin calls this the Skill Luck paradox (link).

This is not to say that no one can beat the market. Concentrated, focused, fundamental, value
oriented investors like Warren Buffett, Charlie Munger, and the superinvestors of Graham and
Doddsville have beaten the market (pdf). However, the math is that only 1% of investors will (by
luck or skill). When ensuring that one can be at the 99-th percentile through virtually no effort, is
it worth passing up on that opportunity? The prudent intelligent individual investor would do well
to index the vast majority of their investments and take selective active beats when the odds are
heavily in their favor. In fact, this is what the legendary Benjamin Graham himself came around
to toward the end of his career.

Credits: Jason Zweig

1C: The magic of market weighted funds

We have seen above that the advantage of the indexed investor lies in buying the market
average at low fees. What is it about market weighted funds that allow exceptionally low fees.
The answer lies in Sloth.

Market weighted index funds simply buy a slice of the market, and do nothing day to day. As
prices (and market caps) of stocks zig and zag, the portfolio is always in balance! To understand
this consider the following simple market with three stocks, A, B, and C with the following prices
on Day 1:

Stock Shares Price (Day 1) Market Cap Market Cap Weight

Outstanding

A 100 $20 $2000 2000/4000 = 50%

B 1000 $1.50 $1500 1500/4000 = 37.5%

 C 200 $2.50 $500 500/4000 = 12.5%

A market cap index would simply hold portfolio in the weight 2000 : 1500 : 500. In other words,
$1000 in a market cap weighted fund would be distributed as $500 in A, $ 375 in B, and $125 in
C. Therefore the fund would buy 25 shares of A, 250 shares of B, and 50 shares of C with the
$1000. Here’s the great thing: as prices move, the fund has to do nothing.

To understand this, consider Day 2 when the prices have changed as follows:

Stock Shares Price (Day 2) Market Market Cap Weight

Outstanding Cap

A 100 $15 $1500 1500/4100 = 36%

B 1000 $2.00 $2000 2000/4100 = 48%

C 200 $3.00 $600 600/4100 = 14%

Here, the weight of Stock B has increased in the market at mainly the cost of A. Does the fund
need to rebalance? No! To understand this, let’s work through the weights of the fund. It still has
25 shares of A, 250 shares of B, and 50 shares of C:

Fund Portfolio Shares Value on Day 2 Ratio of Market Caps

A 25 $15 * 25 = $375 375/1025 = 36%

B 50 $2.00 * 250 = $500 500/1025 = 48%

C 50 $3.00 * 50 = $150 150/1025 = 14%

To recap, the market cap weighted index fund simply buys stock in the proportion to market
caps at any point of time. And stays put. It does not have to rebalance with fluctuations in price.
The only times it needs to rebalance are when companies enter or exit the index or when there
are corporate actions (such as mergers and takeovers or buybacks and issuances).

To fully digest this the implications of this, consider that a stock like Apple was bought into the
S&P 500 index in 1982, and it has never been trimmed or rebalanced (apart from corporate
actions). The index has seen Apple rise over 400x!1

1
This is another key index funds do so well - they let their winners ride, and cut their losers
(when they exit the index).
This infrequent trading means that the market cap weighted index fund can offer truly low costs.
Today, Vanguard’s Total Stock market offers a rock bottom expense ratio of 4 basis points
(0.04%). There are even theories that index funds could eventually offer negative costs, by
continuously reducing trading costs, and earning more in return by allow shares to be borrowed
by short sellers!

1D: After tax return

So far, we have only spoken about pre-tax returns. The after-tax numbers are even more in
favor of index funds!

Active funds beside issuing dividends received from the underlying stocks, also pass on capital
gains to the individual investor. This happens when an active fund manager sells a winner in
their portfolio to buy what may appear as an undervalued stock to them (i.e, portfolio turnover).
Thus the investor in the active fund pays taxes on both dividends and capital gains. This can be
a huge burden to the individual investor. In fact, sometimes, the capital gains issued to investors
exceeds the gain recent investors have seen (link)2!

An index fund however, almost never distributes capital gains.

● Firstly, it never sells it’s big winners.

● Secondly, most of the stocks it sells are those leaving the index (and are thus likely to
have shrunk rather than grown in value).
● Finally, there is almost no turnover - the overall turnover of the Vanguard S&P 500 was a
measly 4%!

