Thursday, March 30, 2017

Five Myths About Index Investing

Index investing has become extremely popular in recent years. A lot of new investors have embraced the strategy in recent years. Unfortunately, many investors are embracing the strategy by believing certain myths that are simply not true. I am going to examine several of their problematic thought points, and discuss why they are myths that could hurt those investors in the future. In reality, there is nothing magical about index investing.

I will refute the five myths about index investing below:

1) 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 their original allocation. This is market timing, dressed up in indexing clothes.

Index investors fail to understand the fact that an index is merely a collection of investments, that is actively selected by a group or a committee, using some sort of a quantitative or arbitrary reason. For example, the index committees on 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 index S&P 500 routinely changes 4% - 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 on to 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, or in the case of the millionaire dividend investor Ronald Read.

For a portfolio to be truly passive in the indexing world, you need to own all investable assets in the world. Otherwise, you are exercising judgment, and hence you 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 in who is dressed up in passive investor clothes.

The author Cullen Roche has spoken in more detail about the myth of passive investing than me (also here).

2) Index investors do better than other investors.

There is no data to support this claim. Index investors suffer from the same issues like everyone else. Those issues include overtrading, chasing hot assets, picking tops, not sticking to their strategy, meddling too much with portfolios etc. 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 2008, if stocks went lower from there.

There is an infinite amount of combinations that index fund investors can pick and choose for their portfolios. So you do not know if your allocation will do better than someone else’s allocation.

The reality is that 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 that index funds have done better than mutual funds is because they have lower costs and lower turnover rates than other regular mutual funds.

This is it.

Of course, it makes intuitive sense that you will do better, if you pay only 0.10%/year to hold a portfolio of securities, rather than paying 1%/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 – 20 index funds to include in your portfolio.

My personal investment experience also shows that 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 strictly to the indexing route. However, I will never be so arrogant as to tell you that my portfolio is better than yours.

3) You do not need to save as much with index investing

Because of myth number two, many novice index investors believe that they need to save less than anyone else. As I mentioned in the myth above, investors do not know their future returns in advance.
Therefore, they forget that 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 that 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 themselves on spending too much money. This investor abandoned dividend investing, after determining that a 3% - 4% dividend yield will not produce enough income for them to live off in retirement. The interesting point about their approach is that they expect 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 them.

4) I will stick to Index investing through thick or thin

The funniest myth I have heard, comes from individuals who claim that they will stock to their active selection of index funds no matter what. Most people who today swear by indexing have only been doing it during a recent bull market.

After observing investor behavior for 20 years, I am reasonably certain that 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 from 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 – 2012 period, where their past performance was abysmal. This showcases the fact that index investors essentially continue their habits of chasing what it hot today, after it has gone up. I am just hopeful that they won’t 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 that the index fund itself won't make changes to the formula. I read once about an index investor who bought a balanced fund because they didn't want to tinker with allocations. Then 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, and changes 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 mish-mash 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 that mutual fund portfolio through a human or robo-advisor, and pays an annual fee for the right to select 15 - 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.

5) 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 that 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. 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 – 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%/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 piling on one-decision stocks or portfolios, without giving it much though.

Conclusion

Most index investors will hate this article. I am hopeful however that the lessons I shared in this article will inspire investors to improve themselves.

Noone 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 that an index fund portfolio will even turn a profit for you over your holding period. Of course because of the behaviors they exhibit, it is likely that this indexing approach is not a bad course of action for a large portion index investors who will stick to the strategy even when times get rough.

I didn’t write this article to tell you that index fund investing sucks, 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 life choices or to compensate for some deficiency they have.

I wrote this article in an effort to share my observations with investors, and help them become better versions of themselves.

The chief reasons for investor failures includes:

1) Not Saving Enough
2) Failure to develop and stick to their plan through thick or thin
3) Paying high investment costs for commissions, advisers, taxes
4) Overtrading
5) Chasing Performance
6) Blindly following others

An investor in index funds is not somehow magically immune to these problems.

If they stick to their plan however, they will do well for themselves.

Relevant Articles:

Time in the market is your greatest ally in investing
Is Buy and Hold Dividend Investing dead?
The Perfect Dividend Portfolio
Should dividend investors invest in index funds?
Dividend Investing Knowledge Accumulates Like Compound Interest
Five Myths About Index Investing


This article was written by Dividend Growth Investor. If you enjoyed this article, please subscribe to have future articles emailed to you [Email] or follow me on Twitter [Twitter]

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