The Case for Stock Picking
By: David Ferrara
Tags: Personal Finance, Stocks, Index Funds, Investing, Stock Market

Warren Buffet bets hedge fund managers

In 2007 Warren Buffet bet a million dollars that an index fund would outperform a basket of funds selected by a hedge fund manager. He won that bet. From 2007 to 2017 the S&P 500 averaged 7.1% vs the asset manager’s 2.2%.

Mr. Buffet’s purpose in doing this was to highlight his belief that the average return of the total U.S. Stock Market would outperform stock pickers.

Index funds vs stock picking

This idea has pervaded U.S. investors over the past few decades because of the Jack Bogle and Warren Buffets of the world.

Which is why there has been a big push towards investing in index funds with many more becoming available. The most famous one perhaps being Vanguard funds (Jack Bogles’ funds).

But is this where you should really put all of your money? Well leaving out real estate or your own business etc. If you are looking for a “passive” return where you put your money into an investment to earn dividends and appreciation is this where you should put your money?

Well the short answer is yes, of course. I’m not going to go against Mr. Buffet on this one.

But the question I have is for how long? In 2007, when the bet was placed closer to 14% of all funds invested in the U.S. stock markets was in an index fund.

What does the increase in index investing impact the market?

Well think of it this way. The total U.S. stock market is made up of, of course the Fortune 500 biggest Publicly Traded Companies in the world. Think Amazon, Apple, Alphabet, Exxon, CitiBank, JP Morgan, Wells Fargo and many more both well known brands, as well as less well known brands but massive and profitable Companies.

The U.S. stock market is also made up of little biotech startups that are equally likely to go bust as hit it big.

As well as companies made up of people that are little more than hustlers that are trying to cash in on the next trend to grab your money. Think all of the Pot Stocks that popped up 10 years ago pretty much all of which have gone bust or are trading for less than a penny a share. I’m not talking about the current boom of Pot Stocks, and Canopy Growth Corp. No, what I am talking about is there was a boom around 2010, before legalization began occurring of several dozen of strike it rich type, early adopter types that have pretty much all disappeared.

Ok, so clearly we have some winners and losers that make up the total stock market.

Well let’s do a thought experiment.

Let’s say the percentage of index funds gets to 100%. I know that will never happen but it’s just a thought experiment so go with me. Well if that happens, then every dollar invested or sold would be either buying or selling only the entire U.S. stock market as a whole. Never individual companies. Which means that all Companies would be valued the exact same.

Amazon would be the exact same value as that penny Pot Stock. Ok, so I know you’re thinking that’s ridiculous and would never happen. But what if we hit 90% index funds? or 80% or 60%. At some point that would cause massive imbalances in valuation where Amazon is valued much too low and the Pot Stock is valued much too highly.

So, we’re at 41% currently. So, how high do we go before the stock market becomes unbalanced? To be specific before certain stocks are overvalued and other’s are undervalued.

The advice out there currently is to make sure that you have a substantial amount of your retirement in a mutual fund and the second bit of advice is the best mutual funds are typically the low cost index funds such as Vanguard VTSAX. So, I expect that that 41% is going to keep creeping higher over the next several years. Until there’s an inevitable backlash as valuations start to get out of line.

At that point the stock pickers are going to start winning again. As they’ll be able to pick the under valued stocks, stay out of the overvalued stocks, and then over the next 10 year period as the backlash occurs (the backlash being people fleeing index funds and going back to the stock pickers) and valuations return to normal (i.e. the out of whack valuations start to move more in line to what the Company should be valued at) they would have won that bet with Warren Buffet.

Should you invest in index funds?

So, just to be clear what I am not saying is not to invest in index funds. I myself have more than three quarters of my investments in index funds. But what I am saying is keep your eye out on how much of the total stock market is invested in index funds. If the percentage starts going up significantly, perhaps think about adjusting your portfolio.

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