In fact, most index funds have not distributed capital gains for many years now. Vanguard total
stock market has not distributed capital gains since 2000 (link), and even then it was much less
than 1%.

Thus the index fund investor only pays taxes on dividends and almost never on capital gains.
The above returns we saw in 1A were pre-tax returns and almost nobody in the financial
industry reports post-tax returns. For those in a high tax bracket, the index fund will outperform
even more than the non-indexed dollar in the market!

1E: What if everyone indexed?

One of the most common questions is, “What if everyone indexed?”. This theme, “the rise of
passive indexing” along with “it’s a stock picker’s market” are two of the most commonly used
phrases by active managers and market commentators to justify periods of poor performance.

2
This situation can never happen with ETFs, and is the primary advantage index ETFs offer over index
mutual funds for the long term investor.
Firstly, I estimate that only about 17% of the market is indexed today (link). Secondly passive
indexing accounts, including ETF arbitrage for less than 5% of all trading on exchanges today.
Further, there has been no connection between the rise of indexing and price dispersion.

Credit: vanguard.com (link)

But, what if?

Let us now consider a hypothetical world where 90% of the market is indexed. Even here, the
simple arithmetic of averages and fees holds. The indexed dollars (90%) in the market will
achieve the average market return net of fees beating the average remaining active investor.

Are we likely to have a breakdown in market dynamics due to a small number of active
investors? Again, the answer is No. For one, the average holding period is less than 4 months in
2018 and falling consistently. The remaining 10% of shares are likely to change hands very
quickly. Secondly, all that is required to have a functioning price setting environment is a few
active participants. As one popular joke goes all it takes is 2 dentists on a dinner table in
Nashville to set the price on a security. Even today, there are companies with a significant
percentage owned by insiders not available for trading. Does this decrease the dynamism with
the remaining shares? No. Does this add a discount to valuation? Potentially. It is important to
separate these two questions.

More importantly, it is very likely that the few remaining players are ever more so highly skilled.
Due to the luck-skill paradox, their returns are more dependent on skill than ever before.
The rise of the individual investor is in other ways, the disappearance of patsy at the poker
table.

How likely is it?

As effective and arithmetic as indexing is, it does not remove behavioral bias. Investors will still
buy for the fear of missing out, and sell for the fear of losing it all. As equity markets give us
bumpy returns, the fraction of indexing too, will ebb and flow. When sectors (such as Technology
or energy) beat the market for a few years at a time, capital will chase performance and follow.
Because of these reasons, a large fraction of the market (say 90%+) being indexed is likely to
take a very long time.

Key Idea 2: Staying the Course: The world’s worst market timer
In 2014, Ben Carlson (whose blog is excellent), wrote a post about Bob, the world’s worst
market timer (link). I encourage you to read the actual post, but I’ll provide a short summary
here:

Bob was paranoid about losing money in the stock market, and would diligently save
cash. However, at the peak of every bull market, Bob would finally succumb to hype,
envy, and the fear of missing out, and would invest all his cash. Thus, Bob would only
ever buy at market peaks. One would assume Bob would have terrible investment
returns.

Credit: awealthofcommonsense.com

However, Bob had, in Ben’s words, “one redeeming quality”. Bob never sold once he
bought the index. Despite being the world’s worst market timer, Bob did pretty darn well,
ending up with over $1.1million or making nearly 6 times his money! Before you ask, Bob
received a 9% annualized return compared to 12% annualized return of the S&P 500.
Not bad for the world’s worst market timer.
The key lesson here is that market timing matters far far less than staying the course and being
disciplined about one’s strategy. Would Bob have done better waiting for each crash? Of course,
but no one can time the market before hand. One can do much better than Bob by dollar cost
averaging into the market over time. And you’d be hard pressed to find a strategy that beat
dollar cost averaging into the index over a 30 year horizon!

Key Idea 3: Asset Allocation & Periodic Table of Returns

An astute observer would say that Bob got lucky with buying the US stock market at a period of
incredible returns. And diversifying across asset classes can help protect against this.

Broadly, there are 4 broad asset classes in the world - stocks, bonds, commodities and real
estate. Historically, equities have provided the best return (link), they have also come with a lot
of volatility. Companies go bankrupt, business cycles turn, countries go to war, and markets
panic. Diversification across asset classes can not only help smoothen the ride, but can often
help increase return for the same level risk or decrease risk for the same level of return. This
idea is a very core idea in Finance and one that Henry Markowitz won the Nobel Prize for.

