Index Fund beginner

JohnWinder

‘Some of the problems I see with this argument (NOTE: I assume you mean ‘the market reflects the best information’) arise from the observation that market prices are set by those people who trade most often:
Most of those people driving market prices are primarily aiming for maximum returns, I am not.

I agree, but it's fanciful to imagine. Example: some Russians, feeling put down, want to boost the standing of Russian stocks for reasons of national pride, so they buy up like crazy. You and I think they’re over-valued and won’t touch them, or just hold less than their market cap weighting. You and I win compared to the index trackers because eventually those stock prices can’t be sustained. Can any such process be happening to cause US and tech stocks to be over-valued; are there people with other than optimising returns motives who are setting the prices?

So are you saying ‘people like me not seeking maximum returns also drive prices’, or ‘pricing based on maximising returns doesn’t affect me because I don’t chase maximum returns’?

Firstly, everyone who trades particular shares influences the market price; prices change in response to buy and sell decisions.  If stock investors wanted maximum returns they'd use leveraged investing, borrowing to invest, so clearly most don't want 'maximum returns'.

But as already noted, investors want the biggest return for the risk they are taking, not the biggest return regardless of increased risk. I want the market return, as high as possible, and I can’t get lower than that except for costs and tracking error, with a tracker; I minimise the risk by not taking concentrated positions in certain shares or certain countries. To own Apple only would be very risky, just like once owning only Sinclair was. But I would have once owned Sinclair and Apple had they been in the index 40 years ago, and my Sinclair holding would have faded away to a loss as it drifted into oblivion; but had my holdings favoured it over the market cap weighting I’d have lost out more, just as I’d have lucked out if I’d been overweight Apple 40 years ago. That’s the extra, in addition to, market risk that you take if you don’t hold all stocks by cap weighting - you can lose out or you can gain with returns, but you don’t reduce your risk as measured by price variations which is an important type of risk when it’s on the down side.

2) Most of the people in the market are short term investors.  That is not me.

Even if you hold only and never trade, the market price is still set by traders some of whom are short term investors. Their strategy is very different from yours and mine, but they still determine the market price.

3) Regarding "the wisdom of the crowds": https://www.pnas.org/doi/10.1073/pnas.1008636108 argues that it can be undermined by social inflence.  Surely the stock market is a prime example.  Furthermore it is only valid if there is a right answer to the question asked that could be known now.  For example a million people guessing the result of the toss of the coin is no more accurate than one person doing it.  This I would argue applies to a significant extent to the stock market predicting the future.

I don’t know what effect social influence has on market pricing, probably quite a lot, but the fact remains that the market participants determine the market price. And it doesn’t matter if you and I think US stocks are ‘over-valued’, we will have no influence on the price if we don’t trade anything and only have an influence if we can convince others to sell or buy something else in which case those traders have bought new information to the market (from us) and the market now reflects all credible information. That makes the market price the best estimate of value, ignoring rich Russian patriots distorting the market for non-financial reasons.

Here’s a Nobel prize winner:
‘What the market does, it brings all of us who are coming into that market, and taking actions on the basis of things we know, things we want to achieve, all right? That's how prices are formed. The market encapsulates that aggregate information from all of us that none of us have. The first point to make is the market is a very important source of information. It has information that no one has, okay? Now, the question is, how good is that information? That has to be measured relative to the information you have.’
https://rationalreminder.ca/podcast/234

Why should following the index be most appropriate for meeting my objectives?’

Because by taking stock market risk with some of your money you can hope for stock market returns which result from, putting aside businesses making profits, all market participants deciding how the value of your investments rise over the years, and by taking a more concentrated position (less US stocks) than the market you would take on above market risk.

Not keen on the coin tossing. Both the million guessing heads, and you guessing tails have a 50% chance of being right. When we toss the coin we know who was right. But there is no ‘right price’ in the stock market other than the price set by traders, because if there was other information which pointed to the real value of any stocks then someone would bring that to the market to make some money from it.

JohnWinder

There is no aversion to investing in US companies.  The issue is  the %.  At 40%, US is still the largest geographic area in my portfolio.

Not suggesting you should change that, but discussing can help other readers perhaps.

The effect size of the impact of your choice, always relevant, is perhaps small if we talk about returns compared with 60% US and 40% elsewhere. Portfoliovisualizer indicates a difference in return for the past 35 years of 0.7%/year.

If your approach, to underweight US stocks is because a tumbling market there will have a bigger impact than you wish, you have simply moved the danger to the rest of the world tumbling causing you bigger problems than holding market cap weighting would. Or if it’s because you think US is over-valued, then you ought to be prepared to over-weight US stocks if you think they become under-valued; now you’re an active trader, about which no criticism but good to recognise.
History doesn’t tell us about the future, but it shows your ’40/60’ (US/rest of world) compared with ’60/40’ (rest/US) was slightly more volatile, had a worse ‘worst calendar year’, a bigger biggest fall,  and a worse risk adjusted return not surprisingly given the 0.7%/year shortfall. Those comparisons could reverse in the coming decades I'm sure. But in the past, US alone compared with rest of the world alone, did better by 3.5%/year, with less variation in yearly returns, a better ‘worst year’, a smaller biggest drop, and better risk adjusted return not surprisingly.

Linton

JohnWinder said:

There is no aversion to investing in US companies.  The issue is  the %.  At 40%, US is still the largest geographic area in my portfolio.

