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Sunday, 27 December 2009

Index Funds Are Overrated

Virtually every single personal finance blog or book I read claims that index funds are the solution to all your money problems. Simply invest in an index fund and you will be rich.

Normally what happens is the person recommending index funds will claim that investing in passively managed funds is cheaper and less risky than investing in actively managed funds.

I think that index funds can be great (I use them myself) but there are many misconceptions people get from the index buy-and-holders that I feel I should warn you about.

1. Is the index diversified?

Many people say that investing in a single company is risky because that company could collapse. They then recommend you invest in a fund that tracks the S&P500 index. But the S&P500 index tracks the performance of only American companies. How can you be properly diversifying if you invest in companies that are headquartered in one country and there are hundreds of other countries whose companies you can invest in? What if national tax laws negatively affect American companies? What if the American economy simply collapsed?

2. Holding for the long run does not guarantee gain.

Many people say that if you buy-and-hold for the long run you will reduce risk. This is not true. There is no solid evidence for this. The companies that sell you mutual funds know they cannot give this guarantee so they tempt you by showing you long-run charts showing their investments going up over the long run to give you the impression that in the long run it will go up, but when you read carefully their contracts they always say, "Past performance is no indicator of long-term performance."

The reality is that perpetually rising index performance is dependent on perpetually rising company profits and perpetually rising company profits depend on perpetual technological innovation. How can perpetual technological innovation be guaranteed?

Many buy-and-holders often concede this, saying that of course there is risk in investing for the long term. But then they often say that they have incredible faith in business, in capitalism, in America, or whatever. Warren Buffett's line is, "It never pays to bet against America." I don't disagree with this. I think you should invest in whatever investments you strongly believe are undervalued. However, buy-and-hold indexers are not supposed to believe this. They are supposed to believe not in stock selection but in diversification. That is why they prefer indexing as opposed to selecting specific stocks. Likewise, if you want to diversify over time you cannot be a buy-and-holder because by doing so you bet on long-term success as opposed to short-term or medium-term success. If indexers believe in diversification they should diversify across time as well instead of just betting everything on the long-term performance of corporate America.

3. Laziness, not just greed, can create asset bubbles

The Great Recession of 2007-09 was triggered when the residential property market in American collapsed. Many citizens saw property values going up and up. "Property always goes up," they all said at barbecues and dinner functions. "Property doubles every seven years." "Property cannot go down." All these lies get passed around and people, driven by greed, invest in an asset based on ignorance. An asset bubble occurs when the value of an asset is above fundamental value. Price is above fundamental value if people investing in the asset are ignorant of its true value.

Just as greed can drive people to invest in poor assets, so too can laziness, which is how index funds can create asset price bubbles. Many people just lazily invest in index funds thinking it is an infallible investment. The problem has gotten worse lately as many retirement funds also invest in index funds, which mean that many average citizens invest in index funds without even knowing it. Because this investing is completely blind, prices are guaranteed not to reflect fundamental value since fundamental value requires people buy according to information about that asset and if people are lazy and just buy anyway, prices are bound to be higher than fundamental value.

This is most obvious when you look at the dividend yield of S&P500 funds. The Wikipedia article on the S&P500 dividend yield says the following:
In 1982 the dividend yield on the S&P 500 Index reached 6.7%. Over the following 16 years, the dividend yield declined to just a percentage value of 1.4% during 1998, because stock prices increased faster than dividend payments from earnings, and public company earnings increased slower than stock prices. During the 20th century, the highest growth rates for earnings and dividends over any 30-year period were 6.3% annually for dividends, and 7.8% for earnings. As of 2008, the average dividend yield is around 2%
Sure, investing in the S&P500 index fund would make sense when the yield is 6-7 per cent, but nowadays the yield is 2-3 per cent.

The chart below from Imarc.org shows how S&P500 dividend yields have gone down over time.


Now I do understand that not all indexers recommend you simply buy into a fund that tracks the S&P500 and then just leave it forever. Many now claim you should diversify into non-American stocks, into bonds, commodities, and so on. Many even recommend the Permanent Portfolio. But this is not how it used to be. I think many of the Bogleheads have become more conservative after losing so much money after the GFC.

I do think it's wise to diversify if you don't have information and you want safety, but if you're going to diversity you should diversify totally, which means more than just the S&P500. I only believe that you should totally diversify for money that you need, i.e. money you need to cover necessities like food. I believe that if you have quite a lot of money (a net worth of more than, say, $100,000) then you can afford to take on more risk, which means you should try to diversify less and, if you have time and think you're good enough, you should try to time markets or select good investments.

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