Debunking “Why Index Investing May Not Be for You”

The Million Dollar Journey brought up 4 reasons why index investing may not be for you. His 4 reasons were:

  1. No Downside Protection
  2. No Control Over your Holdings
  3. An Indexed Portfolio will Always be Average. Never Better, Never Worse.
  4. It’s Boring.

Now onto the debunking:

  1. No Downside Protection What index investing gives you is the average return but with far less costs than active investing (either through an non-index mutual fund or do-it-yourself trading). Period. What does downside protection mean anyways? The only way to have true downside protection is to be able to forecast when the market is going to down. No one has been able to achieve this yet (and no one every will). The other way to have downside protection is to add some other asset class to your portfolio. In the extreme case, being 100% invested in a completely negatively correlated asset class would give you perfect downside protection. This is sort of how mutual funds offer some “downside protection”, however, one could also call this “upside suckage.” Mutual funds often carry some cash. This reduces their losses during down markets but also decreases their returns during up markets. In general, there are more “up markets” than “down markets” (ie. the stock market goes up over time). Therefore you want to be 100% invested all the time to maximize your return. So the fact that index investing has “no downside protection” (at least in the way that Million Dollar Journey means) is actually a good thing because it means you are less invested in cash and more invested in the market. I would say that even if you care about “downside protection” indexes ARE for you.
  2. No Control Over your Holdings He says that “This can potentially lead to over priced stocks having a larger weighting on the index” and cites Nortel as an example. Overpriced stocks in an market-cap weighted index (most indexes are market-cap weighted) do not pose a problem. I only hold indexes in my portfolio. If a stock in one of my indexes increases 100-fold tomorrow, my portfolio may go up a little. If that stock eventually falls back down to its previous levels, I haven’t lost or gained anything. The investor with “more control over his portfolio” may choose to do some trading in that stock. Because he/she cannot predict the future of the stock, he/she can have no effect other than to decrease his/her net returns due to increased trading costs. As for the Nortel example, the only people that would have suffered because of the fact that the index contained a high of Nortel stock (even more than Canadian mutual funds) are those that, say, switched out of Canadian mutual funds and into indexes while Nortel was at its peak. Those that held the indexes all along, would have experienced the huge increase in Nortel’s stock price as well as its decline, whereas those who held a Canadian mutual fund during Nortel’s rise and an index during its fall, would have experienced more of the fall than the rise. (This is all hindsight, of course. Nortel could have kept rising of course and fallen back less.) If you are worried about a re-occurrence of such a scenario, switch over to indexes gradually. Having less control is better. It means less trading, less costs, and higher returns.
  3. An Indexed Portfolio will Always be Average. Never Better, Never Worse. This is a good thing. Any portfolio, whether it be a carefully chosen assortment of stocks, a randomly chosen assortment of stocks, or a mutual fund, will on average get the average market return. What that means is that if we sum up the returns of a bunch of portfolios and divide by the number of portfolios the average return of those portfolios will be the same as the average market return (or equivalently, plot a histogram of the portfolios returns and the center of the bell curve will be the same as the average market return). The question is, can you control whether or not your portfolio’s future return will lie above or below the center of the bell curve? This is very difficult to do (if not impossible) in an efficient market, especially after you take into account trading costs. And consider the alternative if you fail in your quest to get above average returns. You may end up getting below average returns. Investing in the index is guaranteed to give you the average market return. It usually also does so at very low cost. The fact that the cost of investing in indexes is so low means that most indexes actually end up beating the majority of mutual funds (and probably those who pick stocks on their own as well). I would provide a citation but there are too many and I wouldn’t be able to decide which one to use.
  4. It’s Boring. The original poster admits that “this is probably the weaker of all the arguments.” He says that if you like “digging in research, watching the markets, and investing when you think the time is right” then index investing is not for you. I would argue that the main reason people do “research,” “watch the market,” and “invest when they think the time is right,” and find those activities non-boring is because they believe they can “beat the market.” Once you realize that you can’t beat the market and give in to that fact, you may find that index investing is not so boring after all. When you invest with indexes you will get the average return (sounds boring), but due to your decreased costs you will beat everyone else who is invested in mutual funds or buying individual stocks on their own, and that is exciting! I agree, however, that index investing is simpler, but that’s what makes it outperform everything else. Simpler means lower costs, and lower costs means greater returns.

