QE and index funds have deformed the stock market as predicted by Goodhart’s Law.

[OhNoNotimAgain]

No it does not. It does not change the allocation of capital at all. The market does overvalue some companies, both big and small...

But it does impact the allocation of new money. Inflows in a cap weighted index fund are allocated according to price. More money goes into expensive stocks than cheap stocks.

Yes, but that is the correct allocation of new money, according to the market. If the same amount of money was allocated to each stock irrespective of size, the small stocks would become horrendously overpriced. The same price for buying out Apple and a small market stall would not make any sense.

Size can be measured in many different ways.

[GeoffF100]

No it does not. It does not change the allocation of capital at all. The market does overvalue some companies, both big and small...

But it does impact the allocation of new money. Inflows in a cap weighted index fund are allocated according to price. More money goes into expensive stocks than cheap stocks.

Yes, but that is the correct allocation of new money, according to the market. If the same amount of money was allocated to each stock irrespective of size, the small stocks would become horrendously overpriced. The same price for buying out Apple and a small market stall would not make any sense.

Size can be measured in many different ways.

The relevant measure here is market capitalisation. Anything else is an attempt to beat the market.

[OhNoNotimAgain]

The relevant measure here is market capitalisation. Anything else is an attempt to beat the market.

https://en.wikipedia.org/wiki/Goodhart's_law

[GeoffF100]

The relevant measure here is market capitalisation. Anything else is an attempt to beat the market.

https://en.wikipedia.org/wiki/Goodhart's_law

That is yet another reason for market weighting. It cannot be targeted in that way. OK, if everyone market weighted, there would be no price discovery, and market weighting would then no longer work. Nonetheless, as I have said, that is not going to happen. There will always be wishful thinkers who believe that they can beat the market or identify in advance someone else who will subsequently beat the market for them.

[tjh290633]

No it does not. It does not change the allocation of capital at all. The market does overvalue some companies, both big and small...

But it does impact the allocation of new money. Inflows in a cap weighted index fund are allocated according to price. More money goes into expensive stocks than cheap stocks.

Yes, but that is the correct allocation of new money, according to the market. If the same amount of money was allocated to each stock irrespective of size, the small stocks would become horrendously overpriced. The same price for buying out Apple and a small market stall would not make any sense.

Size can be measured in many different ways.

The relevant measure here is market capitalisation. Anything else is an attempt to beat the market.

It is only relevant if you are weighting by market capitalization. That is a convenient measure for index linkers and institutional investors. For the rest of us, it is neither here nor there. There is no way that I could build a portfolio with a mixture of high and low market capitalization shares.

The point being missed is that in an equally weighted portfolio, a 10% rise in a low cap share has the same effect as a similar rise in the value of a very high capitalization share.

TJH

[GeoffF100]

But it does impact the allocation of new money. Inflows in a cap weighted index fund are allocated according to price. More money goes into expensive stocks than cheap stocks.

Yes, but that is the correct allocation of new money, according to the market. If the same amount of money was allocated to each stock irrespective of size, the small stocks would become horrendously overpriced. The same price for buying out Apple and a small market stall would not make any sense.

Size can be measured in many different ways.

The relevant measure here is market capitalisation. Anything else is an attempt to beat the market.

It is only relevant if you are weighting by market capitalization. That is a convenient measure for index linkers and institutional investors. For the rest of us, it is neither here nor there. There is no way that I could build a portfolio with a mixture of high and low market capitalization shares.

The point being missed is that in an equally weighted portfolio, a 10% rise in a low cap share has the same effect as a similar rise in the value of a very high capitalization share.

TJH

We are discussing the impact on market prices. If $trillions are invested by market capitalisation, that pushes up the prices of equities as whole, but it does not affect the relative pricing because all stocks become overvalued by the same percentage. If you invest the same amount of money in all the stocks in the global markets, and lots of other people do the same with large amounts of money, you will push up the prices of the smaller stocks relative to those of the larger stocks.

