Ah, no. Index investing is for people who want the best possible results.
Over the last year or so some of my investing ideas have drawn comment on other blogs and forums. Lately I’ve noticed that even those folks seeking to compliment me sometimes frame my position on Vanguard and index funds as sound advice only for average people who don’t want to work very hard at investing. The idea being that with a little more effort in the selection of individual stocks and/or actively managed funds smarter, more diligent folks can do better.
I can’t do this. Can you do this?
I can’t pick winning individual stocks and you can’t either. It is vanishingly difficult, expensive and a fool’s errand. It will erode your returns in such a fashion as to make planning your withdrawal rate a much dicier proposition.
Take a look at this video clip from a few months back and consider Apple, then most valuable company in the world: http://video.cnbc.com/gallery/?video=3000116834&play=1
These are very smart people being interviewed, with analytical tools us individual investors can only dream about. Apple was trading at 700, clearly on its way to 1000. The interviewer pushes to get even a hint of possible concerns, and good on him for it. But they were absolutely convinced Apple was cheap and a buy at 700. Their reasoning was sound. Yet here it is opening at 442 today. Oops.
Will it go higher from here? Possibly. That’s why people are willing to buy at this level. Will it go lower? Possibly. That’s why an equal number of people are willing to sell at this level. Never lose sight of the fact that anytime you buy or sell a stock, no matter how careful your research and sound your thinking, there is someone on the other side of that trade just as convinced you’re wrong.
As you may know there is a school of thought that suggests that even the super-star investors, think Warren Buffet, are simply lucky. Even for a hard-core indexer like me, that is tough to wrap my head around. Yet here’s research that suggests that only the very top-tier of money managers out perform and that when they do it is almost impossible to distinguish skill from luck: Luck v. Skill in Mutual Fund Performance
Many years ago I had a martial arts instructor who was talking about effective street fighting. On the subject of high kicks he had this to say: “Before you decide to use kicking techniques on the street ask yourself this question: ‘Am I Bruce Lee?’ If the answer is ‘no’ keep your feet on the ground.” Good advice when you’re playing for keeps.
Are you Bruce Lee?
The point is this: As cool and effective as kicks look in the movies, tournaments and in the dojo, on the street they are very high risk. Unless you are both very skilled and significantly more skilled than your opponent (something unknowable in street fighting or investing) they are likely to leave you exposed and vulnerable. Even, and this is critical, if you’ve had success with them before.
So too with investing. Before you start trying to pick individual stocks and/or fund managers ask yourself this simple question: “Am I Warren Buffett?” If the answer is “no,” keep your feet firmly on the ground with indexing. (If the answer is “yes,” it’s nice to have you here, Warren.)
So let me take a moment to be absolutely clear. I don’t favor indexing just because it is easier, although it is. Or because it is simpler, although it is that too.
I favor it because it is more effective and more powerful in building wealth than the alternatives.
I’d happily put in more effort for more return. More effort for less return? Not so much.
Here’s Jack Bogle on the Market. Bogle is the best thing that ever happened for us small investors. Listen to this five minute interview and take the concepts to heart. On Market Timing: “I’ve been in this business 61 years and I can’t do it. I’ve never met anybody who can do it. I’ve never met anybody who’s met anybody who can do it.”
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
“After reading your series and the Bogle book, I can’t come up with a reason not to pursue a nearly solely index-fund strategy. It is so elegant in its simplicity and it makes intuitive sense to me, and you can outperform nearly everyone else with zero work and nearly zero fees. That’s incredible!” Brad of Richmond Savers
That comment is from an exchange we had on his blog under the post the link will take you to. I can’t say it any more eloquently than that.
Addendum IV: Warren Buffett’s plan for his widow
Speaking of Warren Buffet, in the comments below reader sbvol98 provided this link: Warren Buffet on track to win hedge fund bet
Back in 2008 Buffett bet a S&P 500 index fund would best a fancy-pants Hedge Fund over ten years. Six years in:
Fancy Hedge Fund: +12.56%
S&P 500 index fund: +43.8%
At various points on this blog I suggest only about 20% of active managers out-perform the index. That’s being a bit generous.
This is a ball park figure based on the many articles on this I’ve come across on this over the years. In fact you can Google this question and find several falling around this percentage. I’m not sure why they vary. Some look at different time frames. Some at different metrics. Some factor in costs, some don’t.
Clearly it is easier to get lucky and outperform the shorter the time you need to do it. Even I called the market almost exactly last year, and I can assure you it was no more than luck: http://jlcollinsnh.com/2014/01/01/1st-annual-louis-rukeyser-memorial-market-prediction-contest-2013-results-and-your-chance-to-enter-for-2014/
Vanguard has done research on this looking at a 15-year time frame:
In it they point out that 45% of actively managed funds fail to even survive over that time, let alone outperform. Only 18% both survived and outperformed. And even those frequently had long periods of underperformance.
So even if you are lucky enough to pick one of the out-performers, it will be tough to live with.
This article references studies done for an even longer period: 1976-2006, 30 years: http://www.marketwatch.com/story/almost-no-one-can-beat-the-market-2013-10-25
The results are even more shocking. As the article says:
“Barras, Scaillet and Wermers tracked 2,076 actively managed U.S. domestic equity mutual funds between 1976 and 2006.
“And — are you sitting down? Only 0.6% — you read that right, 0.6% — showed any true skill at beating the market consistently, ‘statistically indistinguishable from zero,’ the three researchers concluded.”
On reflection, calling the out-performers at 20% I am too generously off the mark.
Addendum VII: In his comment here, reader Nate sums it up exactly:
“I’m at 100% equities. Ever since I graduated two years ago, my only investment ever has been the total stock market index fund. I love the simplicity of it and I have no interest in trying to time the dips. You get such amazing, nearly magical returns from the extremely low cost and broad diversification of the total stock market index fund. It makes me kind of sad to see people getting nervous or excited about the dips and rallies. You have this almost perfect wealth building tool and very few people trust it and use it through the highs and lows.”