In a prior post I questioned whether ignorant citizens should be allowed to gamble by buying individual stocks, as opposed to investing in an index of stocks to reduce risk. Your comments raised some interesting questions that I think are worth wrestling with.

First, many of you pointed out that capitalism depends on people having the option of buying individual stocks. That's how companies raise capital. But surely there is a better way to raise capital than by convincing idiots they know more than they do.

Suppose citizens had two ways they could invest in equities. One channel is through the general index of all stocks (not just the S&P 500). The other is a fund managed by venture capitalists along with their own money. With this system startups still get funded, but only by experts who are close to the action, and citizens are still diversified. And I could imagine some sort of percentage-of-assets limit on how much individuals could invest in venture capital funds.

If a startup succeeds, it gets rolled into the index. From that point on its stock price would move with its actual earnings, as estimated by some sort of regulating board. It wouldn't matter if the regulators got the stock price wrong one year because it would average out with other stocks, and they could always go back and adjust it on appeal from the company.

Employees of a company could still own stock in that enterprise, so they are incented to get profits up. But outsiders could not own the individual stock.

The second objection to banning individuals from owning stock is the Warren Buffett argument. The thinking is that Warren Buffett's method of investing proves that individuals can succeed by buying undervalued stocks and holding them for the long run. So since we know individuals can somewhat easily succeed at investing in stocks, it would be an unreasonable limit on freedom to prevent them from doing it.

There are a few problems with that line of thinking. First, Warren Buffett buys companies, not stocks, in the sense that his stake is so large he can influence management. And his access to information about the company is much better than yours. He's a perfect example of why an individual should NOT be buying stocks; you're competing against the likes of Warren Buffett for limited resources. In the long run, Warren Buffett will have his money and yours too. You're no Warren Buffett.

Still, there are plenty of civilian investors who have done well buying value stocks and holding for the long run. But wouldn't you expect a wide distribution of luck in any gambling arena? If every investor picked stocks entirely randomly, you would still produce a good number of Warren Buffetts entirely by chance. And our brains are wired to assume those winners had the secret formula for investing.

If Warren Buffett's success is indeed a function of following a simple philosophy of investing, and that method has been well understood for decades, you would expect most managed mutual funds to beat the averages too. They don't.
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Dec 23, 2008
Scott, I see some flaws in the logic of your second objection.

Warren Buffett may have been buying companies for a long time now and also any other of his investing methods have been necessarily different from the average person since a long time but he did start selecting stocks, didn't he?. A different matter is if the strategy he used then would be valid today or not.

Why mutual funds don't do just as well? The truth is, some actually do. Take Magellan with Peter Lynch for example. Among the reasons the majority don't outperform the market are: they don't have the courage not to follow the herd and avoid doing especially bad, they are managing too much money to do specially well, maybe managers are content with their pay and don't see the reason to try and be another Buffett or maybe the Buffett kind of investing method being the best has not yet become an accepted methodology in the books, etc.

"If every investor picked stocks entirely randomly, you would still produce a good number of Warren Buffetts entirely by chance"

Read the "Superinvestors of Graham and Doddsville" by Buffett for this point. ;)
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Dec 23, 2008
You could always buy the stocks Warren Buffett buys at about the time he buys them. That information is fairly easily available.
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Dec 23, 2008
Excellent post.

That's exactly how investment should work.

Maybe a range of trackers for different groups of companies, such as global, USA, UK, tech etc, but that's the limit.

And I take issue with the argument of "how did Warren Buffet" get rich posted by an earlier commenter.

Frankly, not everybody will be as successful as Warren Buffet. Very smart, hard working people can't beat the indexes, so how will we?

Should you be allowed to "risk it all"? Well maybe if you don't mind being deported from the planet if you lose it. I'm going to have enough trouble paying for my own retirement without subsidising yours because you felt like a flutter.
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Dec 23, 2008
The question is, in your system who gets to invest in the stock market? Let's say that today people want to buy 5 billion dollars worth of stock but people only want to sell 1 billion dollars worth. In the free market, the price goes up until you convince enough current holders that they want to sell and/or enough buyers to decide it's not worth it.

In your scheme the stock price is determined by a governing board based on earnings per share, so the price can't adjust. Companies can't solve the problem by issuing new stock, because that will dilute earnings per share as well. Are you planning to have a waiting list for stocks? What happens if more people want to sell than there are buyers?

