Index investing has become extremely popular in recent years as a lot of new investors have embraced the strategy. Unfortunately, many investors are adopting the strategy because they believe certain myths that are simply not true. I am going to examine several of their problematic points and discuss why these myths could hurt those investors in the future. In reality, there is nothing magical about index investing.
I will refute five myths about index investing below:
Indexing is passive investing
Indexing is not passive because there is a requirement for the investor to exercise judgment as to which index funds to select. It then also imposes forced market timing through buying and selling of assets at certain time periods. In addition, the indexes themselves comprise portfolios of individual stocks or bonds which constantly add or remove components for a variety of reasons. One recent example includes this advisor, who decided to add to international stocks in early 2015 rather than stick to the original allocation. This is market timing dressed up in indexing clothes.
Index investors fail to understand an index is merely a collection of investments that is actively selected by a group or committee using some sort of quantitative or arbitrary reasoning. For example, the index committees of the S&P 500 or Dow Jones Industrial Average make active component changes for various reasons. As you can see, an index investor actively chooses their funds, and then the funds themselves actively choose the components using some criteria.
For example, the popular S&P 500 index routinely changes 4% to 5% of its holdings every year. It also engages in changes to the strategy, such as the one in 1976, the massive allocations to technology stocks in 1999, the elimination of foreign companies in 2002 and changes to its weighting mechanisms in 2005.
In contrast, a dividend investor can build a diversified portfolio of individual dividend stocks and just hold onto it through thick or thin without paying any costs or having much forced turnover. This is a much better form of passive investing, which has worked in the case of the Corporate Leaders Trust and for millionaire dividend investor Ronald Read.
For a portfolio to be truly passive in the realm of indexing, you need to own all investable assets in the world. Otherwise, you are exercising judgment and, hence, are an active investor.
Plus, if you are reading about investing and participate in active decision-making such as picking some indexes over others, you are essentially an active investor who is dressed up in a passive investor's clothes.
Author Cullen Roche has spoken in more detail about the myth of passive investing than me (also here).
Index investors perform better than other investors
There is no data to support this claim. Index investors suffer from the same issues everyone else does. Those issues include overtrading, chasing hot assets, picking tops, not sticking to their strategy, meddling too much with portfolios and so on. I have observed index investors who get scared away when stock prices fall. I have also observed index investors who cannot stick to their portfolio holdings when stock prices go up, and then they have the tendency to sell. I have also observed index investors who grow impatient after an asset class they selected goes nowhere for a decade. Case in point is this famous index investor who was considering selling his index funds during the bear market lows in 2008Ă‚ if stocks went lower from there.
There is an infinite number of combinations index fund investors can pick and choose for their portfolios, so you do not know if your allocation will perform better than someone else’s allocation.
The reality is you cannot say in advance whether your selection of index funds will do better or worse than someone else’s portfolio.
The only real reason index funds have performed better than mutual funds is because they have lower costs and lower turnover rates. That is all.
Of course, it makes intuitive sense that you will do better if you pay only 0.10% per year to hold a portfolio of securities, rather than paying 1% per year for the same group of stocks.
As a dividend investor, I take this idea even further by paying a one-time fee to buy each portfolio component and then to sit on it for years, without incurring any investment fees in the process.
It is pretty simple to identify a number of companies to include in a portfolio, and then set it and forget it. It is as simple as identifying 15 to 20 index funds to include in your portfolio.
My personal investment experience also shows index fund portfolios are not always better for you. In fact, my dividend portfolio has done better for me than any index fund portfolio I could have selected had I gone the indexing route. I will never be so arrogant as to tell you my portfolio is better than yours, however.
You do not need to save as much with index investing
Because of myth number two, many novice index investors believe they need to save less than anyone else. As mentioned previously, investors do not know their future returns in advance.
Therefore, they forget the only things within their control is their ability to save, their decision how to invest those savings and the amount of time they will let their investments compound for them.
The fact these people are even thinking about it is an interesting point to note about their unrealistic assumptions.
In fact, there was one former dividend investor who prides himself on spending too much money. This investor abandoned dividend investing after determining a 3% to 4% dividend yield will not produce enough income for him to live off of in retirement. The interesting point about his approach is he expects to have a 6% withdrawal rate in retirement using index funds. Unfortunately, the discipline of living within your means that dividend investing imposes was too restrictive for him.
