Re: Index mutual funds
Do you seriously find this exercise helpful? Couldn't you just as easily back out the (von Neumann-Morgenstern, I presume) utility function you need to get an introspectively plausible answer? In other words, if you feel nervous with a SD of 20% of the mean, could looking at utility functions really make you feel better about it? Well this is a tad embarrassing. I thought I was using standard values for the coefficient of relative risk aversion, but had messed up its definition so that I was actually using values that were very very low. Using a CRRA of 3, a reduction in the standard deviation of income from 20% to 10% gives an increase in utility equivalent to about a 7.5% increase in income (RV is a normal truncated and + or - 3). Sound more reasonable? However, this does drop off rapidly as you decrease the CRRA. For example, with a value of 1 (the commonly used log utility) it only takes a 1.7% increase in your income to compensate you for an increase in the standard deviation from 10 to 20% of your income. - - Bill William T. Dickens The Brookings Institution 1775 Massachusetts Avenue, NW Washington, DC 20036 Phone: (202) 797-6113 FAX: (202) 797-6181 E-MAIL: [EMAIL PROTECTED] AOL IM: wtdickens
Re: Index mutual funds
William Dickens wrote: Not that much. Assuming constant variance and correlation the variance fraction of the possible reduction you can get is inversely proportional to the number of stocks you hold (you get half the reduction relative to holding one stock by holding 2 90% by holding 10 etc). If correlation isn't constant then you should be able to do better than that by choosing less correlated stocks. Right, but if you want to reduce the SD of your return, you've got to square those numbers - you need 100 stocks to get the SD down by 90%. And isn't that the measure of risk most people vaguely have in mind? In any case, I'd like to thank Bill for the only useful investment information I've learned since the JEL piece on international diversification. So Bill, if you had to guess, roughly what expected return reduction would you get from (a) standard stock-picking and active trading, (b) managed mutual funds, (c) index funds, and (d) buy and hold with discount brokers? I would still guess that (c) closes 90% of the distance between (a) and (d), but I'd like to hear your guesstimate. -- Prof. Bryan Caplan Department of Economics George Mason University http://www.bcaplan.com [EMAIL PROTECTED] He wrote a letter, but did not post it because he felt that no one would have understood what he wanted to say, and besides it was not necessary that anyone but himself should understand it. Leo Tolstoy, *The Cossacks*
Re: Index mutual funds
Bryan wrote: Right, but if you want to reduce the SD of your return, you've got to square those numbers - you need 100 stocks to get the SD down by 90%. And isn't that the measure of risk most people vaguely have in mind? Well what I suppose we should be using isn't either the SD or the Var, but the % of the maximum increase in utility that is possible with increasing diversification. Playing around with a few examples it looked to me that the gain in utility was inversely proportional to the decline in variance - - not the SD. However, more surprising than that was the incredibly small utility gain that one obtains by reducing the standard deviation of your income from say 20% of the mean to 10% of the mean. In all the examples I worked out a .1 or .2% increase in the rate of return completely dominated that. In any case, I'd like to thank Bill for the only useful investment information I've learned since the JEL piece on international diversification. Your welcome. Just note that this was never intended as investment advice, your milage may vary, not doing exactly what someone else told you to do will certainly cost you your life fortune and leave you broke and starving, its not my fault, repeat PLEASE DON'T SUE ME! So Bill, if you had to guess, roughly what expected return reduction would you get from (a) standard stock-picking and active trading, (b) managed mutual funds, (c) index funds, and (d) buy and hold with discount brokers? I would still guess that (c) closes 90% of the distance between (a) and (d), but I'd like to hear your guesstimate. Depends on the size of your portfolio. If its $2,000 you might very well be better off with the mutual fund. With a million dollars or more I expect that 90% is almost exactly right (figure zero percentage costs vs. annual costs of .5% of your current net worth in present value terms for 20 years). I use the .5% figure rather than the .17% or .2% figures for the reasons I mentioned in a previous post plus one more I've thought of since then. If you buy individual stocks you are likely to have some losers. You can sell those to take capital losses that you can use to reduce your tax liability for your unavoidable investment income (dividends and interest on fixed income assets). Can't do that if you diversify in a mutual fund. - - Bill Prof. Bryan Caplan Department of Economics George Mason University http://www.bcaplan.com [EMAIL PROTECTED] He wrote a letter, but did not post it because he felt that no one would have understood what he wanted to say, and besides it was not necessary that anyone but himself should understand it. Leo Tolstoy, *The Cossacks*
Re: Index mutual funds
William Dickens wrote: Well what I suppose we should be using isn't either the SD or the Var, but the % of the maximum increase in utility that is possible with increasing diversification. Playing around with a few examples it looked to me that the gain in utility was inversely proportional to the decline in variance - - not the SD. However, more surprising than that was the incredibly small utility gain that one obtains by reducing the standard deviation of your income from say 20% of the mean to 10% of the mean. In all the examples I worked out a .1 or .2% increase in the rate of return completely dominated that. Do you seriously find this exercise helpful? Couldn't you just as easily back out the (von Neumann-Morgenstern, I presume) utility function you need to get an introspectively plausible answer? In other words, if you feel nervous with a SD of 20% of the mean, could looking at utility functions really make you feel better about it? -- Prof. Bryan Caplan Department of Economics George Mason University http://www.bcaplan.com [EMAIL PROTECTED] He lives in deadly terror of agreeing; 'Twould make him seem an ordinary being. Indeed, he's so in love with contradiction, He'll turn against his most profound conviction And with a furious eloquence deplore it, If only someone else is speaking for it. Moliere, *The Misanthrope*
Re: Index mutual funds
[EMAIL PROTECTED] 07/14/02 14:19 PM If I want to buy shares in the 500 or so companies on the SP 500, I'll be looking at commissions of at least $3000, right (unless I have a commissionless trading account, which requires a minimum balance of $500,000 or so)? If I hold those stocks for 20 years without ever rebalancing, that's $150/year. $150 divided by .2% is $75,000. What if I don't happen to have $75,000? Should I not invest in stocks at all until I've raised that much money just so I can save on commissions and fees? If I buy 10 stocks and hold them for 20 years, I might pay less in commissions and management fees, but I'm much less diversified, right? There is definitely a point at which mutual funds become less cost-effective than buying individual stocks, but I'm pretty certain you need to have at least $1 million dollars lying around in your stock portfolio for that to be true. I've read in the Wall Street Journal that exchange-traded funds are a better deal than index mutual funds if you have $30,000. If you are able to accumulate $30,000 in cash every month, then mutual funds don't make sense. (That implies a disposable income of at least $360,000 a year). At lower amounts, mutual funds are by far the best choice for convenience, cost, and diversification. Are there any flaws in my reasoning here? James
Re: Index mutual funds
If I want to buy shares in the 500 or so companies on the SP 500, Should I not invest in stocks at all until I've raised that much money just so I can save on commissions and fees? James Why not just buy an SP index fund? I've read in the Wall Street Journal that exchange-traded funds are a better deal than index mutual funds if you have $30,000. If you are able to accumulate $30,000 in cash every month, then mutual funds don't make sense. Why would index mutual funds not make sense? Fred Foldvary = [EMAIL PROTECTED] __ Do You Yahoo!? Yahoo! Autos - Get free new car price quotes http://autos.yahoo.com
