The Power of Self-Cleansing

Photo by Andrew Keymaster on Unsplash

 

Earlier this year I was getting a flood of concern over how dominate the tech/AI sector had become in the S&P 500, and by extension a total market ETF like VTI.

In The Simple Path to Wealth May 26th newsletter, I addressed this question:

Q: Given the top 10 holdings in Fidelity’s total market index fund are primarily composed of companies enmeshed in the AI battle, what are your thoughts on hedging against an “AI bubble” with mid-cap or other index funds? Do you think there’s a bubble at all? —Kenny S.

A: Hi Kenny,

Great question!

I have no idea if we are in an AI bubble or if this is the beginning of a great new technology. Or something in between. Nobody does, including all those in the media these days claiming they do.

It is said the market will do whatever it needs to do to embarrass the most people.



In short, I don’t know. I don’t have to.

 This is the beauty of investing in low-cost broad-based index funds.

We don’t have to guess at which stocks will do well and which will do poorly. Nor do we need to worry about which sectors will dominate and for how long.

Years ago I coined a term—the market is “self-cleansing”—to describe the process.

Index funds like these are “cap-weighted,” which simply means a greater percentage of the fund is in the bigger, more successful companies.

The stocks and sectors that do well rise to the top, and our fund owns more of these winners. When/if they begin to fade, we will own less of them and more of those that take over.

To be clear, this doesn’t mean there will never be bubbles or crashes.

There definitely will be.

It is just that nobody can predict them.

When they come, we tie ourselves to the mast and endure the storm, knowing it will pass and the market will resume its relentless rise.



—JL

Well, it didn’t take long for some those tech names to go off the rails.

In this post…

Picking Stocks in a Bloodbath

…Ben Carlson shows just how badly hit some of these names have been. Some are off 30, 40, 50 60+ percent.

He points out similar plunges are happening in other sectors like apparel brands. Along with the “absolute wreckage” of the “pandemic darlings” over the last few years.

Yet the market overall is up ~10% YTD.

Sectors rotate in and out of favor, just like individual stocks. Predicting which, when, how and by how much is impossible.

But we invest in the total stock market, so we don’t care.

We don’t have to.

This is the power of “self-cleansing”

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    Comments

    1. Sam Hill says

      I’m concerned that the CRSP index (which is what VTI tracks) has changed their rules to allow unprofitable companies like SpaceX to be included in their index. There are other unprofitable companies preparing for IPO that will also likely be included soon in VTI. For those reasons, I have switched from holding VTI to holding VOO.

      Do you have concerns about the recent changes to CRSP inclusion requirements?

      • Tech says

        I certainly do have concerns when the mega rich ruling parties start changing the rules to benefit themselves at the expense of the majority. I just don’t think there is a better way to invest that broad-based total market indexes. To do so you have to not only pick the correct investments you also have to time correctly both when to buy and to sell. I am with JL on letting the self-cleaning over the long run in total market indexing make those choices and timings for me.

    2. Chris says

      These questions about the wisdom of investing in an S&P 500 index fund are valid. In short, I don’t think it’s wise, due to the massive disproportionate weighting of just a few companies. I believe that only 10 companies hold about 40% of the wealth of the S&P 500. That’s simply not good diversification. That is way VTI, and other forms of the “Total Stock Market” are a wiser bet. Exactly the reason that most reputable 401k accounts invest in a Total Stock Market fund as opposed to an S&P 500.

      • Sam Hill says

        However, if the few big companies values go down, won’t their proportion of wieght decrease as well and at the same time some of the smaller companies will move up and have a higher weight.

        I personally have left VTI in favor of VOO due to the fact the index that VTI tracks (CRSP) has fast tracked SpaceX and soon will be fast tracking other expected large IPOs that, like SpaceX, are not yet profitable. At least the S&P 500 requires companies to be profitable and will wait a full year after IPO to help make sure their stock value is more correctly priced.

    3. SFL says

      Many investors have changed from 100% VTI or VTSAX to include some exposure to international stocks. The reason some give is that they are concerned over President Trump’s fickle tariff policy, but I suspect it has to do more with Mr. Schiller’s CAPE graph……. which is applicable only to the S&P and is approaching all-time highs. Stocks are very expensive now if you look at P/E. It’s a question of “when” not “if” the S&P retreats a bit but that will give us an opportunity to buy more shares on sale unless you are in retirement already and are withdrawing. But, as mentioned, the new highs could be the start of a new great technology boom. We never know and don’t need to know.

