Index Investing Is For Losers
The principles of successful investing defies normal principles of life. We’ve been taught growing up that we shouldn’t settle for average. That we should strive to be the best that we can be. But as an investor, ironically we can be well above average by settling for an index fund’s ‘average’ returns.
We’ve been taught that in times of crisis, we should be action oriented. Don’t just stand there. Make a decision. But ironically trying to fix a perceived investment crisis by taking more action is a recipe for poor returns.
We’ve been taught that if we don’t understand something, we should hire an expert. An investment advisor to help us manage our money. But in the case of investing, oftentimes we will get much less than we pay for.
Life Principles & Investing
The reason why so many common successful life principles don’t apply to the world of investing is very simple. The short-run performance of the stock market is random, unpredictable and for most people, emotionally traumatizing. There are countless studies that compare the S&P 500 or Total Market Index Fund versus Actively Managed Mutual funds and results show again and again the low cost index funds outperforming actively managed funds. Most often, these underperformance are due to investor or fund manager behavior of either marketing timing or pursuit of chasing hot funds.
The notion that someone knows how the stock market or any given stock is going to perform in the next few weeks, months or years is oftentimes based on unfortunate self-delusion. There are more than 200 years of US stock market history and the long-term trend is up. In the long-run, the stock market performance has been rather consistent.
But in contrast to the long-term returns, short-term returns and movement of the market is quite unpredictable and volatile. I firmly believe that stocks over the long-run offer one of the greatest potential returns for the average investors like you and I. But in the short-run, the roller coaster rides can be quite a nightmare for those who don’t understand the basic principles of the market and lack a pragmatic plan to cope with it. The bottom line is that investing has a whole new set of rules, and if we want to be successful, we must learn to play by these new rules. New rules that might make us feel like losers in comparison to the common successful principles of life we have been conditioned by.
Index Investing - It Pays To Be A Loser
Index investing on the surface seems like an investment strategy that would be perfect for my special friend, Andy Dweir. It takes very little investing knowledge, almost no extra time and effort, and no special skills whatsoever. Yet, it outperforms more than 80% of all investors out there - maybe even more.
It frees you up to spend your time on whatever else you want to be doing instead of looking at the stock market or investing news. While you are doing more important things with your life, your investment compounds and grows on autopilot. It really is about as difficult as brushing your teeth and takes as much as time going to the dentist once a year. Trust me. I’m not exaggerating. I’m an index investor, and if I can do it I’m quite sure you can do it too.
What Is Index Investing?
Index investing in a nutshell is this. Instead of hiring an expert or spending a lot of your brain bandwidth trying to select the right stocks or actively managed mutual funds, you just invest in a good low cost index fund like VTSAX and essentially forget about it.
An index fund attempts to match the return of the segment of the market that it is indexing. An S&P 500 Index Fund matches the 500 largest publicly traded companies in the United States. A Total Stock Market Index Fund replicates all the publicly traded companies in the United States. A Total International Index Fund replicates a broad cross-section of thousands of reputable international stocks. With a small management fee for each fund, ranging from 0.04% to 0.11%, you can be invested in an index fund within minutes.
Indexing in many expert’s opinions is really one of the best ways to invest because they have and will continue to outperform the thousands of actively managed funds over a long period of time.
Higher Diversification
Diversification is the key to reducing investment risk. The fastest way to get rich overnight is to own the next Netflix. But the fastest way to lose all your money is to own the next Blockbusters. To know what companies will do well or not do well is nearly impossible. However, you don’t need to have a magic ball in order to get healthy returns on your investment.
If you buy an S&P 500 or Total Stock Market Index Fund, your investment is highly diversified and its performance will match that of the companies that the fund is indexing. Is it possible to lose all your money? Of course, but that means that all the major US companies have essentially been destroyed and in that case, the value of your investment portfolio will be the least of your worries.
Low Operating Cost
Actively managed funds are known to charge anywhere between 1 to 2 percent expense ratios. This means that between 1 to 2 percent of your investment is deducted each year to pay the fund manager to run the fund. On a $100,000 portfolio, that comes out to $1K to $2K annually.
By contrast, index funds are much cheaper given no person is actually managing the fund’s performance. There isn’t a person deciding which funds to buy or sell or when to buy or sell them. The fund simply replicates the index. As a result, most index funds have an expense ratio well under 0.1%.
VTSAX and VFIAX, Vanguard’s Total Stock Market Index Fund and Vanguard's S&P 500 Index Fund have respective expense ratios of 0.04%. On a $100,000 portfolio, this comes out to $40 annually. I’ll take a $40 expense over $2,000 any day. The real power of low operating cost really comes to play when you incorporate compounding into the formula. These expense ratios can net you or cost you hundreds of thousands of dollars over a period of 10 to 20 years. Cost matters and the king of low cost are passively managed index funds.
No Investment Manager
I firmly believe that with enough right information, any of you can effectively manage your own portfolio. When you have an investment manager, they take a huge chunk of your portfolio to manage your money for you. This is real money that is going into someone else’s pocket instead of staying and compounding in your account.
Some argue that there are really good investment managers whose performance is worth the cost. Peter Lynch, managed the Fidelity Magellan fund from 1978 to 1990 and posted an average annual return of 29%. However, such individuals are so rare that some investment scholars attribute their consistent performance to luck rather than skill.
Peter Lynch - Genius or Lucky?
Just like stocks, many of yesterday’s superstar managers can quickly turn to today’s underperformers. How can you effectively identify who tomorrow’s superstar will be? This too unfortunately is a futile pursuit. The bottom line is that with index funds, who’s managing the fund is not an issue. Index funds only track the index. Nothing more. Nothing less.
We won’t know what the future will hold. However, what is sure is that when it comes to investing, more activity, more timing and more supposed ‘expert’ advice won’t get us better returns. When it comes to investing, be ok with being a loser.