[OhNoNotimAgain]

The relevant measure here is market capitalisation. Anything else is an attempt to beat the market.

https://en.wikipedia.org/wiki/Goodhart's_law

That is yet another reason for market weighting. It cannot be targeted in that way. OK, if everyone market weighted, there would be no price discovery, and market weighting would then no longer work. Nonetheless, as I have said, that is not going to happen. There will always be wishful thinkers who believe that they can beat the market or identify in advance someone else who will subsequently beat the market for them.

You don't need everyone to do it for it to become the dominant factor.
Moreover, as Terry points out, virtually all instituitional money is run that way. If a manager doesn't roughly track the index he runs a huge risk of underperforming. That is a bigger career risk to him than anything else. So why do it?

[OhNoNotimAgain]

The point being missed is that in an equally weighted portfolio, a 10% rise in a low cap share has the same effect as a similar rise in the value of a very high capitalization share.

TJH

Terry, you know more than anyone that capital growth is less important than dividends over the long term. So forget chasing growth, income is what matters, then reinvesting it. That is why large companies do so much of the heavy lifting of equity returns.

[OhNoNotimAgain]

If you invest the same amount of money in all the stocks in the global markets, and lots of other people do the same with large amounts of money, you will push up the prices of the smaller stocks relative to those of the larger stocks.

The same amount of money is not invested in all the stocks.

[GeoffF100]

If you invest the same amount of money in all the stocks in the global markets, and lots of other people do the same with large amounts of money, you will push up the prices of the smaller stocks relative to those of the larger stocks.

The same amount of money is not invested in all the stocks.

By hypothesis it is. It is possible in principle, but there are limitations in practice. You can buy an equal weighted S&P 500 tracker. (It is not available to UK retail investors, but that is besides the point.)

[Bubblesofearth]

Terry, you know more than anyone that capital growth is less important than dividends over the long term. So forget chasing growth, income is what matters, then reinvesting it. That is why large companies do so much of the heavy lifting of equity returns.

This has been exposed as a fallacy many times before on these boards. For the market as a whole return from dividends and cap growth are approximately equal. The trap not to fall into is to attribute cap growth on reinvested dividends to dividends. It's cap growth. This is more obvious for growth on retained earnings but comes to the same thing.

The danger inherent in thinking that dividends matter more than growth is that it can lead you down a path of chasing exclusively high dividend payers. The risk of this approach is lack of adequate diversification, both local and international.

BoE

[Bubblesofearth]

For the market as a whole return from dividends and cap growth are approximately equal.

BoE

For clarity I'm talking about the UK market here. For many other markets cap growth (e.g. US) dominates total returns

[Bubblesofearth]

That is yet another reason for market weighting. It cannot be targeted in that way. OK, if everyone market weighted, there would be no price discovery, and market weighting would then no longer work. Nonetheless, as I have said, that is not going to happen. There will always be wishful thinkers who believe that they can beat the market or identify in advance someone else who will subsequently beat the market for them.

You are starting from the conclusion. Just because the market has a cap weighting doesn't mean that is the best way for a private investor to invest.

If you ignore market cap and focus on the two most important factors for any company, expected return and risk, then you should be able to construct an (at least approximately) optimum portfolio that maximises the former whilst minimising the latter.

If you look at historic data (Dimson et al studies have a lot of this) then it's pretty clear that, over most long time-periods, there is a small cap premium, i.e. small caps (taken as a whole) have outperformed big caps. So the expected return for small caps is larger than for big caps. The reason for this is pretty obvious and relates to the other critical investment factor, risk.

However, risk can be reduced by diversification. The question then becomes can risk be reduced sufficiently to justify an equal weighted portfolio that is able to capture the small cap premium? If you look at correlations between share price movements then IMO this is possible and is at the heart of the outperformance of such portfolios, especially ones that diversify by sector as well as company, compared to the cap weighted index. Somewhat ironically this (again IMO) lies at the heart of HYP outperformance, not the focus on dividends.

