In How to Find Money to Invest, I suggested investors just starting out to invest in a low-cost index fund such as Vanguard 500 Index Fund. It's a fine advice (because I gave it). Indexing is awesome because you don't have to know a thing about investing. But even if you hate investing, the least you can do for yourself is to understand indexing.
John Bogle, the founder of Vanguard Group, started the first index fund in 1975 after Burton Malkiel popularized the efficient market theory (EMT) and commented "It is time the public can [buy an index]." The EMT basically says the stock price reflects all the best information currently available (even though it may be incorrect) about the company. Now that you know what EMT is, you can skip all 522 pages of Burton Malkiel's A Random Walk Down Wall Street.
Because most mutual fund managers fail to beat the index, it makes perfect sense for the uninitiated investor to simply buy the index. But there are a few things you need to understand about indexing.
With indexing, you will at best earn a market matching return. In fact, when buying an index fund one of the most important factors to consider is the cost. The lower the cost the closer your performance to the index. By indexing, you are subscribing to the notion that the market is efficient. To put it bluntly, you are not willing to try to beat the market.
Warren Buffett wrote "in any sort of a contest — financial, mental or physical — it's an enormous advantage to have opponents who have been taught that it's useless to even try."[1] If you crave a market beating return, you will have to either pick your own stocks or invest in a mutual fund run by a guru.
Investing by definition is making buy sell decisions based on the difference between current price and perceived value. When you buy an index fund, you are not investing because you have no idea what you own. Yes, you know the tickers that belong in the index but you don't know the companies the tickers represent. Since you don't understand what you own, you will not be able to estimate its value.
In other words, you are buying in the hopes that the prices will go up not because the underlying of the securities will go up, but because you think the next buyer will pay a higher price. This is speculating. Don't get me wrong. Speculating is not a bad way to make money if you loathe investing.
As an index investor, you are inevitably buying high and selling low. When a stock is added to the index the price spikes. Similarly, when a stock is removed the price sinks. Two days after GameStop was added to the S & P 500 replacing Dow Jones, the shares surged 6%. This is because index fund managers were rushing in to buy the stock to match the index. With so many parties vying for a piece of the pie, it is only reasonable to expect to pay a higher price.
As a value investor, you just can't help but wonder: Did GameStop just become more valuable overnight because it was added to an index? Did it really increase its future cash flow overnight?
At a typical stock corporation, shareholders get to vote on matters that are important to the company and themselves. It is also one way (albeit not the most effective way) of keeping tabs on management. Sometimes winning a proxy fight against management (think Yahoo!) could be quite lucrative for the shareholders.
However, when you buy an index fund, you are waiving your rights to vote as a shareholder. You are leaving the voting decision up to the index fund manager. The index fund manager's only goal is to track the index closely. As a matter of fact, because the manager has no fundamental knowledge of the company, he is incapable of making an informed decision.
This may sound counterintuitive: the more investors index, the more inefficient the market. Because everyone assumes the price correctly reflects the value of the security, no one will try to correct the price even if it significantly deviates from the underlying value.
Barron's observed, "A self-reinforcing feedback loop has been created, where the success of indexing has bolstered the performance of the index itself, which, in turn promotes more indexing." As I pointed out earlier, an indexed stock typically trades higher than its non-indexed counterpart. But, when the market goes south, matching the index return seems silly when the non-indexed stocks perform better. Thus, indexers rush for the exits, promptly dumping shares as we saw recently with Lehman Brothers.
Despite the gloomy picture I painted for index investors, it is important to recognize that index funds still kicked the pants off the majority of the mutual funds. But at the same time, it is also crucial to understand the implications of investing in index funds. At least you know what to look out for.
For those who abhor everything to do with investing, index fund is still the best way to go. In the end, what matters most is you get to enjoy collecting wine corks if that suits your fancy while earning a decent return on your investment.
References
I'm Ye, a Principal of Qovax. Qovax is a small web development company that builds beautiful websites and thoughtful applications from sunny California. Read more articles like this on my blog.
