The year 2020 will go down in history as one of the strangest periods on record for the stock market. The first quarter was defined by one of the sharpest market slumps in history as investors rushed to dump assets in the face of the pandemic.
However, in the second quarter, sentiment changed utterly. Following colossal market intervention from central banks around the world, risk assets charged higher. The quarter was one of the best on record for the stock market.
Despite this whiplash performance, any investor or analyst that took time to consider the underlying economic fundamental data would have seen spending collapsing, bad debts rising and overall borrowing growing. GDP has collapsed, wages have dropped and unemployment has soared. This isn't limited to just the United States. Virtually every country in the world is suffering. Yet, the stock market continues to act as if nothing has happened, barring the one dramatic blip in February to March.
This has resulted in a somewhat tongue-in-cheek philosophy building among investors and traders. "Stocks only go up" has become the tag line for investing. No matter what happens to the global economy, stocks will only go up, the philosophy dictates.
This idea has attracted plenty of criticism. Critics argue that stocks won't go up forever, and it's only a matter of time before those traders following this philosophy end up losing everything.
Highly-paid wealth managers, Wall Street analysts and famous investors like Warren Buffett (Trades, Portfolio) all say that buying stocks on nothing but the hope they will go up is not a sensible investment strategy. Instead, they argue investors should buy index funds for the long term. But isn't this the same piece of advice?
Relying on the index
On several occasions in the past few years, Buffett has stated that the best investment for most people is an S&P 500 index fund. He believes this to be the case because the index beats most active managers over the long term. That statement is true, although we have to ask why it is true.
It's true because the S&P 500 has risen over the long-term at an average rate of 9% per annum. Put these two factors together, and Buffett is inferring that investors should buy the S&P 500 because stocks only go up.
If he didn't believe that, he might advocate other products. If he didn't believe that stocks only go up, he might have advocated buying individual companies, private equity funds or bonds. These investments might do a better job of protecting wealth if stocks didn't always go up.
The industry standard
I'm unfairly picking on Buffett here. Most robo and non-robo advisors advocate a similar approach, which has been quickly adopted by the FIRE movement. This movement suggests that it's easy to retire early if you save lots and invest all your money because stocks only go up.
At this point, I should note that there is nothing manifestly wrong with this approach. History shows us that stocks generally increase in value over the long term. It seems sensible to bet on the fact that this will continue as the global economy grows, productivity increases and innovation drives new sectors and industries.
Nevertheless, it seems sensible to acknowledge that relying on index funds alone relies on the principle that stocks only go up. If Buffett and other money managers didn't believe this, it's unlikely they would advocate index funds in the first place. Active managers would be a better option. Active managers can pick and choose the best stocks based on a range of factors.
There is no right or wrong answer to this issue. It's just something that I think is worth considering in the current market. If you believe the "stocks always go up" mentality is wrong, that clashes with the "index funds are best" mentality.
Disclosure: The author owns no share mentioned.
Read more here:
- Warren Buffett: Growth Stocks Are Not Always the Best Option
- Charlie Munger's Advice on How to Get Rich
- Charlie Munger on How to Think Like an Investor​
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