The problem isn't that people are stupid (at least that's not the whole problem). The problem is that people need to fund retirement, and the stock market is the only investment vehicle that (on average) provides returns that will be sufficient. But people born in the wrong year are going to end up with far worse than average returns at the end of their working life, and end up losing money they can't afford to lose.

Rather than trying to fix prices for the entire stock market, a better solution is for the government and/or private insurance companies to provide an alternate investment for retirement by selling retirement annuities. These would guarantee (based on simple equation) an inflation adjusted revenue stream in retirement based on how many dollars have been invested in the annuities and for how long. If you really wanted to make sure people had enough to support themselves when they can no longer work, you could force people to invest in them via a payroll deduction scheme.
Dec 23, 2008
Scott, one quick thing: "If Warren Buffett's success is indeed a function of following a simple philosophy of investing, and that method has been well understood for decades, you would expect most managed mutual funds to beat the averages too. They don't."

No, you would expect HALF the funds to beat the average, and HALF of them to do worse. That's what an average is.

What you seem to have a problem with is individual risk. The thing is, this country has been remarkably successful over the last few centuries precisely because we've taken amazing risks that paid off. The economy is large and healthy enough that it can generally absorb those risks that fail, and spectacularly reward those that succeed.

In fact, it's precisely the risks that are too large to be absorbed by the economy as a whole that can cause problems. Yet, you're advocating allowing only those large risks, and prohibiting the smaller risks instead. To clarify, you want to only allow institutional investors, and bar individuals from investing.

Somehow, I don't think the math would work out on that.
Dec 23, 2008
I just love all these techno-creeps self confidence in investing. Making a few bucks on your options or your stock purchase plan doesn't make you an investment Guru. Unless you're an insider (regardless of the law, there's too damn many of them), investing is really just a crap shoot. In a reasonable economy the odds are somewhat in your favor since said reasonable economies are growing. In Bushonomics the deck is stacked against EVERYBODY. Pillaging the middle class can only last so long. Blind faith in the Big Guy upstairs or Daddy bailing you out is Horse Excrement. We have to find something to produce so we can sell it and employ people again. Any ideas out there? The stock market isn't the answer. Wall street is a sick bunch of rich egomaniacs. Companies just can't make a profit, that profit has to be growing and the rate of growth has to be increasing for any traction or mindshare with those idiots.
Scott, what is the criteria to be a successful restaurateur? Can you just meet expenses and have a few bucks left over? Or do you have to meet some arbitrary rate of return based on your cost of money? Wall street mentality complicated stuff and negates business that could employ people in favor of some get rich quick scheme. "But we've got Shareholders to satisfy..." is a cop out. There's also customers, employees and community that needs consideration.
Dec 23, 2008
Scott, a much more reasoned post than yesterday's. You're approaching the idea of individual finance from a more realistic perspective. I will respond in kind.

It all starts with education. Schools today seem to assiduously avoid teaching two topics (three, actually, but two are closely related): Civics, US History (except vignettes about how horrible America is and always has been), and economics/personal finance. If schools actually taught these things, a lot of our problems would go away. Students would not only understand capitalism in the context of the country's history, but would also understand how to manage their own personal finance, weigh the risks, and make (and live with) their choices.

Your posts indicate that you care about people's financial well-being. But what you're actually saying, whether you mean to or not, is that you favor equality of outcome rather than equality of opportunity. And therein lies your fatal flaw.

It's the difference between leveling the playing field and equalizing the scoreboard. Do the former and you allow people to reach for the stars and try to become all they can be - and pass that knowledge and gain along to their children. If you do the latter, you ensure that people will remain children their entire lives. They'll never grow up, because mommy government will take care of them forever, and while they'll never achieve greatness, they'll never have to fear failure.

Government people are mostly lawyers. Few of them have any idea of economics. That means that they can't do much to effect equality of opportunity, since they don't know what that would take. But they sure know how to tax the producers and give it to the indigent, so they will always focus on what they know: equality of outcome. For everyone but them. Think they'll give up Walter Reed and get into the system if we go to socialized medicine? Not effing likely.

If you want to live in that kind of country, please move to France. But don't try to turn America into a bunch of cheese-eating surrender monkeys. And by the way, look at France. As we move toward socialism, they're realizing that it doesn't work and are moving toward capitalism.

