Over on the post 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 two, plus a money market fund.
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 everything. 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 drumbeat 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.
*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 III: Warren Buffett’s plan for his widow
Addendum IV: At various points on this blog I suggest only about 20% of active managers outperform the index. That’s being a bit generous.
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: https://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.”
Always ask, where are the missing bullet holes?
On reflection, calling the out-performers at 20% I am too generously off the mark.