John Bogle, the founder of Vanguard Group, started the first index fund in 1975 after Burton Malkiel popularized the efficient market theory (EMT) and commented "It is time the public can [buy an index]." The EMT basically says the stock price reflects all the best information currently available (even though it may be incorrect) about the company. Now that you know what EMT is, you can skip all 522 pages of Burton Malkiel's A Random Walk Down Wall Street.Because most mutual fund managers fail to beat the index, it makes perfect sense for the uninitiated investor to simply buy the index. But there are a few things you need to understand about indexing.
You will never outperform the market.
With indexing, you will at best earn a market matching return. In fact, when buying an index fund one of the most important factors to consider is the cost. The lower the cost the closer your performance to the index. By indexing, you are subscribing to the notion that the market is efficient. To put it bluntly, you are not willing to try to beat the market.
Warren Buffett wrote "in any sort of a contest — financial, mental or physical — it's an enormous advantage to have opponents who have been taught that it's useless to even try."[1] If you crave a market beating return, you will have to either pick your own stocks or invest in a mutual fund run by a guru.
You are not investing, but speculating.
Investing by definition is making buy sell decisions based on the difference between current price and perceived value. When you buy an index fund, you are not investing because you have no idea what you own. Yes, you know the tickers that belong in the index but you don't know the companies the tickers represent. Since you don't understand what you own, you will not be able to estimate its value.
In other words, you are buying in the hopes that the prices will go up not because the underlying of the securities will go up, but because you think the next buyer will pay a higher price. This is speculating. Don't get me wrong. Speculating is not a bad way to make money if you loathe investing.
You are buying high and selling low.
As an index investor, you are inevitably buying high and selling low. When a stock is added to the index the price spikes. Similarly, when a stock is removed the price sinks. Two days after GameStop was added to the S & P 500 replacing Dow Jones, the shares surged 6%. This is because index fund managers were rushing in to buy the stock to match the index. With so many parties vying for a piece of the pie, it is only reasonable to expect to pay a higher price.
As a value investor, you just can't help but wonder: Did GameStop just become more valuable overnight because it was added to an index? Did it really increase its future cash flow overnight?
You are forfeiting your shareholder rights.
At a typical stock corporation, shareholders get to vote on matters that are important to the company and themselves. It is also one way (albeit not the most effective way) of keeping tabs on management. Sometimes winning a proxy fight against management (think Yahoo!) could be quite lucrative for the shareholders.
However, when you buy an index fund, you are waiving your rights to vote as a shareholder. You are leaving the voting decision up to the index fund manager. The index fund manager's only goal is to track the index closely. As a matter of fact, because the manager has no fundamental knowledge of the company, he is incapable of making an informed decision.
Prevalent indexing leads to poor returns.
This may sound counterintuitive: the more investors index, the more inefficient the market. Because everyone assumes the price correctly reflects the value of the security, no one will try to correct the price even if it significantly deviates from the underlying value.
Barron's observed, "A self-reinforcing feedback loop has been created, where the success of indexing has bolstered the performance of the index itself, which, in turn promotes more indexing." As I pointed out earlier, an indexed stock typically trades higher than its non-indexed counterpart. But, when the market goes south, matching the index return seems silly when the non-indexed stocks perform better. Thus, indexers rush for the exits, promptly dumping shares as we saw recently with Lehman Brothers.
Despite the gloomy picture I painted for index investors, it is important to recognize that index funds still kicked the pants off the majority of the mutual funds. But at the same time, it is also crucial to understand the implications of investing in index funds. At least you know what to look out for.
For those who abhor everything to do with investing, index fund is still the best way to go. In the end, what matters most is you get to enjoy collecting wine corks if that suits your fancy while earning a decent return on your investment.
References
- Berkshire Hathaway, Inc., annual report for 1988, p. 18.
- Seth A. Klarman, Margin of Safety, HarperBusiness, 1991, p. 50 - 54.
I'm Ye, a Principal of Qovax. Qovax is a small web development company that builds beautiful websites and thoughtful applications from sunny California. Read more articles like this on my blog.