Capitalism requires risk-taking. Risk means the possibility of failure. If you eliminate the possibility of failure by eliminating risk, you also eliminate the possibility of return. The economy stagnates, and we go in a downward spiral that ends in poverty. If that sounds good to you, then let the government remove your liberty. But don't complain later. You put the chains on yourself.

The reason many investors make bad decisions is that they react emotionally. They buy high and sell low. They see a stock going up so they buy it, and then they hold it until it goes low enough that they panic and sell it for a loss. For that reason, Morningstar and other rating companies have gone from simply reporting a fund's performance year-to-year, they are reporting the actual investor return (buy price versus price when sold). That's a much different number, and always lower.

The key to successful investing is to buy high-quality assets, diversify, and wait. Time is the real key. Overall, the economy always goes up. The successful investor is not a child of the thirty-minute TV resolution, who expects everything to work out wonderfully in a short time. It's the patient person, who invests in a well-diversified way and plans for the long term, and who is not going to panic every time the cyclical down times come.

To your specific points: if you're truly interested in the answers (or at least some great opinions) on the subjects you opined upon in this post, here are some great books to read:

On Warren Buffett and his good/bad ideas: "Even Buffett Isn't Perfect" by Vahan Janjigian

What's wrong with mutual funds and why you should stay away from them: "The Lies About Money" by Ric Edelman (chosen as the best financial book of 2008)

On capitalism versus socialism in real life: "Eat the Rich" by P. J. O'Rourke

There are also some good books out there in how emotion impacts our investment decisions. Do a search on "behavioral finance" and you'll get a lot of interesting articles and books.

Good reading. Thanks for the discussion and the opportunity to respond.
Dec 23, 2008
The problem would be how to decide someone is an expert. An once you do it does not make it any less likely they won't be crooks or liars for example, Madoff and Jérôme Kerviel.
Dec 23, 2008
Any process of limiting any sort of activity becomes - where do you draw the line. Who would be "certified" a venture capitalist? Would you limit the number of choices of venture capital funds? If yes, then how many would you have? If you diminish the number, then the remaining funds would be extremely risk adverse. The truly revolutionary start-ups would NOT be funded.

A truly dynamic financial system must depend on the knowledge &, yes, lack of knowledge, of all its participants; not just the judgements of a chosen few. Only a free market that allows Pet Rocks to be successful, can provide the base for the next green technology breakthrough.

Also, the basic premise that we need to restrict the buying of stocks because some/most have recently lost money misunderstands the essence of the free market. Losses on investments is not market failure.
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Dec 23, 2008

1) You’re right that Buffett could be explained by chance. But the collective success of Graham and Dodd investors can’t be. Do us all a favor and read this essay by Warren Buffett: http://www4.gsb.columbia.edu/null/CIER?exclusive=filemgr.download&file_id=645551&showthumb=0

2) Managed funds underperform because of all their disadvantages – cash on hand rules, percentage in single companies, redemption readiness, etc. These disadvantages are precisely what give an individual investor an edge. While the big boys do enjoy an information advantage, it has been and continues to erode rapidly.

3) Index funds are a good choice for ‘savers’ who don’t put in the time and effort in investment selection. But disciplined ‘investors’ can outperform them.

4) This system will reduce competition among companies for investor capital and among investors for investment opportunities. The result will be a less efficient allocation of resources. There is no board of ‘experts’ who can outperform the free market, no matter how smart they are.

5) I know you say you’re not advocating this system, but you’re certainly spending lots of effort singing its praises. I think it’s intellectually dishonest to explain why it’s so much better while keeping your fingers crossed. If you think it’s better, advocate it. If you don’t, say why.

6) Please, please, please don’t advocate for or encourage a system that restricts the means by which I can peacefully provide for my family. I’ll manage my money; you manage yours, etc. etc. What’s wrong with that?

7) I hate to speak for others, but I am. Those of us who ‘lean libertarian’ are proud to count you among us. But the last couple of days you’re not making us proud. We still like to have you aboard, though; you’re great for publicity.

Dec 23, 2008
Sounds like Singapore.
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Dec 23, 2008
Chenlambec - read this: http://www.forbes.com/lists/2008/10/billionaires08_Warren-Buffett_C0R3.html
You'll quickly discover Mr. Buffett's success, he studied and worked hard, made mistakes and learned from those mistakes and quietly grew quite wealthy. I think this is what Scott is advocating - study, understand what you doing, learn from your mistakes and stop expecting others to protect you. To ask someone to qualify before investing via a test or means based process makes tremendous sense that eliminates casino-based decisions.

