Meet Ian… the index investor.
One evening, while watching CNBC from the comfort of his couch, Ian listened as a guy in a fancy suit told him that index investing is the easiest way to make money in the stock market.
All he had to do, the guy insisted, was to follow the strategy through thick and thin, and he’d be wealthy.
What the guy left out is that successful investing, like everything else in life, requires work.
If I’d been part of the conversation, I’d have told Ian that most of what the guy on his television told him about ETFs is wrong.
Let’s find out why…
Index Investors Perform Better
Index investing reminds me of a political movement.
Sometimes supporters are plentiful… other times, they’re thin on the ground.
Currently, the former is the reality.
The stock market has been performing well during the recent expansion, and the argument for index investing has proven valid.
If you invested in 2009, at the start of the current bull run, you would have tripled your money by now… explaining why index investing has lately gained many followers.
However, if you look a little further back in history, you find that there have been periods when the return on this strategy has been dismal.
Those who invested in the S&P 500 in 2000, at the top of a bull market, had to wait more than 15 years to see positive returns on their investments (adjusted for inflation).
And, even if you had invested in 1997, in the middle of the cycle, a decade-and-a-half later, you would still be at 0% return.
That’s longer than any sane investor is willing to wait… and why nobody was hyping index investing at the time.
Indexing Is Passive Investing
Most seem to think that indexing is a form of passive investing. That you just add money to the account and it magically grows.
Nothing is that simple or easy. Even index investing requires a lot of work.
First, you must judge which fund is best for your needs. You need to analyze its constituents, dividend yield, and expense ratio.
Moreover, you must correctly estimate the macro conditions. How will a trade dispute, for example, a currency crisis, or low GDP growth affect stocks in these funds?
Then you need to look at market timing. Mistime your purchase, and you could find yourself overpaying or, worse, buying into a bear market.
Finally, remember that index portfolios are comprised of hundreds of bonds and stocks. The mix changes all the time… and not always for the better. You must actively monitor adjustments to see if your investment still makes sense.
Index Investing Is Not Safer Than Any Other Kind Of Investing
Another common misconception is that index investing is safe. But that’s only because people are not aware of the risks.
ETFs are notoriously vulnerable to increased volatility. In such times, market pressures can lead to a considerable price disparity and loss of value. During the flash crash of 2010 and again in August 2015, funds tracking the S&P 500 went haywire, dropping by 20% to 50%.
ETFs also buy high and sell low (that is not a typo).
When an index changes constituency, it must announce that change in advance. This gives arbitrageurs an opportunity to buy the stocks coming in, driving prices up, and then sell (short) the stocks going out, pushing their prices down, resulting in ETFs buying high and selling low.
Further, when investing in smaller funds, such as those that track lesser-known indexes, you run an obscurity risk. The provider could simply decide to discontinue the product. In this case, the fund would either forcefully liquidate you… or leave you with an illiquid zombie ETF. Either way, you’re left with no choice but to sell at a significantly discounted price.
How To Beat The Pants Off Index Investing
Index investing defies logic.
The idea is that you can make money without thinking about it. If that were true, we’d all be Wall Street billionaires.
Don’t get me wrong. I’m all about holding multiple stocks in my portfolio. But those stocks should be the best the market has to offer, and I want to know each one intimately.
When you make individual quality picks, the potential for success is far greater. If you had successfully identified the FAANG stocks in 2015, you would have beat the S&P 500 by more than four times in only three years.