The bashing of Index Funds, Jack Bogle and a Jedi dog trick

Over on Magic Beans reader Mark had this to say in the comments:

“Being a Boglehead myself, I read the ERE article to see what he had to say. I had to sigh when I got to this: “Index investing is basically equivalent to a buy and hold strategy with very low turnover of a few large growth companies.” This is absurd. The S&P 500 is just one index. There are indexes for large cap, small cap, growth, value, US, Europe, emerging markets, REITs, every kind of bond, you name it. Index investing is about choosing an asset allocation that matches your need and willingness to take risk, and using low-cost index funds to hold the most diversified position possible within those asset classes. Why is it that the people bashing “index investing” have so little understanding of what it is?”

It’s not just people bashing Indexing Mark, it’s an entire financial industry.

In addition to offering some good points, Mark got me thinking about just why it is that concept of Index Funds meets with such resistance in some quarters.  First, a little background.

Jack Bogle founded the Vanguard Group in 1974 and launched the first index fund,  the S&P 500 Index, in 1976.  The  basic concept with Vanguard is that an investment firm’s interests should be aligned with those of its shareholders.  To this day it is the only firm that is and as such is the only firm I recommend.

The basic concept of indexing is that, since the odds of selecting stocks that outperform is vanishingly small, better results will be achieved by buying every stock in a given index.  This was soundly ridiculed at the time and in some quarters it still is.

But quickly and increasingly over the past 36 years the truth of Bogle’s idea has been repeatedly confirmed.

After replying it occurred to me this is a subject that deserves a post of its own.  Below is my slightly expanded response to Mark.

Hi Mark… Always good to meet a fellow Boglehead.

Warren Buffet is typically held up, with good reason, as the pinnacle of all that is good in investment.  He certainly has an impressive record.

But for my money (pun intended), no one has done more for the individual investor than Jack Bogle.  From Vanguard and its unique structure that benefits shareholders to Index Funds,  he is a financial saint and a personal hero.

You are, of course, correct. The S&P Index is only the first of its kind and now is one of many. Each tailored to a unique need. As mentioned elsewhere I use/need only three, plus a money market fund.

As to why people bash them with little understanding, all I can say is that seems to be a common human trait.

I have a lot of respect for Jacob and ERE. He’s clearly very bright and thoughtful. Why he choose to dismiss Indexing in the manner he does, baffles me.

As to why people who do take the time to understand indexing and who still reject it, I think there is a lot of psychology behind it:

1) It is very hard for smart people to accept that they can’t outperform an Index that  simply  buys every thing. It seems it should be so easy to spot the good companies and avoid the bad. It’s not. This was my personal hangup and I wasted years and many $$$ in the pursuit of out-performance.

It should be easy to spot the bad ideas, right?

2) To buy the index is to accept “average.” People have trouble seeing themselves or anything in their life as average.

But in this context “average” is not in the middle, it is the performance of the all the stocks in an index.  Professional managers are measured against how well they do against this return.  In any given year, and of course this varies year to year, 80% of actively managed funds underperform their index.  This means just buying the index guarantees you’ll be in the top performance tier.  Year after year. Not bad for accepting “average.”  I can live (and prosper) with that kind of “average.”

3) The financial media is filled with stories of individuals and pros who have outperformed the index for a year or two or three. Or in the rare case, like Buffet, who has done it over time. (I cringe at the often touted suggestion to just do what Buffet does.)  But investing is a long term game.  You’ll have no better luck picking and switching winning managers than winning stocks over the decades.4) People underestimate the drag of costs to investing. 1 or 1.5 or 2 percent seems so low, especially in a good year. Fees are a devil’s ball & chain on your wealth.  As Bogle says, performance comes and goes. Expenses are always there.*

5) People want quick results. They want to brag about their stock that tripled or their fund that beat the S&P. Letting an Index work its magic over the years isn’t very exciting. It is only very profitable.

6) People want exciting. Heck, I’ve even admitted to playing with individual stocks with a (very) small fraction of my stash. But I let the Indexes do the heavy lifting and they are the ones that got me F-you Money.

