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.