To understand why diversification works, we will need to understand two key ideas:

● The math of compounded returns

● The variations in returns for an asset class

3A: The math of compounded returns

Consider an investor receiving a stream of yearly returns: r1 , r2 , ..., rn . The compounded
returns received by the investor over n years would be:

(1 + r1 ) * (1 + r2 ) * ... (1 + rn )

However, from AM >= GM, we know that:

(1 + r1 ) * (1 + r2 ) * ... (1 + rn ) <= (1 + average(r))n

Thus, the investor receiving a stream of returns will always do worse than another equivalent
investor receiving the constant stream of the arithmetic mean of these returns. To crystallize
this, an investor who receives 8%, 3%, 7%, -5%, 12%, would do worse than the investor who
receives the stream of the average return: 5%, 5%, 5%, 5%, 5%. In fact, the first investor would
end up with $1.26 for every dollar invester, while the second investor would receive $1.27.
Further, the lumpier the return stream, the worse it will perform compared to the constant
stream of mean returns.
And this is before any behavioral biases! The investor who receives the lumpy stream might
panic after the -5%, or might get euphoric after 3 years of positive returns.

3B. Periodic Table of Investment Returns

The investment firm Callan has been compiling yearly returns of asset classes into what
they call the periodic table of investment returns (link):

Credit: https://www.callan.com/periodic-table/

There is plenty of mean reversion happening here: Asset classes that outperform for a
period tend to underperform afterwards.

This is the second reason diversification works.

3C. What’s a good asset allocation?

There is no universal good asset allocation. What’s good depends on one’s horizon, and the
volatility one can withstand over the horizon.

The largest factor in investment returns and volatility is the ratio of stocks to bonds. Many
investment professionals call the 60% stock, 40% bond portfolio, as the benchmark balanced
portfolio. Warren Buffett on the other hand recommends 90% S&P 500 and 10% short term
treasuries to his investment trust:
 Page 20 of 2013 Berkshire Hathaway Annual Letter (link)

For more choices and explanations, the Bogleheads page on asset allocation is a great starting
point (link). Whatever the choice, a good allocation involves a writing down of one’s investment
philosophy and sticking to it for the long haul. Investment Policy by Charley Ellis is an excellent
read on this topic.

3D. Time diversification

Just like asset diversification, there is also the risk of being concentrated in time. Consider the
typical investor in their accumulation stage - she’s exposed to the sequence of returns risk (link).
She will have very different (worse) performance in a market that rises and then falls (say 8%,
10%, -5%), compared to a market that falls and the rises (-5%, 8%, 10%). One often suggested
alternative to diversify against time concentration is for the investor to use (decreasing) leverage
during their accumulation phase. However, this is a dangerous approach and like all kinds of
leverage can lead to severe financial loss.

Time diversification is very hard to achieve, but it is important to be cognizant of this for the
young investor.

Key Idea 4: Tax Loss Harvesting

In taxable accounts, tax loss harvesting can be employed to further boost investment returns.
While firms like Wealthfront tend to overestimate the benefits of Tax Loss Harvesting (TLH), it no
doubt proves a benefit to the individual investor. The key idea is that returns (even after
diversification) do not follow a straight path and consist of zigs and zags.

Consider the series of returns to your

right (blue). For an investor who is
regularly buying into the market, the dip
at time period 4, provides a great
opportunity. At t = 4, they can sell some
of the index funds they bought at t = 3 or
t = 2 and replace them with near
equivalents (this is important). The
investor loses little apart from the
commissions of a single trade, but
benefits by having a large realized tax loss. They may now choose to sell other profitable
investments that have had a gain (including those from t = 1) and effectively reset cost basis or
claim (upto $3000) in deductions on their individual return. To learn more, wealthfront’s
summary is an excellent explanation of Tax Loss Harvesting (link).

Near equivalents: The wash sale rule in general does not allow tax loss harvesting
immediately, and forces the investor to wait for a period of 30 days. However, if the underlying
index is different, the index fund investor can immediately replace one for the other. Thus one
could potentially tax loss harvest VOO (Vanguard S&P 500) and immediately replace it with a
world index such as VTI (Vanguard US Total Stock Market).

Summary
These salient ideas together form the basis for long-term, regular investing in a diversified
equity-driven portfolio. Successful investing is simple, but not easy. In the long run, emotional
and behavioral mistakes are our biggest risk. In investing, we are our biggest enemy.