I will stick to index investing through thick and thinÂ
The funniest myth I have heard is from individuals who claim they will stock to their active selection of index funds no matter what. Most people today that swear by indexing have only been doing it during the current bull market.
After observing investor behavior for 20 years, I am reasonably certain many of those investors will abandon their strategy when things go south. As a matter of fact, many investors will also abandon their strategy when things go north, or if their investments tread water for extended periods of time. Most index investors today are recent converts who have mostly seen a bull market.
For whatever reason, I did not hear about the simplicity of index funds from anyone during the 2008 to 2012 period, where their past performance was abysmal. This showcases the fact index investors essentially continue their habits of chasing what is currently hot after it has gone up. I am just hopeful they will not end up “changing their asset allocation to become more conservative” if their selection of index funds starts going down.
Even if an investor decides to stick to their investing plan, there is no guarantee the index fund itself will not make changes to the formula. I read once about an index investor who bought a balanced fund because he did not want to tinker with allocations. A few years later, the fund started making changes, tinkering with the funds and weights in the portfolio. This renders historical performance prior to the tinkering obsolete, changing the expected returns for the portfolio.
Many index investors continue timing the market, constantly buying and selling investments, failing to stick to a plan, getting impatient after an investment goes nowhere or getting fearful when stock prices go down. Many of those investors who lacked the discipline to build their own portfolios are now exhibiting this same behavior by haphazardly picking a mishmash of mutual funds (and also considering themselves smart enough to be evaluating credit risk by picking peer-to-peer loans). It would be interesting to see how many self-proclaimed index investor diehards will stick to their investments when the bull market ends. Last but not least, if that investor owns a mutual fund portfolio through a human or robo advisor and pays an annual fee for the right to select 15 to 20 individual funds for their portfolio, they will cost themselves a lot of money in the process.
To be successful in investing, you need to build a portfolio and sit on it for decades while minimizing turnover and expenses. Unfortunately, index investors regularly tinker with their allocations.
You do not need to worry about anything with index investing
I call this myth “ famous last words.” One of the dangers of index investing is it forces you to buy regardless of valuation in order to stick to your plan. This could be good from a discipline point of view. But it could be bad if it forces you to continue paying stratospheric valuations for a group of assets, regardless of their future expected returns. For example, paying over 30 times earnings for any index fund is likely to deliver low future expected returns.
Valuation does matter as it determines what future returns will be. Overvaluation was the reason why the Vanguard Pacific Index Fund did not return much over inflation over the past 27 years. Paying too much for equities is dangerous. Too much, in my opinion, is 25 to 30 times earnings or more. Sticking your head in the sand is dangerous. Buying asset classes for the sake of following some blind model could be costly down the road.
For example, a lot of investors today are holding a large portion of fixed-income instruments today, which are unlikely to generate much in terms of long-term returns. With a 10-year bond, the most you will get is 2.50% per year unless you are willing to take on more risk. A portfolio that is heavy on fixed income does not have high expected returns. A portfolio that is more equity-centric will have higher expected returns today.
As a rule, I am worried when a group of investors pile into one-decision stocks or portfolios without giving them much thought.
Conclusion
While most index investors will hate these insights, I am hopeful the lessons shared will inspire investors to improve themselves.
No one knows in advance if their portfolio of index funds will do better or worse than a portfolio of dividend stocks over any period of time. There is no guarantee an index fund portfolio will even turn a profit over your holding period. Of course, because of the behaviors they exhibit, it is likely this indexing approach is not a bad course of action for a large portion of index investors who will stick to the strategy even when times get tough.
My intention in sharing this information is not to tell you index fund investing is stupid and that dividend investing is better. People who make such arguments need to make bold claims in order to make themselves feel better about their poor choices or to compensate for some deficiency they have. Rather, my intention was to share my observations with investors in order to help them become better versions of themselves.
The chief reasons for investor failures include:
- Not saving enough.
- Failure to develop and stick to their plan through thick and thin.
- Paying high investment costs for commissions, advisers and taxes.
- Overtrading.
- Chasing performance.
- Blindly following others.
An index fund investor is not somehow magically immune to these problems.
If they stick to their plan, they will do well for themselves.
