Sunday, September 27, 2009

Reversion To The Mean

I happened to briefly glance through the book "Bogle's Guide to Common Sense Investing" and it raises a serious issue for me and to every stock picking individual. The underlying thread is that you should forget about selecting a good mutual fund, but rather invest passively and through the use of an Index Fund.

Reversion To The Mean
Why invest passively through an Index Fund? To do injustice to the book, he says that in the long run, no one style (value, dividend, sectoral) can beat the broad market in general. Every style that gains in one particular year will suffer eventually. Something called reversion to the mean. And due to cost efficiency and the ability to buy the broad market (S&P500), he recommends buying Index Fund.

Can I Beat The Market?
That must mean eventually I will lag the market! As it is, I am aware that my stocks in the portfolio are nowhere near the STI or the FTSE All Shares, the latter being a better representation of the Singapore market. Gasp! It must mean that should you choose to pick individual stocks,rather than invest in the broad market, it will be eventually a very demanding process.

It is thus important that you set an objective how much you wish to make from stocks, with a sum of money by the end date. For instance,

"I wish to beat the STI annually, and register an average a growth rate 10% at the end of 20 years, with minimal trading."

As I mention averages smooth out the particular. I believe that it is likely that I will double my portfolio to $20,000 by year's end. But then, it might be harder for me to make that $20,000 into $40,000 as the inherent design of the portfolio might mean that i do not benefit from certain sectors growing.

But by the end of 20 years, without adding any more money to the portfolio, and I have got $68,000, it means that I have compounded on average of 10% per annum. The $68,000 figure is calculated by $10,000x(1+0.10)^20, where 0.1 is 10% annual returns.

I believe that if you managed to get out of the bear markets and get in somewhere near the bottom, your average annualised return will increase even more. I will explain what possible ways there are to spot a down-a-lot scenario, something like what happened the past 2 year.

The learning point here is that we buy stocks not only for a good return but also because we enjoy finding winners. Thus, by trying to find good companies and by trading less, we might not make as much as an index fund, but the intangibles should make up for it.

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