7) Finally, and perhaps most influential, there is a huge business dedicated to selling advice and brokering trades to people who believe they can outperform. Money managers, mutual fund companies, financial advisers, stock analysts, newsletters, blogs, brokers all want their hand in your pocket. Billions are at stake and the drum beat marketing the idea of out-performance is relentless. In short we are brainwashed.

Indexing threatens the huge fees they can collect enabling your belief and effort in the vanishingly difficult quest for the alluring siren of out-performance.

Use The Index and keep what is yours.

 

Addendum I:

*In addition to underperforming Index Funds, actively managed funds cost more, and those costs have a very serious and negative impact on your results. My pal Shilpan has a great post on this:  That Mutual Fund is Robbing Your Retirement

Addendum II: Warren Buffett’s plan for his widow

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10 Comments

  1. Trish Rempen
    Posted January 6, 2012 at 6:24 pm | Permalink

    All possible. Number 5 has my vote!

    • Posted January 6, 2012 at 9:54 pm | Permalink

      Yep. In #5 Ego is a big part of the dynamic and it is what gives #7 its power.

      Like I’ve said before:

      “If you choose to try to best the averages, God Bless and God Speed. You may well be smarter and more talented than I. You are most certainly likely to be better looking. I’ll look for your name along with Warren and Peter’s in the not too distant future.

      I extend the same to all those folks I’ve met in Vegas who assure me they have bested the house. I listen, gaze up at the billion dollar casinos and reflect on how many smarter, more talented and better looking people there are than me.” ;)

      http://jlcollinsnh.wordpress.com/2011/06/02/why-i-can’t-pick-winning-stocks-and-you-can’t-either/

  2. Kalo
    Posted March 11, 2013 at 10:28 pm | Permalink

    One other thing about indexing, especially the Total Market indexes (Stock, Bond or REIT) that is implied in the above discussion that I like is that there’s a sense of comfort one gets knowing one can go on vacation mentally for years or decades and still retain confidence about an investment. The allocation should be reviewed periodically, but even that can be put on auto pilot through Vanguard. My favorite example of the opposite is Kodak. Who could have predicted several decades ago the fate of this former DOW 30 stock?

    People usually don’t factor in the cost of monitoring a portfolio. Maybe because they convince themselves that they enjoy it. I did as much in the past. But there is time, stress, energy. And the nagging fear that you are making a mistake. I am so much happier with my few Vanguard ETF’s purchased at zero brokerage commissions through Vanguard brokerage service. I may convert these to the corresponding mutual funds to make my life even easier in the future.

    Thanks for this web site. I was directed here from MMM’s site and am also a fan of Bogleheads.

    • jlcollinsnh
      Posted March 12, 2013 at 1:35 am | Permalink

      Welcome Kalo…

      and congratulations. Sounds like you’ve got it working for you, not the other way around!

      Great point on Kodak, and that’s a story repeated many times.

      Way back in 1896 a guy named Charles Dow selected 12 stocks from leading American industries to create his Index. Today the DJIA is comprised of 30 large American companies. Care to guess how many of the original 12 are still around?

      One. General Electric.

      BTW, your ETFs are a fine way to hold your investments. If they are in tax deferred accounts, switch them if you like. But if they are not, be aware of the capital gain taxes you’ll owe if you switch. At least if you’re here in the USA.

      • Kalo
        Posted March 12, 2013 at 12:37 pm | Permalink

        Thanks. I appreciate the advice. I am in the US and most of my holdings are in tax deferred. The ones in the taxable account I plan to keep in ETF’s. I had experience years ago reporting on fractional shares for taxes and want to avoid that. So I buy VTI in 50 share increments when I can and keep the reinvest options turned off. Then just use the dividends plus new contributions to make new purchases. That way I never have fractional shares. Not an issue in the tax deferred accounts.

        I have reviewed Bogleheads on the subject but am still not totally clear about ETF’s vs Funds. Most of the issues I understand. And since Vanguard charges no brokerage commissions, the ETF’s work and are sometimes lower cost. I originally converted from funds to ETF’s because I thought I may want to time the market, but since then I’ve come to believe I can’t do it profitably. I guess the one thing I wonder about is if there were ever a total economic catastrophe if the funds would be better but in that case it probably wouldn’t matter because everyone would be toast anyway.

