Creating a systematic investment plan, such as a value-weighted index, helps investors keep their worst instincts in check, says author and investor Joel Greenblatt.
Leggio: Is it fair to say that you think over long periods of time, either 10-year rolling return periods or full market cycles, that the fundamental index should beat the S&P 500, and also that your value-weighted indexes should beat the fundamentally weighted indexes over long periods?
Greenblatt: Right. Well, this is the way I really look at it. Market cap-weighted indexes subtract 2% from the returns you're supposed to have. Equally weighted and fundamentally weighted indexes give you back that 2% that the inefficiencies of the market cap-weighted index took away from you. So they don't really, in my mind, add value, they just make the errors random, and they give you back the 2% inefficiencies of market-cap weighting. So, what we're trying to do here is add value. We are trying, by weighting toward the cheapest stocks that we can find continually, we are trying to actually make extra money.
So some of our extra money comes for free, our extra money over the traditional indexes, because they are 2% inefficient. So the first 2% of what we make additionally is just making back the errors that are being done in a traditional S&P 500 or Russell 1000 Index. And the rest of the money we are adding 4% or 5%, in addition to what a fundamentally weighted index would make or a equally weighted index would make, is really the result of taking advantage systematically of the mistakes that people make by over discounting certain stocks that are out of favor. We are trying to take advantage of that by paying cheap prices for good companies when they are available.
Leggio: An important point you make both in the latest edition of The Little Book That Beats the Market and this book is that, in order to take advantage of these systematic errors you have to be a long-term investor, you can't just own these funds for two or three years and expect fantastic returns, is that right?
Greenblatt: Yeah, I think that's a great point, and even though that sounds bad, meaning having to be patient, it's actually the only reason why this works. If it worked every week and every month and every year, everyone would do it, and it would stop where so much money would pile into these things that they would stop working. These work because they make sense. If you buy, if you figure out what something's worth and pay a lot less for it--and I tell you the market eventually gets things right even though it could take two or three years--then this kind of system should work very, very well over long periods of time. No guarantees over shorter periods under three or four years, possibly.
So that's the good thing because it's very hard to do as a result. Everyone doesn't do this because it's hard to stick with something that hasn't worked in last year or two. In fact, all the research we did on active managers is that everyone follows those managers, and those managers who did well in the last year or two get all the money. And anyone who didn't do well in the last year or two, they lose all the money and don't gain any other money. And that's just human nature, and I talk about that in the book, too.
But it's because of that human nature that people's instincts are wrong, that we're able to buy these bargains when the market allows us to buy these bargains. And if we take advantage of that in a systematic way like the value-weighted index, we sort of overcome the human frailties and emotions that people have. The only way to do it is to be patient, and the only other reason why you should do it is if you understand.
So, these last two books that I wrote, the whole idea behind them is to explain the logic of buying above-average companies at below-average prices. If that makes sense of you, you'll stick with the strategy that's doing that, and if it doesn't make sense to you and you don't take the time to read and really understand what you're doing, there is no shot that you will stick with something that's not doing well in the short term. So, I hope education could be the reason why some people can make money investing in these types of opportunities.