As I was writing this, the Canadian Capitalist published a great reply to Million Dollar Journey’s post as well.

8 thoughts on “Debunking “Why Index Investing May Not Be for You””

  1. Thanks for the mention. Individual investors are no better at timing either. Rob Carrick writes today that as markets were falling, investors were piling onto money market funds. Downside protection is provided by adding bonds — not superior stock selection or market timing.

  2. I’m a little confused. First you say, “to forecast when the market is going to down. No one has been able to achieve this yet (and no one every will).” Then a few sentences later you say, “the stock market goes up over time.”

    In the late ’90s there was a dot-com boom. Since the S&P500 is tech-heavy, index funds tracking in the S&P500 went up and then crashed. With index funds you don’t control whether you want tech stocks in your holdings or not. You are just given it because indexing essentially is just following the herd.

  3. Maddy, most people consider it a given that stock markets go up over time, at least as long as our economies grow.

    Currently 16% of the S&P 500 is made up of information technology stocks, the largest holdings being Microsoft, IBM, and Apple. I wouldn’t say that 16% tech makes it tech-heavy. As I said, you can’t forecast the markets so why pick and choose sectors to invest in? Of course if someone switched $100,000 from cash or bonds or financial stocks into the S&P500 or the Nasdaq in the year 2000, they would have suffered quite a bit in the years following.

    This is no different then buying a house at the peak of a bubble or switching from renting to owning a house during the peak of a bubble; however, those who have been invested in the S&P500 for a long time, or the housing market for a long time, don’t notice the bubble. The large decline in value just offsets the large gain in value. The only people that were affected by the housing bubble were those that bought or sold during a certain period and the only ones that suffered during the bubble were those that bought or sold tech stocks during that period.

    It’s a fact of life I guess. Personally, I will probably never notice anything like the tech bubble, going forward. My asset allocation is fixed and I am continually putting money into the market at a fairly constant rate.

  4. The statements about indexing providing only average performance a bit misleading. For instance, the S&P 500 has had years wherein it is an above average performer. Also, if average annual returns are 13-14%, on an absolute basis, that is pretty good when taking into account the effect of compounding. In other words, $100,000. left to reinvest for 10 years grows to $404,000.
    Another thing to consider, there are now so many ETF’s that track many different market sectors, asset classes and economic sectors (both long & short, some with considerable leverage. Ultra-Pro) that the potential to significantly out-perform the market through asset allocation is simply amazing.
    This is compared to “back in the day” (from which most market history is derived) investing in single stocks as an alternative.
    Of course, one must now fear company specific risk and events (Fannie, Freddie) v. market volatility.
    The “average” investor earning “average” returns can profit substantially and control the level of market related risk he wishes to take and may profit from either the long or short side of a market.
    This will hold so long as market volatility in the extremes we have witnessed in recent years holds. If volatility eases for a prolonged period, single stock investing may again win out. Time will tell.

  5. Ben333, you are right, the S&P500 is not quite the entire market, however, Vanguard’s Total Stock Market Index is (pretty much). I only mentioned the S&P500 because Maddy was referring to it.

    With the more specialized ETFs that you refer to (sector ETFs) one must be careful of the higher MERs often associated with those ETFs.

    Are you saying that the more volatile the market is, the more one can profit from good asset allocation? Good point. There is definitely way more of a rebalancing bonus the more volatile stocks are bonds are, relative to each other.

  6. Dave, that’s an excellent point when you mention that the reason many people enjoy researching stocks and attempting to time the market is because they believe they can beat the market.

    I used to be that way. But after reading books like Bernstein’s ‘Four Pillars of Investing’, Malkiel’s ‘Random Walk Down Wall Street’, and Swensons ‘Unconventional Success’, I became convinced that this was the wrong approach.

    After becoming an indexer, I found a lot of the stock research and business news headlines that used to be so riveting had lost much of their appeal. I still keep track of what’s going on at a macro level as I can’t help but wonder what’s happening to my mortgage interest rate and the price of gas, but these things no longer influence my investing decisions.

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