        If you have any thoughts about ETF’s vs funds I’d be happy to hear them.

  3. Posted June 11, 2013 at 10:47 pm | Permalink

    One of the recent Vanguard papers (indirectly) made a very good point — that 100% of good index funds underperform their index :P (And index fund that outperforms its index is probably tracking it poorly, and thus isn’t a good fund.)

    They mentioned that (I’m getting the numbers wrong) if you compare active funds to index funds (instead of to the uninvestable index), the 80% underperform turns into more like 70% underperform.

    So the important part is that a good index fund will underperform its index by an amount they told you upfront, the expense ratio, which is why costs matter so much.

    (And the average managed fund will, in practice, also underperform its benchmark by its expense ratio, but that expense ratio will be much higher than for the index fund.)

    • jlcollinsnh
      Posted June 12, 2013 at 12:55 pm | Permalink

      Good point. Even modest expenses are a drag on performance and that drag precisely matches the expense.

      Another factor is that even index funds typically have some cash on hand. Partly just the inflow of new money, partly to have on hand for when investors want to sell.

      In a rising market, this will be a drag. In a falling market, it will be a cushion. But either way the effect is slight as index funds strive (correctly) to keep cash at a minimum.

  4. Josh
    Posted September 4, 2013 at 2:32 pm | Permalink

    Jim I’m curious if you own any Berkshire Hathaway stock, after reading your frequent descriptions of Warren Buffet’s Berkshire Hathaway as an example of a stock, or I guess mutual fund but not sure, that has beat the S&P index over time.

    Great blog, I found you via MMM and have been hooked ever since. I enjoy your ability to condense your points with a dusting of humor. Keep up the good work.

    • jlcollinsnh
      Posted September 20, 2013 at 10:30 am | Permalink

      Welcome Josh….

      and thanks for the kind words. Glad you found your way over here!

      Sorry for the delay in responding. As you may know, I’m just back from spending most of the summer in Ecuador and am only now catching up.

      Nope, I’ve never owned any BRK and what a spectacular investment it would have been!!

      Here’s the problem. Back in the day, there was no way to know Warren Buffett would turn out to be, well, Warren Buffett.

      I mean this not just in his stock picking performance, but in his longevity.

      Back in the 1980s I found Michael Price, who was running the Mutual Series of funds. He, too, turned in a spectacular performance and made me a lot of money.

      But choosing him, from among all the others, was sheer luck on my part and not likely repeatable.

      But then he sold out to Franklin Templeton for half a billion dollars. They, and he, tried hard to convince shareholders that the funds’ success wasn’t just him but a function of the efforts of his team. Fortunately, I didn’t listen. The funds were never the same after his departure.

      Certainly those lucky enough to have bought and held BRK over the decades have out performed the index. About 5% of money managers pull this off over decades. A vanishingly small percent when you are picking them from the starting line as we all must do.

      The real question, of course, is what about now? Well, Mr. Buffett is 80-something years old. The harsh reality is that investing in his acumen now is a short term proposition. All too soon you’ll need to make the same call as I did with Price.

      For the past several years, BRK and Buffett have been floating the idea that the spectacular results were a team effort and that these results will continue even with out him. Just like Mutual Shares and M. Price. That’s a very long-shot in my view….

  5. kyle
    Posted November 15, 2013 at 10:13 am | Permalink

    After reading Jack Bogle’s ‘The Little Book of Common Sense Investing’ it’s clear to see Jack is an honest man, who wants the best for the investors who trust and invest with Vanguard. He created the first index fund with the American investors in mind, not his (dare I say?) greedy colleagues in the investment industry. As human beings, we want the best. We want the best health, the best lifestyle, the best house, the best for our children, it’s written into our DNA. It makes sense that accepting average for anything in life is quite simply unacceptable and seemingly lazy and boring. When you zoom out and look at the big picture, ‘average’ in the form of indexing is actually the best you can get in the long term because you are avoiding costly fees (that line the pockets of fund managers), you are outpacing inflation (if you are foolish to not invest at all!), you are not timing the market, and you are diversifying your investments. It’s really above average, as you said, it’s just not exciting in terms of looking at your gains on a yearly basis. Thanks for this article, Jim.

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