There’s an interesting Investopedia article I saw recently that comes out against indexing your investments. While I share many of the questions the author has about modern portfolio theory, I find it hard to share his enthusiasm for active management. One of the interesting things is his first point, that indexing exposes you do to the downside of the market index you choose. While it’s true that this is a common complaint, the problem isn’t the downside. It’s the opposite in fact; the problem is that you might get higher returns than the market average.
Why would that be a bad thing? It’s simple – when people complain that they have to follow the market down with an index, they’re really complaining that it’s more volatile than the long-run trend. While this sometimes causes the market to decline more than it should and become underpriced, it also causes the market to rise more than it should and become overpriced. When this happens it can’t be sustained for ever, which means investors buying into the index at the higher price level lose money while those selling at that time make a profit. There is a potential for a gain if you’re invested before an abnormal increase in prices, but it also causes an eventual decline or stagnation for those who invest later or don’t sell anything on the way up.
To make matters worse, many investors are liable to miss the upside because they chase past performance – only those who bought in at undervalues or fairly priced levels will actually get this upside – and even then they may follow the market back down and lose it all again. Because of these factors, even the desirable idea of getting above-average returns from an index fund doesn’t help many investors. Thinking you can get all the upside without the downside is a lot like planning how you can pick the 10 stocks that will have done the best in a decade – sure it would make you a millionaire from a small initial investment but it’s also IMPOSSIBLE.
The real complaint then is that index funds deviate from the long-run trends in the markets occasionally, with negative effects to investors who aren’t in the market for a long period of time. However that doesn’t mean that you can get the return without the volatility – part of the return from stocks is a reward for potentially not having quick access to your money. In this sense active management has nothing to offer but lower, more steady returns (if not lower and more volatile returns). There are ways to reduce the volatility, such as sticking to an asset allocation planned to give you the right level of risk. Another thing I find myself bringing up a lot recently is that a well-informed investor can adjust their asset allocation based on reasonable estimates of future returns, potentially putting their money in the markets where it has a better chance to grow.
The next point in the article – that you can’t protect yourself against losses because two different strategies would move in opposite directions - is also wrong. You can protect yourself against big downturns while allowing for a small loss, using put options if you just want to avoid a loss or shorting if you’re sure the market will go down. Again everyone would like to avoid the small loss but like any insurance the price to be fully protected would be too high. Careful use of options is another way to reduce the volatility by paying a small amount (a decrease in returns) to avoid losing a much larger amount.
If you had perfect knowledge of the market an index fund would hurt you, but for all regular investors the volatility comes with the asset class rather than the index. You can reduce the volatility at the same time as your returns, or you can pick a more stable asset class with lower returns, but the article fails to bring up a significantly better alternative (something which I find very unlikely). There are a few other complaints about index funds in the article as well – stay tuned for more!
April 27, 2009 at 9:55 pm
My view is that the two big pluses of indexing are that it offers huge diversification at low cost and that it is simple because it does not require researching stocks.
There are also two big downsides.
One is that indexing locks you in to the market return. That’s fine when the market is likely to do well in the long term (times of reasonable prices). It’s death when the market is not likely to do well in the long term (times of extremely high prices). Those picking stocks can do well even at times of great overvaluation. Indexers cannot.
The other big negative is that indexing is an artificial approach. Investors who pick stocks are forced to learn about the companies, which generally means they get better over time (or else get burned so bad that they get out of the market). I have come across a good number of indexers who don’t possess a sure grasp of how investing works. Indexing is so simple that you can go a long time without learning even the basics. That’s dangerous.
Overall, I view indexing as a great option that has been oversold by its proponents.
Rob
April 28, 2009 at 3:11 pm
There are several problems with index investing, but for the time input required there’s nothing that can beat it.
The market return can be seen in two ways. One is that it’s just the average and you can weed out the bad parts to do better; another is that it’s usually ok but the market as a whole sometimes goes in the wrong direction. The article seems mostly concerned with the first view but I’m more interested in the second. While I understand why it could be possible to do better than an index, that’s reserved for a very small fraction of investors who have the knowledge and the time to do research.
For most investors the best thing is to pick asset classes and get the most reliable exposure they can without getting into more details. In this case the easiest way to get the actual return of the asset class is with index funds. That still leaves the problem of when the whole market goes in the wrong direction, but the alternatives require exceptional skill to avoid that (beating the index alone, even when it goes down, is enough of a challenge). Unless you have the ability to find a consistent positive return with volatile assets the problems with the whole asset class will affect everyone who invests in it. This is when an informed investor can evaluate future potential and adjust their allocation.
Indexing does occasionally have downsides that aren’t discussed very often, but that depends on your skill level. For most investors who are liable to over-estimate their skill it’s better to buy index funds and ignore the news than to do nothing – or even to buy lifecycle funds so they don’t have to remember to make adjustments.