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Keep the Faith

Jonathan Clements

INDEXING IS A GREAT strategy—and yet there’s also a constant temptation to stray.

When stocks soar, so does our self-confidence, as we attribute our investment gains to our own brilliance. At such times, there’s a risk that even hardcore indexers will start dabbling in individual stocks, actively managed funds, cryptocurrencies and goodness knows what else. Meanwhile, amid market slumps, index funds suffer just as much as the market averages, and some indexers may look to sidestep the pain—by “temporarily” abandoning their funds.

Tempted to give up on or lighten up on broad market index funds? Let’s not forget the virtues of what we already own. Here are six reasons to stay the course:

1. Less time. Other than adding new savings and rebalancing occasionally, a portfolio of broad market index funds involves very little upkeep. That frees up time to focus on improving other areas of our financial life, including reducing taxes, minimizing borrowing costs, planning our estate, getting the right insurance and spending thoughtfully. These are all areas where a little effort can deliver big benefits.

2. Less worry. Sure, with an index-fund portfolio, we’re at the mercy of the financial markets. But at least we don’t have to worry about whether the investments we pick will underperform the market averages. Index funds offer relative certainty: Whatever the markets deliver, we indexers know that’s what we’ll get.

3. Tax efficiency. Pursuing active investment strategies in a regular taxable account often leads to big tax bills. That isn’t something indexers need to worry about, because broad market index funds have tiny portfolio turnover, which means they’re slow to realize capital gains. Because of the way shares are created and redeemed, exchange-traded index funds can be especially tax-efficient.

4. Lower costs. Investors collectively earn the markets’ results—before investment expenses. After costs, they inevitably earn less.

Index funds get their edge by mimicking the market averages while minimizing costs. What about active investors? Whether they’re picking individual stocks or buying actively managed funds, the odds are they’ll end up lagging behind the market averages, thanks to the higher costs they incur.

5. Winners included. Almost every year, the market averages are skewed higher—or prevented from falling even more steeply—by a minority of stocks with huge gains. If we try to pick the big winners, we’ll most likely fail. If we buy broad market index funds, we’re guaranteed to own them.

6. Free ride. The financial talking heads—who are almost always proponents of active management—will claim that index funds are distorting market prices or are dangerously overweighted in certain stocks. But the fact is, if we own market-capitalization-weighted index funds, we own exactly the same stocks that active investors collectively own in exactly the same proportions.

The only difference: We didn’t waste time and money trying to figure out which stocks were the best value. Plenty of others remain happy to do so, and we thank them for sacrificing their time and money to keep the markets efficient.

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César Bardají
César Bardají
4 months ago

Dear Richard,
Fully agree with your points and I would suggest you add one more: “Lossers excluded” as we consider the mechanic to include/exclude companies from time to time
Best,
Cesar Bardaji

Richard Gore
Richard Gore
4 months ago

My problem with indexing is the inverse of numbers 2 & 5. Yes, you get 100% of the winners, but you also get 100% of losers. And, the net result is by definition average. I’ve found that I can beat the market on average by avoiding the biggest losers (e.g. tech stocks in 2000 & bank stocks in 2008) and by buying solid straightforward dividend paying stocks.

I also worry less (#2) under this approach because I don’t feel like I’m at the mercy of the market. As long as my companies are building value the short term price doesn’t matter to me.

Also, #3 isn’t relevant for me because I only invest in tax deferred accounts and my costs (#4) are essentially zero nowadays.

Nevertheless, I agree that index funds are the sensible choice.

Philip Stein
Philip Stein
4 months ago
Reply to  Richard Gore

I’ve read that stock market winners outperform to a greater extent than the losers underperform. If so, it would appear that index performance is not average, but actually above average.

Besides, if index performance were average, you’d expect about half of active managers to beat the index each year. S&P’s SPIVA study has shown, and continues to show, that that’s not the case.

manager
manager
4 months ago

With modern fund indexing products, one can also exploit Nobel laureate academic research through investment in the small & large “value” stock universe ( Fama and French “three factor model”, University of Chicago ). For an income stage investor, employing these equity asset classes as “base” portfolio allocations, further research has shown the ability of a 50/50 portfolio of small / large value in sustaining an annual inflation adjusted income of between “3.5 – 7%”, depending on conditions applied, accompanied by terminal portfolio growth, over seventy-two rolling 20 year periods since 1931. https://tinyurl.com/yckmev96

This income stability and persistence can be crucial as the conventional financial planning wisdom has the average boomer demographic portfolio residing in majority % allocations of U.S Treasury securities / bonds ( ala “glidepath” formulas ) – securities which have had perpetually shrinking total returns as laddered term structure rates have been fast approaching the “0%” limit ( falling into sub 1% levels in July 2020 ). An investor, who may rely on Treasury securities for a reasonable portion of their retirement income, would be hard pressed towards generating a livable income off of that level of interest rate over an appreciable amount of time.

Inversely, value equities have unlimited upside, this persistent upside being generated through the earnings derived from sales of products and services of productive enterprises. Warren Buffett described stocks as “equity coupons” or “equity bonds”.

Last edited 4 months ago by manager
Rick Connor
Rick Connor
4 months ago

I had a discussion earlier this week with a colleague who was considering an advisor with a wealth manager aligned with one of the nationwide banks. The portfolio that was suggested was pretty extensive – 8 mutual funds, and some annuities. My buddy is smart enough to research the funds and found they were OK, but no better than low cost alternatives with Vanguard of Fidelity. He’s looking for evidence that the planner could outperform an index portfolio, but can’t find it.

medhat
medhat
4 months ago

I suppose there’s always an upside, Jon. If everyone were to take the advice in this article to heart and apply it, the personal investor portion of the market would not longer be reading Humble Dollar! But on a slightly more serious note, the investor sentiment that almost always leads to less than market average gains reminds me of the tagline for Lake Wobegone, where “all the children are above average!”

