Index Fund Investing

"The statistical evidence proving that stock index funds outperform between 80% and 90% of actively managed equity funds is so overwhelming that it takes enormously expensive advertising campaigns to obscure the truth from investors." - The Motley Fool

From The Little Book of Common Sense Investing by John "Jack" Bogle:

"Of the 355 equity funds in 1970, fully 233 of those funds--almost two thirds--have gone out of business. Only 24 outpaced the market by more than one percentage point a year--one out of every 14. Let's face it: These are terrible odds!."

That excerpt, and others from the book, can be found here.

This recent CNBC article, written by Dan Solin, added this view:

"Nothing gets my attention quicker than the perpetuation of what I call 'the big lie.' 

It is usually presented like this: Index based investing is fine if you are not too bright, or lazy and don't have the time to do the research, or if you are willing to settle for "average" returns. Otherwise, you should include actively managed mutual funds..."

The evidence more than just suggests that quite the opposite is true. Solin later added:

"There is no reliable way to predict which actively managed funds are likely to outperform their designated benchmarks in the future."

So...

"Don't be misled by statements indicating there is some way you can identify actively managed funds that will outperform their benchmarks prospectively."

John "Jack" Bogle was once asked this question during an "Ask Jack" Q&A:

Mr. Bogle, 

"In researching your work I don't understand one point. 

If everything you say is true regarding the relationship of fees to investment performance, where did you come up with the statistic that "passive" investing beats 90% of the active managers? 

I would think it would beat 99% of the managers!!!!!!!!"

His reponse:

"Thanks for writing. The percentage of managers outperformed by the broad market index is, well, time-dependent. On a given day, it's likely about 55%; over a year maybe 60-65%, over a decade perhaps 75-80%, and over 50 years...well, there's no data (yet!) on that!

But the probability statistics suggest that over a 50-year period, some 98% of managers will lose to the market index."

He also said this on Page 177 of Bogle on Mutual Funds:

"There is one final problem in selecting a winning manager. According to Richard A. Brealey, '...you probably need at least 25 years of fund performance to distinguish at the 95% significance level whether a manager has above average competence.'"

Some are convinced that the market is so efficient that pretty much no one can outperform. From an interview with Eugene Fama:

Question: "When is the market likely to be inefficient or to misprice securities?" 
Fama: "When it's closed..."

I'm no fan of the efficient market hypothesis (EMH), but the advantage of index funds does not come down to, as some seem to believe, how efficient markets happen to be. An index fund investor earns the market's return minus expenses whether the market is generally mispriced or not.

Passively managed index funds are just a convenient way for an investor to capture the return of a broad-based index while incurring minimal costs. Well, at least that's true if the investor doesn't attempt to trade in and out of the index. That way mistakes and frictional costs remain minimized.

Of course, there is plenty of evidence that fund investors tend to do their buying and selling at just the wrong time.*

Unfortunately, too many investors buy when stocks are expensive (when the outlook is rosiest and the good times seem likely to continue, indefinitely). They also tend to sell under the opposite conditions. In a remarkably reliable manner that's what many investors do. As a result, real world returns usually suffer materially compared to what the funds themselves deliver on an absolute and relative basis.

To me, the idea that markets are always efficient is more than a little flawed. Markets aren't necessarily efficient but they don't have to be for index based investing to make sense. Index funds do seem the right choice for many investors. The evidence is too strong to ignore or suggest otherwise.

Yet some, especially those who believe that EMH has few or no flaws, seem to take the wisdom of owning index funds to an extreme. They don't just suggest it is very difficult to do better than a market as a whole. They go further and seem to imply or assert outright it's effectively not possible to do so.

Well, those that think this way are conveniently ignoring things like what Buffett wrote in The Superinvestors of Graham-and-Doddsville and his own long-term track record. The list of investors with a long enough track record of outperformance may be a short one, but it's certainly not non-existent.

Buffett himself has expressed support for the wisdom of owning index funds as a way to gain exposure to equities.

"Most investors, both institutional and individual, will find that the best way to own common stocks (shares) is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals." - From the 1996 Berkshire Hathaway Shareholder Letter

Peter Lynch has said much the same:

"Most individual investors would be better off in an index mutual fund." - Peter Lynch

Accumulating shares of a very low expense index fund over time makes a ton of sense for many investors. It's an investing approach that does tend to beat most alternatives. Yet, that reality doesn't logically lead to the conclusion no investors would be better off buying individual equities. It's a matter of knowing one's own limits.

"By periodically investing in an index fund...the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb. 

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

It's not likely, over the long haul, that many investors will do better than low cost index funds. Yet there's a big difference between not possible and not likely.

Also, consider that buying individual stocks adds complexity to the investing process. Added complexity ought to offer a clear benefit or else that complexity is not worth the trouble. Those not realistic about whether they gain a real advantage by owning individual equities will see their returns suffer quite a lot. (Adding complexity with not only no clear benefit, but possibly even reduced returns.)

No matter what kind of investment vehicle is used, it's generally best to buy when the headlines are pretty awful. That's, of course, when the largest margin of safety is likely to be available to investors. Too many investors do just the opposite.

Whatever the right long-term investment vehicle(s) might be (it's necessarily different for each individual) the key is always to avoid the temptation to trade excessively.

Based upon trends in recent decades, it seems fair to say not many market participants will be easily convinced they should minimize their trading activities.

Adam

* Unfortunately, the returns investors in mutual funds achieve in the real world ends up being even worse than the funds themselves. That's not the fault of the funds. It's the result of investor behavior. Here's a good explanation by Lou Harvey, president of DALBAR, back in 2009: "...investor returns lag what performance reports and prospectuses would lead one to believe is achievable. While those returns are, in fact, theoretically achievable, the reality is that investors are not rational, and make buy and sell decisions at the worst possible moments," he said. Professional money managers certainly do, on average, underperform the S&P 500 index over the long haul. According to Vanguard founder John Bogle, from 1984 to 2002 the average mutual fund delivered a 9.3% annual return compared to the S&P 500's return of 12.2% a year. Even worse, during that same period the average fund investor, according to DALBAR, earned just 2.6% a year. 
(The average fund investor does much worse largely due to ill-timed buy/sell decisions and fund selection. In other words, a timing penalty and a selection penalty. Bogle adds why he thinks the DALBAR study might actually overstate the annual returns. See his explanation under the Is the DALBAR Study Accurate? section for more details.)
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Index Fund Investing
Index Fund Investing
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