Category Archives: Books

Seth Klarman On Index Investing

Recently I started reading Seth Klarman’s book ‘Margin Of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor‘. Although the book came out in 1991 it is still a very interesting read. To me the paragraph about index investing stood out. Indexing is the practice of buying all the components of a market index, such as the Standard & Poor’s 500 Index, in proportion to the weightings of the index and then passively holding them. This comes from the believe that financial markets are efficient and that all information is reflected in stock prices instantaneously. According to this theory it’s almost impossible to outperform the market, something value investors, who believe in inefficient markets, disagree with. I always thought that index investing was a more recent phenomenon popularized by ETFs (exchange-traded funds) since the mid ’90s but apparently it was already popular in the ’80s. 

Since index investing is widely popular right now it is nice to hear a critical note against it. Even Warren Buffet recommended index investing in his latest letter to shareholders. Below is a summary of what Seth had to say about it in his book (pages 40-42). He was not really positive about index investing (he even called the paragraph “Index Funds: The Trend Toward Mindless Investing”) and thought it was a fad that would eventually disappear. The reasons he gives are:

  • An index fund manager never buys or sells shares when they hit an attractive value and index fund managers are not interested in the financial statements of the companies they invest in. Furthermore, they don’t even need to know which business the companies they invest are in.
  • The higher the percentage of investors who index the more inefficient markets become. Fewer and fewer investors would be performing research and fundamental analysis. In extreme circumstances, when everyone would index, stock prices would never change relative to each other because no one would be left to move them.
  • When a stock in the index needs to be replaced, either because of a take-over or a bankruptcy, index funds will buy the new stock that is getting into the index regardless of whether or not it is a good buy. Since 100’s of funds need to buy the same stock on the same day, a liquidity problem could send the price of the stock higher simply for the reason that index funds need to have it in their fund.
  • Liquidity is also a concern with small-cap stocks. More money flowing into small-cap index funds will push the prices of these stocks higher simply because there is less liquidity in these markets. It will also push the price down more in a bear market because of huge sell orders.
  • The index fund manager has no interest in the performance of the index, other than that fees are based on total managed assets valued at market prices. So the index fund manager wouldn’t be very interested in going to share holder meetings and educate himself on the best outcome for the investors he represents.
  • There is a self-reinforcing feedback loop created whereby the success of index investing leads to more people swarming to index funds which leads to more success for the index. When that trend reverses, matching the market won’t be that attractive according to Seth Klarman, the selling will then work the other way around and depress the price of the index.

Seth Klarman also uses a quote from Warren Buffet on index funds to further make his point: “In any sort of a contest – financial, mental or physical – it’s an enormous advantage to have opponents who have been taught that it’s useless to even try”. Which is none the least interesting because Warren Buffet has been advising his trustee to put 90% of his money in index funds in his Berkshire 2013 letter.

Where Is That Stock And Dollar Crash I’ve Been Waiting For All These Years?

Fear sells. For years a big fear-mongering industry has been putting out books and articles about how the economy is going down the drain soon and the U.S. dollar will be worth less than the paper it is printed on. The bears have been saying this for years. Here are a few (hilarious) examples of “Doom & Gloom” books over the years that I found.

Below is picture of an impressive 300-page book by Doug Casey called “Crisis Investing: Opportunities and Profits in the Coming Depression“. In this book Doug Casey makes the case that the market is about to crash any minute now! The dollar will be destroyed soon and the stock market is going to zero. The next great depression is just around the corner. You have to act fast before all your wealth, that you have been carefully building up for years, will vanish in front of your eyes! But wait.. Let’s check something.. When did this book hit the shelves? July 1980?! There certainly hasn’t been a “new great depression” since then.

Crisis Investing: Opportunities and Profits in the Coming Great Depression by Douglas Casey

Crisis Investing: Opportunities and Profits in the Coming Great Depression by Douglas Casey (1980)

Ok maybe Doug was just a little bit early on his call that ‘the world as we know it’ is going to end. What about this book from Jerome F. Smith: “The Coming Currency Collapse“. In this book Jerome describes how the dollar is going to be toast in the near future. Oh wait that one was penned down in September 1981. He’s only 33 years (and counting) off on his call of an imminent dollar crisis. The only thing that collapsed in all those years is the price of this book since you can now get it for $ 0.01.

Coming Currency Collapse by Jerome F. Smith (1981)

Coming Currency Collapse by Jerome F. Smith (1981)

What about Howard J. Ruff’s book “How To Prosper During The Coming Bad Years“? This book came out in 1984. Everyone who followed the advice in this book missed the greatest bull market in stocks ever. The S&P 500 was trading at 160 at the time. Some reviews for the book on the Amazon page even talk about all the “missed opportunities” investors lost because they followed the recommendations in this book.

How to Prosper During the Coming Bad Years by Howard J. Ruff (1984)

How to Prosper During the Coming Bad Years by Howard J. Ruff (1984)

But Howard J. Ruff was maybe just a few years off of his imminent call for a new period of “Doom & Gloom”. In this book I got here by Martin D. Weiss called: “How To Survive The Money Panic” the author talks about the coming destruction of the U.S. economy and the U.S. dollar (of course). This one came out in 1989.

The Money Panic by Martin D. Weiss (1989)

The Money Panic by Martin D. Weiss (1989)

And then there is this one by Ravi Bata called The Great Depression of 1990. 1990? You got to be kidding me.

The Great Depression Of 1990 by Ravi Bata (1988)

The Great Depression Of 1990 by Ravi Bata (1988)

Here are some more recent ones:

The Dollar Crisis: Causes Consequences, Cures by Richard Duncan. This book came out in 2005.

The Dollar Crisis: Causes Consequences, Cures by Richard Duncan (2005)

The Dollar Crisis: Causes Consequences, Cures by Richard Duncan (2005)

This one is more bizarre because shortly after this book was published in 2008 the dollar index set a long term bottom (chart) and is trading higher ever since. The Collapse of the Dollar and How to Profit from It by James Turk.

The Collapse of the Dollar and How to Profit from It by James Turk (2008)

The Collapse of the Dollar and How to Profit from It by James Turk (2008)

And here is one from November 2013 where the author is forecasting a stock market crash in 2016. The Crash of 2016: The Plot to Destroy America – and What We Can Do to Stop It by Thom Hartmann.

The Crash of 2016: The Plot to Destroy America - and What We Can Do to Stop It by Thom Hartmann (2013)

The Crash of 2016: The Plot to Destroy America – and What We Can Do to Stop It by Thom Hartmann (2013)

The last time I checked (5 minutes ago) the S&P 500 was still trading near all time highs. The U.S. Dollar is still the world reserve currency and certainly not reduced to toilet paper. The Euro is still around as are a lot of other economies and currencies the bears have been warning us for, for years.

All the authors of the books above are still touting their doom & gloom stories to this day.

The bottom line is this: Although the bears are sometimes right about their calls for stock market crashes (2000-2002 and 2008-2009) and housing market crashes (2006-2011) the crashes never seem to bring us to a new normal of forever lower stock/housing prices and a destroyed currency (at least for the U.S. market and the U.S. dollar).

This doesn’t mean that it’s never smart to be a bear. It can be very profitable, but you need to have your timing almost exactly right. It is no secret that the market goes up on average every year (7%).

Being a long term bear is thus bad for your financial health.