Half Baked Idea: The Goldilocks 400 Index Fund

Author and entrepreneur Tim Ferris has been contemplating how to invest his millions... he put together a pretty nice post on rethinking "common sense" investment rules. He even quoted some advice I gave him a while back... Happy to be useful, Tim ;-)

Since he's looking for still more input from the lunatic fringe on the 'net, and he's a bit risk-averse, I thought I'd share the most important piece of advice to new investors: THE STOCK MARKET IS COMPLETELY RIGGED.

This is basic human nature. Any time there is a financial incentive to cheat, people will cheat... and insiders know both how to cheat, and how to stay out of jail. I've read a fair share of books about how hedge-fund managers make their millions... It goes something like this: barely legal bribes for barely legal insider information. Most of our current financial woes are because of Wall Street cons that outlived their usefulness, or went too far.

Does that mean its hopeless? Nope... you just need to know how to make money on a rigged game. This means you need to take a hard look at anything that is currently making money (even index funds), figure out how somebody could rig them, then invest in such a way to minimize the rigging. Don't expect a money manager to give you this advice: that would force him to admit that he's involved in a totally crooked industry.

For example... take Warren Buffet's standard advice to people who want to invest, but don't have the time to monitor individual investments: "buy an index fund, and get back to work!"

Not a bad idea... index funds make a lot of money, especially if you have the cash to invest right now. But first think how could an index fund be rigged? This is simple. Consider the most common index, the Standard & Poor's 500. Next, imagine you're a big company, but the S&P committee judges that you lie just outside the top 500 companies. If only you could do a tiny bit better, you'd be in the index. Why should you care? Well, because if your company makes it to number 500, then suddenly a bazillion computerized 'buy' orders will go through, because your stock is now on the S&P 500 index!

Therefore... the leaders of this company have a strong incentive to engage in sketchy -- if not downright ILLEGAL -- accounting practices to make that happen. This doesn't meant that they would, but there is a strong incentive to do so... if the CFO indeed cooks the books, then the company appears on paper to be healthier than it really is, which pollutes the value of the index... Likewise, company #499 has even MORE reason to cheat... if they had a bad quarter, they fall off the index, a bunch of computerized managers sell the stock, and the stock plummets further. Those who have been on the index for a long time have an even larger incentive to lie, cheat, and steal to stay on that index!

Instead, be like Goldilocks! Have a nice blend of the 400 (or so) companies that have been there for long enough that you know they're OK, but not so long that they have to worry about dropping off. Others have run the numbers, and its true that an index like the Goldilocks 400 makes significantly more than the S&P 500, and could be managed with a very small shell script. Naturally, this advice only works if not many people follow it... luckily nobody reads this blog.

Investors, please line up to the right ;-)

Whole market index fund

This is one reason why Random Walk Down Wall Street recommends investing in a "whole market" index fund, which covers virtually the entire stock market.

the trouble there...

Is that then you can only do as well as the whole stock market... cheaters and all.

Instead, you could invest in companies with good cultures, who by their very nature would churn out competent managers, and honest leadership. Such beasts are hard to find, but they do exist.

How should you find them? There are many ways, but one interesting metric is based on social responsibility... in any industry (lumber, automobile, computer, chemical) there are those that are genuinely more socially responsible. Either based on environmental policies, hiring policies, charity, etc. Wall Street usually skoffs at such behavior, but those who have genuine policies around social responsibility usually have a more long-term view of their industry. This is a good indicator of long term planning, better culture, better managers, fewer lawsuits, fewer PR issues, fewer regulatory issues, and the like.

For example, GM is bigger, but Volkswagen is a better investment. Dell is bigger, but Apple is a better investment. Wall Mart is bigger, but Costco is a better investment. The problem is that most "socially responsible" funds usually shy away from buying energy, automobile, or chemical companies... even tho doing so would encourage better behavior on their parts... so you're pretty much on your own.

Recent comments