Dec 23, 2008
First of all, the main problem with investing in mutual funds is the cost. Those 5-star fund managers command large salaries, and have teams of paid analysts. And who picks up the cost? The small investors, in the form of annual fees.

Venture Capital funds have never been invested in by small investors that I'm aware of. Venture Capitalists have huge pools of money in the hundreds of millions for even small ones. Small time investors aren't even worth their time. Furthermore, Venture Capital companies are more risky than a well diversified portfolio. A good Venture Capital Fund is looking to strike it rich with 10% of its investments, which then make up for the other losers. This means that if a venture capital company invests in an inordinate amount of losers whose IPO doesn't go well or fail in other ways, they get destroyed financially.

Also, for terraxsu, who said that a coin flip was better than Jim Cramer's picks. That may be true for Jim Cramer. However, the Wall Street Journal has done a number of articls on this topic. They had one where a monkey picked stocks and a star fund manager picked five stocks from the S&P500. The fund manager won by a large margin. They do one every year where amateurs and a random number generator pick from the S&P500. They always lose to the pros. Fund managers can make money, or lose less in most cases. Until you take out their fees, at which point its usually better for the little guy to go it alone.

I strongly advocate individuals buying stocks. They just need to know how to invest. Too many people think that a stock will go up because of some the Christmas Holiday boosting sales, when this has already been factored into a stocks price. Too many people think that a news announcement will push a stocks price in a favorable way, only to find out that they're too late. People need to actually learn how to invest.

For these people, I suggest learning a basic Discounted Cash Flow model. You can find a good website at www.valuepro.net
This website gives a basic DCF calculation as well as explaining fairly well what all the numbers mean.
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Dec 23, 2008
Scott, I think it's a good idea, but are you hitting all the use cases? I only want my investments to be in companies that are socially responsible, and have a good environmental track record. I could care less if they make less profit than the less responsible companies. I want my money to invest in a sustainable future. When they start digging up the local mountains and forests to get more coal, I don't want to have to tell my kids, "hey, I helped pay for that!". So I'd like to steer clear of things like coal power, oil drilling companies, firearm manufacturing and sales, etc.
Dec 23, 2008
(Mis-)Interpretation #1 of Scott's premise. Stock Market = Gambling. Let's say, roulette. Gamblers should be protected from loosing their shirts by limiting their bets to only Red or Black (payout = bet x 1), and not pick individual numbers (payout = bet x 36).

Problem: If people put all there money on one bet or a series of bets and they lose, their hosed no matter what. Even though diviersified, the S&P still has lost 40% of its value this year alone. That's 500 individual bets that, in aggrigate, lost big time.


(Mis-)Interpretation #2 of Scott's premise. "Experts" are better able to pick winners than the unwashed masses.

Problem: Bernard "Ponzi" Madoff was an expert hedge fund manager.


(Mis-)Interpretation #3 of Scott's premise: People are drawn to get-rich-quick schemes. Some of them actual do pay off. Yes, this is the law of averages in action, which is one of Scott's points. Yes, it's a sucker bet (another point). People should be protected from themselves.

Problem: If you limit the risk, you eliminate the suckers. And sometimes there are projects that only a fool would beleive in. Like a shortcut from Europe to India by going west, and we all know how badly wrong that wager went.
Dec 23, 2008
Scott, it would appear that the Consumerist blog agrees with you on the index funds. They have an interesting article on how over the last 8 years, you would of done better with coin tosses than listen to Jim Cramer's stock picking advice. He is a tv "stock-picking expert" who doesn't stack up against an index fund. It appears that his investment advice is akin to the old debate strategy of "as long as I'm the loudest, I'm right".

Dec 23, 2008
"...you would expect most managed mutual funds to beat the averages too"

If everybody beat the averages, it wouldn't be an average would it?
Dec 23, 2008
Any system that allows a group of people to set a price for something is asking for corruption. If you think capitalism has corruption just wait and see what would happen with your ideas of a regulating board setting stock prices.
Dec 23, 2008
I forget. How did Warren Buffet get rich in the first place? You know, before he could afford to take whole companies.
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