Subject: RE: Questions for Sam Beard:"Investor's License"
>From: "Steven H. Johnson"
>>>>re Index-based portfolios
>>>>The S&P; 500 index is weighted. Weighting creates problems, as is being pointed out.
>>>>But the concept of an index-based portfolio does not inherently involve weighting.
>>>>If Social Security were steering any significant amount of capital into the stock market, either from the Trust Fund, or in the form of Personal Retirement Accounts, index-based portfolios would be a good place for the investments to go. Social Security cannot predicate an investment strategy for 150 million people on the idea that it's going to help everyone beat the market. All it can do is base its strategy on the proposition that everyone ought to be able to realize the market average growth rate, the market average return rate.
>>>>Given that, there really is no alternative to an index-related portfolio strategy. But it shouldn't pick the S&P; 500 as the reference index. Something much broader, and less weighted, is needed.
Steven,
You have mis-interpreted my post to Michael. It is not the 'weighting' that is the problem with index funds. I merely used that reality to demonstrate the problems with indexing. You cannot avoiding the 'weighting' decision in any indexing scheme. If it's not market cap, what do you use? Do you invest the same amount of money into the smallest stock of the Russell 5000 as you do in the largest stock of the S&P; 500? That is indeed absurd. Do you buy one share of each stock? That causes problems when you compare GM at $88 per share and Berkshire-Hathaway at $77,000 per share.
The real problem with indexing is that it goes against the free market mechanisms inherent in our capitalistic system. The stock market is the mechanism for producing the most efficient use of capital. Indexing goes against that very mechanism. In small overall quantities, indexing works well for individual investors. When it gets to be a large proportion of the market, the market no longer performs its function properly. We can indeed provide everybody with the 'market average return rate'. Unfortunately, it will not be a rate anybody is happy with. There is no 'free lunch'.
I can predicate my movie viewing habits based on the length of the line at the box office, assuming that the longer the line, the more good things these people have heard from people who have seen the movie. But we can't all do that. Somebody has to have taken the 'risk' to watch the movie. And the more people who have taken that 'risk', the better the 'quality' of the recommendation. Rewarding all stocks in an index 'equally' is like going to a grocery store and buying one of each brand of a given product, even the stuff that you think is a bad deal. If we buy 'bad' products, we destroy the incentive to produce 'good' products. In that environment, communism is competative with capitalism. And we know how well communism works.
