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Value Investing And Behavioral Finance

Index Investing

To understand this, one must first understand the distinction between the philosophies that drive a corporation and those that drive an index. Corporations place a premium on continuity. They may perish if they do not receive fresh blood at regular intervals. Indexes, on the other hand, concentrate on discontinuity. They constantly scan the markets, injecting new potential stock and removing the weaker ones. The index never rests on its laurels in this manner and is always focused on future potential. 

 

This is the fundamental principle underlying Index Investing. The issue arises during execution. Market capitalization is the minimum requirement for a stock to be included in the index. Weak companies can sometimes enter the index by playing the market capitalization game. This is why different index funds perform so differently. Because of this index manipulation, especially in emerging markets, an actively managed active investing strategy can pay out large dividends. 

 

The author cites a study conducted by his team. Beginning in the 1990s, whenever a stock was replaced in the index by a new one, he invested the same amount of money in both on the day the transition occurred. In this manner, he accumulated two portfolios, one of the rejects and the other of entrants. Surprisingly, the team discovered that the portfolio of rejects outperformed the portfolio of new entrants by a statistically significant margin.

 

Lessons:

Avoid the Bait

Index funds are created by fund houses and asset management companies to entice lower fees. The author wishes life were so simple that you could buy a basket of stocks and then sit back and wait for the market to reward you. The goal of fund houses is to raise the most money possible. It all comes down to massive assets under management and the fees charged on them. Furthermore, they have no standard against which to measure their performance. The index reflects the market, and if the market falls, so will the index. There is power without accountability. We live in a competitive world, and this type of passive investing is clearly out of date.

 

However, its marketability is very strong because it is a good and effective way to exploit investors' loss-aversion behavioural bias. Lower fees should not entice people to invest in index funds. Do we pick our doctor based on the prices he charges? Certainly not.


His fees are less important than our health. Similarly, our wealth and growth are more important than the nominal fees we try to save.

 

Availability Bias

All of the information available on index investing is so positive that investors assume it is correct. However, we don't know whether index investing worked because there isn't a benchmark. Furthermore, the stock markets have been volatile, with speculators making and losing fortunes. They lost not because equity is a lousy investment class but because of greed and irrational behaviour. This information is so vivid in investors' minds because it can be found in every bull and bear market. Investing and earning returns is all about the cost of the value received.

 

Be Courageous

It only takes little guts to go against the grain and act unconventionally. As one's self-esteem and confidence grow, it becomes a habit. Evidence suggests that going against popular opinion pays off in the long run. Have the courage to put this strategy into action.
There are many irrational people around who are eager to provide you with good market opportunities. However, you will be successful if you take your time.

 

Do Your Own De-indexing

Investing is all about purchasing a stock with the least investor expectations.


Such stocks are discovered when they are removed from the index. We've shown you evidence that such stocks outperform in terms of long-term investor returns. Do some research and select such good stocks that are leaving the index. If you don't want to do that, buy the stocks removed from the index and build your portfolio. We have demonstrated how the laggards performed. You have evidence on your side. To go against the grain, you must have the guts to do so. That is the litmus test for investment success.


Your conviction must fuel your bravery.

 

Key Takeaways

By the end of the week, knowledge has changed. Trends reveal a great deal to us. Trends are significant because they help us know where we're going and provide evidence. This is what we did in the prior studies.

 

Index investing is not superior to active investing. On the contrary, based on the difference in returns between the laggards and the replaced stock portfolios, it is safe to conclude that the contrarian approach to indexing works better.

 

If you want, you can call it "De-Indexing."

 

Finally, investor returns are determined by the price paid for a stock with the fewest pre-existing investor expectations. To become a successful investor, you must be able to control your emotions and resist the pull of the crowd. Are you capable of defying popular opinion? Go ahead. It's similar to taking the road less travelled. It is only after years of perseverance that you will realise how much of a difference it made.

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Units 12/15