BoE

[GeoffF100]

That is yet another reason for market weighting. It cannot be targeted in that way. OK, if everyone market weighted, there would be no price discovery, and market weighting would then no longer work. Nonetheless, as I have said, that is not going to happen. There will always be wishful thinkers who believe that they can beat the market or identify in advance someone else who will subsequently beat the market for them.

You are starting from the conclusion. Just because the market has a cap weighting doesn't mean that is the best way for a private investor to invest.

If you ignore market cap and focus on the two most important factors for any company, expected return and risk, then you should be able to construct an (at least approximately) optimum portfolio that maximises the former whilst minimising the latter.

If you look at historic data (Dimson et al studies have a lot of this) then it's pretty clear that, over most long time-periods, there is a small cap premium, i.e. small caps (taken as a whole) have outperformed big caps. So the expected return for small caps is larger than for big caps. The reason for this is pretty obvious and relates to the other critical investment factor, risk.

However, risk can be reduced by diversification. The question then becomes can risk be reduced sufficiently to justify an equal weighted portfolio that is able to capture the small cap premium? If you look at correlations between share price movements then IMO this is possible and is at the heart of the outperformance of such portfolios, especially ones that diversify by sector as well as company, compared to the cap weighted index. Somewhat ironically this (again IMO) lies at the heart of HYP outperformance, not the focus on dividends.

BoE

Small cap premiums exist only when investors overestimate the small cap risk, or accept it and get lucky. The small cap premium comes and goes. For a long period recently, the mega caps trounced everything. For small caps (and overweighting any other class of share), the strategy becomes self defeating when it is successful. More investors buy the small caps and push the price up to the point when underperform.

The point of this thread is that that this can not happen for market cap weighting. With market cap weighting you are not seeking out performance, and do not get it. You get average performance with very low low costs. The higher cost of an active management compounds up over time, until it falls behind a cheap market weighted tracker, even if the active management is very lucky.

[Bubblesofearth]

Small cap premiums exist only when investors overestimate the small cap risk, or accept it and get lucky. The small cap premium comes and goes. For a long period recently, the mega caps trounced everything. For small caps (and overweighting any other class of share), the strategy becomes self defeating when it is successful. More investors buy the small caps and push the price up to the point when underperform.

Very recent history aside, take a look at FTSE100 vs FTSE250 over last couple of decades.

The point of this thread is that that this can not happen for market cap weighting. With market cap weighting you are not seeking out performance, and do not get it. You get average performance with very low low costs. The higher cost of an active management compounds up over time, until it falls behind a cheap market weighted tracker, even if the active management is very lucky.

I'm not talking about active management. For a private investor the cost of a long-term buy and hold portfolio is negligible, probably less than a passive tracker.

Going back to the point of this thread, if there exists a diversification benefit from holding smaller caps then that should show up in a (somewhat counter-intuitive!) lower expected return for these companies. You would be paying to hold them in a portfolio to achieve a desired level of diversification if everyone wanted this diversification. The fact that there are a lot of cap weighted trackers and portfolios out there means this diversification premium is not realised. In other words it is precisely because so much money goes into tracking that a small (and mid) cap higher expected return persists.

BoE

[GeoffF100]

Small cap premiums exist only when investors overestimate the small cap risk, or accept it and get lucky. The small cap premium comes and goes. For a long period recently, the mega caps trounced everything. For small caps (and overweighting any other class of share), the strategy becomes self defeating when it is successful. More investors buy the small caps and push the price up to the point when underperform.

Very recent history aside, take a look at FTSE100 vs FTSE250 over last couple of decades.

The point of this thread is that that this can not happen for market cap weighting. With market cap weighting you are not seeking out performance, and do not get it. You get average performance with very low low costs. The higher cost of an active management compounds up over time, until it falls behind a cheap market weighted tracker, even if the active management is very lucky.

I'm not talking about active management. For a private investor the cost of a long-term buy and hold portfolio is negligible, probably less than a passive tracker.

Going back to the point of this thread, if there exists a diversification benefit from holding smaller caps then that should show up in a (somewhat counter-intuitive!) lower expected return for these companies. You would be paying to hold them in a portfolio to achieve a desired level of diversification if everyone wanted this diversification. The fact that there are a lot of cap weighted trackers and portfolios out there means this diversification premium is not realised. In other words it is precisely because so much money goes into tracking that a small (and mid) cap higher expected return persists.