B Carr
B Carr
4 months ago

My BFF’s father died in 2018 @ age 94. For over 20 years he entrusted his entire portfolio to Morgan Stanley. My friend tried unsuccessfully for years to convince his father to switch to Vanguard indexing for its much lower cost structure. It was impossible to decipher the quarterly statements that MS provided and the costs and fees were well buried. MS had his father’s asset allocation set to 80/20 made up entirely of a bewildering mix of individual stocks and bonds. When we backtested the MS portfolio (2018 -> 1998) compared with a simple, 2-index-fund Vanguard portfolio of the same AA, the difference was >$700k in Vanguard’s favor.

Jonathan Clements
Admin
Jonathan Clements
4 months ago
Reply to  B Carr

A $700,000 difference? Yikes.

B Carr
B Carr
4 months ago

Yes, at least. My friend wept for days about it.

Jeff Bond
Jeff Bond
4 months ago

A really nice summary. Many thanks!

jay5914
jay5914
4 months ago

Thanks for the refresher on the benefits of index investing. I have met many people over the years that either invest on their own primarily in individual stocks or have “advisors” who do so on their behalf. Over the long term, 10+ years, it is highly likely that most of these people have underperformed the indexes. Much of the reason for this has to do with the benefits of indexing as described in this article and as also written about extensively by John Bogle. To those who claim to “do better” with individual stocks, I often ask them if they or their advisors ever do a “look back” and compare their 5, 10, 20 year returns vs a proper corresponding index. I have yet to have one person say that they have done such an analysis. I acknowledge that there can be exceptions (rare) and also that some are happy with their performance and don’t care much about relative performance and missed returns. To each his own. For family/friends who ask, I advise 100% indexing. If they can’t resist the stock picking bug, I say 90% indexing, 10% individuals.

macropundit
macropundit
4 months ago
Reply to  jay5914

Of course no one with any sense would advise anyone to select individual stocks. Like the joke about affording a yacht, if you have to ask, you can’t do it. That’s got nothing to do with the fact that there are probably a few million over the decades doing what used to be called “coffee can” investing and doing very well. And in part because of lower fees (free trades) and tax efficiency by essentially holding forever. Buffett is right that investing is at bottom a geopolitical bet. Otherwise, why would the Voya Corporate Leaders Trust be able to buy 30 companies in 1930 and hold them to this day, and have a number go bankrupt as you’d guess, and beat the index. In America, everybody is a genius. In fact, it’s not appreciated enough that picking winners isn’t as hard as people think. It’s on the sell side, not selling those winners that people go wrong.

Philip Stein
Philip Stein
4 months ago
Reply to  jay5914

I think it’s important to acknowledge that economic conditions over the last 12 to 13 years or so have been an aberration. Since the Great Recession, the Fed has kept interest rates at or near zero, inflation was modest, and the government engaged in excessive (some would say profligate) spending to ease the economic affects of the pandemic.

Under such conditions, bonds and cash had negative real yields and there was plenty of cash available for investment. Not surprisingly, risk was embraced and the stock market soared. Those who did quite well picking individual stocks during this time have to ask themselves if they truly have stock picking acumen, or were lucky to have invested when gains were easy.

Now that the Fed is raising interest rates, the inflation rate is rising, and government stimulus is likely to be reduced, stock pickers have to ask themselves if they have enough stock picking prowess to continue beating the market in this new economic environment.

macropundit
macropundit
4 months ago
Reply to  Philip Stein

Recognizing the obvious winners within a decade of their multi decade runs isn’t really stock picking. It’s just recognizing the obvious. Ask any of the IBM, MS, or Apple multimillionaires. Stock picking is a repetitive activity, which no one is actually good at.

Martin McCue
Martin McCue
4 months ago

Index funds are at the core of my portfolio for all the reasons stated, plus one that was not called out specifically – diversification. Diversification has a huge and unique value in limiting investment risk. Maybe that is included in point one, but I see it as distinct. I see diversification and low expense as being most important to the average investor. I also like being able to get a seat-of-the-pants assessment of the market every day by just checking the S&P 500 performance. (As I have aged, I’ve shaded into a couple of other funds that offer different but still wide mixes of stocks and that offer some income, too, with a portfolio of bonds. That satisfies my need to be a bit of a “picker” but without hurting myself in the process.)

Ormode
Ormode
4 months ago

I have been an individual stock investor all my life – I’ve never owned any sort of mutual fund. I might do it differently if I was starting right now – or maybe not. Your investment strategy has to suit your character, or you won’t stick to it – and there are many ways to make money as an investor.

M Plate
M Plate
4 months ago

I hold index funds for all the reasons listed. But it is my individual stock picks that have outperformed the market. In the current downturn these picks have lost less than the index funds I hold.
I consider broad index funds as a benchmark for the MINIMUM acceptable investment return. I weed out any holdings that don’t meet this minimum.

Philip Stein
Philip Stein
4 months ago
Reply to  M Plate

Before weeding out stocks that don’t meet your MINIMUM acceptable return standard, those holdings were already underperforming the market, offsetting gains from outperformers.

After trimming, you can’t assume that your remaining stocks will continue to earn market-beating returns indefinitely. So you continue regularly pruning your portfolio of laggards. You may find that at some point you no longer hold individual stocks.

Edmund Marsh
Edmund Marsh
4 months ago

Thank you for succinctly summarizing why indexing is smarter. #1–It took me a while to understand the truth of the first sentence, but I am very thankful for the time and worry that realization has saved me. Now I have plenty of time to worry about those “other areas”.

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