[MUSIC] Learning outcomes. After finishing this video you will be able to: understand the meanings of survivorship bias and Index reconstruction. Understand the past returns are more good predictors of future performance. >> Welcome, we're going to talk about the practice of investing. We start off with figuring out trade off with in risk and return. In efficient capital market there will likely be relationships between risk and return. Investment analysis should begin by considering such relationships, and then proceed to assess the extent of possible deviations from these relationships. Everyone wants a return. Risk, on the other hand, is a four letter word in the world of investments. Yet these two cannot be decoupled. When you invest in an instrument of a particular asset class, you assume the inherent risk associated with that instrument of that asset class, along with the expected returns that you would earn. Let me take an example to illustrate this point. Managed funds, actively managed funds, advertise their services on the premise that fund managers are skilled enough to make superior stock selection or timed markets, which as we have seen is notoriously difficult. Critics of index investing argue that actively managed funds offer better returns. But we've already seen that over a long run, index funds systematically beat actively managed funds. There are a couple of subtle points that critics miss, and I'd like to cover them. First is survivorship bias. Actively managed funds that close due to management inefficiency or losses are not included In data, and databases. If missing data is included, the performance of actively managed funds as a whole will be marketably worse than what we've already seen. And second as already pointed out, past returns are not good predictors of future performance. Moving gears now to index funds. All index funds are not cut from the same cloth. An index should be representative of the broad market. Buying a sectoral index, for example, is not good diversification as there are a lot of risks arising from exposure to a single sector. The underlying constituents in that index are very highly correlated, and they lose out on the diversification effects of a good index. A broad market index offers you more or less the same, the entire investment opportunity set available. A large share of the market pie. It is also important to look through the index constituents and make sure that illiquid assets are not a major part of the index which is chosen. Also, note that assets in an index do have changes. There are corporate actions, companies grow vast so there are small additions and removals to an index. These are called index reconstitutions. Periodic rebalancing, in such cases, become necessary. So in practice, index investing is not purely passive In the strictest sense. [MUSIC]