BoE

The British market is irrelevant here. It is only about 4.1% of the global market. You will not get much diversification there. If you hold international shares directly, you face high exchange rate costs. You also have the problem of reclaiming withholding tax in umpteen languages. Your diversification will still be poor unless you hold thousands of shares. Interactive Brokers is relatively cheap, but they do not do ISAs or SIPPs. Anyway, what is the point? if the professionals cannot beat the market, except by chance, what chance do you have?

[mc2fool]

If you look at historic data (Dimson et al studies have a lot of this) then it's pretty clear that, over most long time-periods, there is a small cap premium, i.e. small caps (taken as a whole) have outperformed big caps. So the expected return for small caps is larger than for big caps. The reason for this is pretty obvious and relates to the other critical investment factor, risk.

Small cap premiums exist only when investors overestimate the small cap risk, or accept it and get lucky. The small cap premium comes and goes. For a long period recently, the mega caps trounced everything. For small caps (and overweighting any other class of share), the strategy becomes self defeating when it is successful. More investors buy the small caps and push the price up to the point when underperform.

Dimson et al studies, which cover IIRC 21 markets over 119 years, do indeed show that over the long term there is a small cap premium, and also a value premium, and also a momentum premium.

Which is all very interesting, but as you say, those premiums come and go, and even though over the long term they may come more than they go, most of us aren't investing over a 119 year period, and the various 10 to 20 to 30 year periods when those premiums are in or out of fashion can be very significant for us mere mortals....

[OhNoNotimAgain]

This has been exposed as a fallacy many times before on these boards. For the market as a whole return from dividends and cap growth are approximately equal. The trap not to fall into is to attribute cap growth on reinvested dividends to dividends. It's cap growth. This is more obvious for growth on retained earnings but comes to the same thing.

The danger inherent in thinking that dividends matter more than growth is that it can lead you down a path of chasing exclusively high dividend payers. The risk of this approach is lack of adequate diversification, both local and international.

BoE

No, its compound interest. For that to work you need income. I have yet to see a credible study that shows capital growth is equally important to dividends.

Bear in mind that the last two decades, I repeat, two decades, are an aberration in capital markets because of super low interest rates and QE. The proof of that is UK gilts have outperformed UK equities over that period.

[GeoffF100]

No, its compound interest. For that to work you need income. I have yet to see a credible study that shows capital growth is equally important to dividends.

Capital growth has been a jolly sight more important than dividends for Berkshire Hathaway, which pays no dividends. Some of the tech giants did not pay dividends for a long time either. Share buy backs are clearly every bit as important as dividends. Total return is what matters.

[GeoffF100]

If you look at historic data (Dimson et al studies have a lot of this) then it's pretty clear that, over most long time-periods, there is a small cap premium, i.e. small caps (taken as a whole) have outperformed big caps. So the expected return for small caps is larger than for big caps. The reason for this is pretty obvious and relates to the other critical investment factor, risk.

Small cap premiums exist only when investors overestimate the small cap risk, or accept it and get lucky. The small cap premium comes and goes. For a long period recently, the mega caps trounced everything. For small caps (and overweighting any other class of share), the strategy becomes self defeating when it is successful. More investors buy the small caps and push the price up to the point when underperform.

Dimson et al studies, which cover IIRC 21 markets over 119 years, do indeed show that over the long term there is a small cap premium, and also a value premium, and also a momentum premium.

Which is all very interesting, but as you say, those premiums come and go, and even though over the long term they may come more than they go, most of us aren't investing over a 119 year period, and the various 10 to 20 to 30 year periods when those premiums are in or out of fashion can be very significant for us mere mortals....

Most of that outperformance was before Dimson et al. If nobody knew that small caps were outperforming, there was no reason to prefer them. The historical small cap premium has been questioned. Dimson does not take the trading costs into account, for example.