Indexing: It Worked For Google's Brin and Page

by: Barry Ritholtz

I stumbled across a fascinating history of indexing in San Francisco magazine.

It begins with an amazing discussion of how Google (NASDAQ:GOOG) -- pre IPO -- prepared the soon to be wealthy troops with a crash course in investment theory [from Bill Sharpe, Burton Malkiel, and John Bogle] before the Wall Street sales crew came tromping through Mountain View:

One by one, some of the most revered names in investment theory were brought in to school a class of brilliant engineers, programmers, and cybergeeks on the fine art of personal investing, something few of them had thought much about. First to arrive was Stanford University’s William [Bill] Sharpe, 1990 Nobel Laureate economist and professor emeritus of finance at the Graduate School of Business. Sharpe drew a large and enthusiastic audience, which he could have wowed with a PowerPoint presentation on his “gradient method for asset allocation optimization” or his “returns-based style analysis for evaluating the performance of investment funds.” But he spared the young geniuses all that complexity and offered a simple formula instead. “Don’t try to beat the market,” he said. Put your savings into some indexed mutual funds, which will make you just as much money [if not more] at much less cost by following the market’s natural ebb and flow, and get on with building Google.

The following week it was Burton Malkiel, formerly dean of the Yale School of Management and now a professor of economics at Princeton and author of the classic A Random Walk Down Wall Street. The book, which you’d be unlikely to find on any broker’s bookshelf, suggests that a “blindfolded monkey” will, in the long run, have as much luck picking a winning investment portfolio as a professional money manager. Malkiel’s advice to the Google folks was in lockstep with Sharpe’s. Don’t try to beat the market, he said, and don’t believe anyone who tells you they can—not a stock broker, a friend with a hot stock tip, or a financial magazine article touting the latest mutual fund. Seasoned investment professionals have been hearing this anti-industry advice, and the praises of indexing, for years. But to a class of 20-something quants who’d grown up listening to stories of tech stocks going through the roof and were eager to test their own ability to outpace the averages, the discouraging message came as a surprise. Still, they listened and pondered as they waited for the following week’s lesson from John Bogle.

“Saint Jack” is the living scourge of Wall Street. Though a self-described archcapitalist and lifelong Republican, on the subject of brokers and financial advisers he sounds more like a seasoned Marxist. “The modern American financial system,” Bogle says in his book The Battle for the Soul of Capitalism, “is undermining our highest social ideals, damaging investors’ trust in the markets, and robbing them of trillions.” But most of his animus in Mountain View was reserved for mutual funds, his own field of business, which he described as an industry organized around “salesmanship rather than stewardship,” which “places the interests of managers ahead of the interests of shareholders,” and is “the consummate example of capitalism gone awry.”

As you can imagine, after that brief education, things did not go as planned when Wall Street's sharpest were paraded through. [heh heh]

The rest of the article is all about the quantitative underpinnings of indexing, and how the entire process came about.

As I've written here before, for many people, indexing is the way to go.

Indexing's largest "flaw" [if you could call it that] comes about during bubble purchases and the ensuing long periods of flat performance. Think about the 1895-1905, the post-1929 crash era, or 1966-82 period. It seems that about every 3 decades or so, markets go through these underperforming periods. Eventually, they mean revert, but during these decade long lulls, Indexing requires extreme amounts of patience.

Regardless, is a fascinating article well worth checking out . . .