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!

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