    4. Jaden says

      And for all of us investing in the Low Cost Broad Base Index Fund S&P 500 Equal Weight instead of VTI? Any words?

    5. George F. says

      Like Joe Saul-Sehy says, Saying index funds win because they self-clean is like saying a computer is powerful because it has a keyboard. The feature exists, but it is not the source of the advantage.

      • JCM says

        This is a terrible analogy. A keyboard is a way to interact with a machine, has nothing to do with it’s power. Self cleansing isn’t a bolt-on feature; it’s a direct description of the mechanism that produces the returns.

    6. Samuel says

      Hiya JL. I’ve heard you speak about doing things from a position of financial strength. It would great to hear more about what this means in practice, including how it supports those who follow the simple path. Regards, Samuel

      • JL Collins says

        Hi Samuel,
        Referring to buying things from a “position of strength” is my shorthand way of saying “only buy things you can easily afford and not the things you can technically afford.”
        Anytime one is stretching their budget to buy something, or worse going into debt for it, that is buying from a position of weakness. Doing so makes you still weaker financially.
        Buying a car with payments that push your income is an example.
        So, too, is buying the most house your realtor and lender say you can technically afford. Remember, they both make more the more you spend. That much house, for you, makes everything financially tougher.
        Buying from a position of weakness keeps people in debt and living pay check to pay check.
        Buying from a position of strength frees up your income to build your wealth and leads to financial independence & freedom.

    7. Jason says

      With regards to getting children interested in the Simple Path to Wealth using a S&P 500 fund, I’m curious what your thoughts are on the Trump Accounts particularly in the case of those individuals fortunate enough to already have fully funded 529 accounts and looking to help kickstart their children’s retirement.

      I’m interested in setting up the Trump Accounts for my kids so that I can start accumulating money that can then be converted into Roth IRAs at 18 (or when they’re no longer dependent to avoid kiddie tax issues) and wondering what your thoughts are on the new Trump account for this particular purpose.

      Thanks so much for your guidance which has put me on the path to wealth!

      • JL Collins says

        Hi Jason,

        Kudos for giving your kids an early start!

        Since it sounds like you have already funded 529s for your kids, you know these are designed for education savings and are tax free on withdrawal if used for that purpose.

        These new Trump Accounts are for more general wealth building for children under the age of 18. If your kid(s) are US citizens and happen to be born in the years 2025 through 2028, the government kicks in a free $1000 to start. You, and many others, can add an additional $5000 per year.

        The money must be invested in broad based, low cost stock index funds which, if you know me, I view as a plus.

        For the most part, the money can’t be tapped until the child turns 18. At that point it basically converts to being a traditional IRA. This means it can remain invested or be withdrawn in part or in full. But any withdrawals are treated the same as any traditional IRA: subject to tax as ordinary income and to a 10% penalty if pulled before age 59 1/2. This being the government, there are probably some exceptions.

        Importantly, at 18 the child has full control over this money. What you might see as a great start to building wealth could go up in hookers & blow. Not your kid, of course, but maybe some other.

        The main concern I mostly hear is the connection to Trump. Those who love him, see this as a plus. Those who see him as a fraudster, see him slipping the money into his own pocket at some point. As far as I can tell, that is structurally unlikely.
        The risks are the more normal ones worth considering. The largest being how responsible the recipient is going to be at age 18. Some others:
        The stock market is volatile and there are no guarantees. That said, historically 18 years in the market has most often worked out very well.
        Congress can always change the rules of the game. But this is true of all these government programs like IRAs and 401Ks. Plus such rules are mostly likely to effect future contributions/accounts and protect those existing. No guarantee, but politicians try to avoid angering voters.
        Inflation is running high these days and certain policies are likely to put more upward pressure on this. Who can say what the next 18 years will bring. That said, most often stocks are a pretty good long-term inflation hedge.
        This is a new program and it is unclear what management/administration costs might be. As we on The Simple Path know, costs are critical.
        In short, the risks are much the same as any government investment program. The risk of fraud or the government seizing the money is, I think, very low.
        My advice, if you have a kid eligible for the $1000, sign up for at least that. Free money!
        Before I added more however, I’d consider opening a Roth IRA for the child.
        They have to have earned income, but that can be most anything. Mowing lawns, working in your business, being a baby model. You can fund it with money you provide up to the current limit or the amount they earn.

        Hope this helps!

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