Not suggesting you should change that, but discussing can help other readers perhaps.

The effect size of the impact of your choice, always relevant, is perhaps small if we talk about returns compared with 60% US and 40% elsewhere. Portfoliovisualizer indicates a difference in return for the past 35 years of 0.7%/year.

If your approach, to underweight US stocks is because a tumbling market there will have a bigger impact than you wish, you have simply moved the danger to the rest of the world tumbling causing you bigger problems than holding market cap weighting would. Or if it’s because you think US is over-valued, then you ought to be prepared to over-weight US stocks if you think they become under-valued; now you’re an active trader, about which no criticism but good to recognise.
History doesn’t tell us about the future, but it shows your ’40/60’ (US/rest of world) compared with ’60/40’ (rest/US) was slightly more volatile, had a worse ‘worst calendar year’, a bigger biggest fall,  and a worse risk adjusted return not surprisingly given the 0.7%/year shortfall. Those comparisons could reverse in the coming decades I'm sure. But in the past, US alone compared with rest of the world alone, did better by 3.5%/year, with less variation in yearly returns, a better ‘worst year’, a smaller biggest drop, and better risk adjusted return not surprisingly.

My overall concern about 60% US is long term diversification rather than current valuations.  Poor diversification does increase the impact of localised geographic circumstances on one's portfolio.  This is mitigated by ensuring that the portfolio is well spread across the world.  60% US means 40% everywhere else.  I believe there are too many opportunities outside the US to allocate a meaningful amount of one's wealth into 40%.

I would suspect the figures on relative performance are very dependent on the time period chosen but If correct may well show that a higher US allocation would have performed even better.  Would you advocate this or perhaps you may consider basing future allocations on past success a faulty strategy?

Edited...

How did you separate out the effect of geographic allocation from sector allocation?  

dunstonh

Historically, you tend to find that US equity vs global (inc US) equity sees each performing better than the other almost every other cycle.   i.e. 10-15 years sees US equity best and the next 10-15 years sees global best.

This is largely in part due to exchange rate movements.    This last cycle saw sterling fall and dollar rise. That pushed up US returns for UK investors making them higher than US investors would have seen.  Indeed, many UK investors have seen their US funds go up in value (or hold steady) over 2022 despite all of the US stockmarkets go down over 20%.

The risk going forward into the next cycle is that Sterling rises and the dollar falls.  So, that will offset any gains in the US markets.

You can avoid that by going with a currency hedged US equity fund and that is quite popular at the moment (even if its likely only to be short term).

Too many UK based novice investors have gone 100% into S&P500 trackers and don't realise the pain they are going to have in the future. They were too busy looking at the past performance.

The 10 year period from 2000 to 2009 saw US equity, for UK investors, go negative (indeed, it took 12 years to recover).   Global equity significantly outperformed it.  The swing back happened from around 2012 and US equity significantly outperformed global equity.   Nobody knows when this cycle will change.  However, since October last year, global equity has significantly outperformed US equity.

GazzaBloom

dunstonh said:

Historically, you tend to find that US equity vs global (inc US) equity sees each performing better than the other almost every other cycle.   i.e. 10-15 years sees US equity best and the next 10-15 years sees global best.

This is largely in part due to exchange rate movements.    This last cycle saw sterling fall and dollar rise. That pushed up US returns for UK investors making them higher than US investors would have seen.  Indeed, many UK investors have seen their US funds go up in value (or hold steady) over 2022 despite all of the US stockmarkets go down over 20%.

The risk going forward into the next cycle is that Sterling rises and the dollar falls.  So, that will offset any gains in the US markets.

You can avoid that by going with a currency hedged US equity fund and that is quite popular at the moment (even if its likely only to be short term).

Too many UK based novice investors have gone 100% into S&P500 trackers and don't realise the pain they are going to have in the future. They were too busy looking at the past performance.

The 10 year period from 2000 to 2009 saw US equity, for UK investors, go negative (indeed, it took 12 years to recover).   Global equity significantly outperformed it.  The swing back happened from around 2012 and US equity significantly outperformed global equity.   Nobody knows when this cycle will change.  However, since October last year, global equity has significantly outperformed US equity.

Very true.

The US and Global tracker funds I have access to for my work pension bear out the better performance of Global vs US since October. The pound rose against the dollar during the back end of last year after the Truss/Kwarteng chaos, which would have hurt the US fund in GBP terms, so it's a little early to know if this is going to be a longer term reversal of fortunes:

bostonerimus

OP, ignore most of the last couple of pages of comments as they are not that relevant to a beginner. Just read a few of he books and links on the first page and then make sure you are debt free (apart from mortgage), have an emergency fund in the bank and then invest in 2 or 3 index funds or something like the Vanguard LifeStrategy products. Remember your workplace pension (if it is a DC one) is the best place to start investing as you get great tax advantages.

JohnWinder

This is largely in part due to exchange rate movements.

Yes, the historical data I detailed was from a US investor using $US perspective because I used portfoliovisualizer.

How did you separate out the effect of geographic allocation from sector allocation? 

I'm not quite sure what your question is, but I used portfoliovisualizer and back-tested the asset allocations 'US stock market' and 'global ex-US stock market' in different proportions. hope that helps.

And, risking unnecessary repetition, I don't think those past results should guide future proportion choices. And the issue of 'home bias' is a different consideration, if moving from global weighting, in my view.