Chapter 11
Index funds are really just for lazy
people, right?
Ah, no. Index investing is for people who want the best possible results.
Over the past couple of years, some of my investing ideas have drawn comment from other writers. While honored, I’ve noticed that even those folks seeking to compliment me sometimes frame my position on Vanguard and index funds as sound advice, but only for average people who don’t want to work very hard at investing. The idea being that with a little more effort and smarts in the selection of individual stocks and/or actively managed funds, more diligent folks can do better.
Rubbish!
Back in Chapter 7, I introduced you to Jack Bogle. For my money (pun intended), no one has done more for the individual investor than Mr. Bogle.
From launching Vanguard and its unique structure that benefits shareholders to creating index funds; he is a Titan in the financial industry, an investing saint and a personal hero.
Now in his 80s, here’s what he has to say about successfully besting the market: “I’ve been in this business 61 years and I can’t do it. I’ve never met anybody who can do it. I’ve never met anybody who’s met anybody who
can do it.”
Neither have I.
This reality is something he had recognized decades earlier working on his thesis as a student and his decades in the business only served to confirm it. Namely, buying all the stocks in the market index reliably and consistently outperforms professional management, especially when taking costs into consideration.
The basic concept of indexing is that, since the odds of selecting stocks that outperform are vanishingly small, better results will be achieved by buying every stock in a given index. This idea fundamentally challenged and threatened the rationale behind paying high fees to Wall Street professionals. Not surprisingly, the pushback was swift and harsh. Mr.
Bogle was roundly ridiculed at the time and in some quarters still is.
But increasingly over the past 40 years since his launch of the first index fund, the validity of Bogle’s idea has been repeatedly confirmed.
The harsh truth is, I can’t pick winning individual stocks and you can’t either. Nor can the vast majority who claim they can. It is extraordinarily difficult, expensive and a fool’s errand. Having the humility to accept this will do wonders for your ability to accumulate wealth.
There is even a school of thought that suggests superstar investors— think Warren Buffett, Peter Lynch and Michael Price—are simply lucky.
Even for a hard-core indexer like me, that is tough to wrap my head around.
Yet the research suggests that only 1% of the very top-tier of money managers outperform, and on the rare occasion they do it is hard to distinguish skill from luck.
So if this is the case, why do so many still resist the idea of indexing? I think there is a lot of psychology behind it. These are a few of the reasons that occur to me:
1. It is a challenge for smart people to accept that they can’t outperform an index that simply buys everything. It seems it should be so easy to spot the good companies and avoid the bad. It’s not. This was my personal hang-up, and I wasted years and many thousands of dollars in the vain pursuit of outperformance.
Consider that in the 1960s the U.S. government was seriously considering (it never happened) the forced breakup of General Motors. GM was deemed so dominant and powerful that no other car company could compete. This is the same GM that survives today only by the grace of a huge bailout by that same government. On the other hand, back in the 1990s the smart money was betting Apple might not survive. As of this writing it is the single largest U.S. company as measured by market capitalization.
Today’s stars are tomorrow’s wrecks. Today’s fallen are tomorrow’s exciting turnarounds.
2. To buy the index is to accept the market’s “average” return. People have trouble accepting the idea of themselves or anything in their life as average.
But in this context the word “average” is mostly misunderstood. Rather than meaning index fund returns are at the midpoint, the word “average” here means the combined performance of the all the stocks in an index.
Professional money managers are measured against how well they do against this return. As we’ve seen, in any given year most underperform their target index. Indeed, over periods of 15 to 30 years, the index will outperform 82% to 99% of actively managed funds.
This means just buying a total stock market index fund like VTSAX guarantees you’ll be in the top performance tier. Year after year. Not bad for accepting “average.” I can live (and prosper) with that kind of average.
3. The financial media is filled with stories of individuals and professionals who have outperformed the index for a year or two or three. Or in the very rare case, like Buffett, over time. (I cringe at the often-touted suggestion to just do what Buffett does. As if!) It’s exciting and, after all, the companies that employ them are often advertisers. Or prospective advertisers.
But investing is a long-term game. You’ll have no better luck picking and switching winning managers than winning stocks over the decades.
4. People underestimate the drag of costs to investing.
Paying fund and/or advisor fees of 1-2 percent seems low, especially in a good year. But make no mistake, these annual fees are a devil’s ball and chain on your wealth. As a point of reference, the average mutual fund ER (expense ratio: the fee funds charge investors) is ~1.25%. The ER for VTSAX is .05%. As Bogle says, performance comes and goes but expenses are always there, year after year. After year. Compounded over time the amount lost is breathtaking.
Consider this: Once you begin living on the returns from your portfolio you’ll be able to spend roughly 4% of your assets per year. (We’ll explore this 4% concept in Part IV) If 1% of your money is going to management fees, that is a full 25% of your income.
5. People want quick results, excitement and bragging rights. They want the thrill of victory and to boast about their stock that tripled or their fund that beat the S&P 500. Letting an index work its magic over the years isn’t very exciting. It is only very profitable.
As for me, I seek my excitement elsewhere and let indexing do the heavy lifting of my wealth-building.
6. Finally—and perhaps most influential—there is a huge business dedicated to selling advice and brokering trades to people who can be persuaded to believe they can outperform. Money managers, mutual fund companies, financial advisers, stock analysts, newsletters, blogs, and brokers all want their hand in your pocket. Billions are at stake and the drumbeat marketing the idea of outperformance is relentless. In short: we are brainwashed.
Indexing threatens the huge fees money managers and their lot routinely collect. They thrive on enabling your belief in the vain quest for the alluring siren of outperformance. It is no wonder they disparage indexing at every turn.
Many years ago I had a martial arts instructor who was talking about effective street fighting. On the subject of high kicks he had this to say: “Before you decide to use kicking techniques on the street ask yourself this question: ‘Am I Bruce Lee?’ If the answer is ‘no’ keep your feet on the ground.” Good advice when you’re playing for keeps.
As cool and effective as kicks look in the movies, tournaments and in the dojo, on the street they are very high risk. Unless you are both very skilled and significantly more skilled than your opponent (something unknowable in street fighting or investing) they are likely to leave you exposed and vulnerable. Even, and this is critical, if you’ve had success with them before.
So too with investing. Before you start trying to pick individual stocks and/or fund managers ask yourself this simple question: “Am I Warren Buffett?” If the answer is “no,” keep your feet firmly on the ground with indexing.
Let me take a moment to be absolutely clear. I don’t favor indexing just because it is easier, although it is. Or because it is simpler, although it is that too. I favor it because it is more effective and more powerful in building wealth than the alternatives.
I’d happily put in more effort for more return. More effort for less return? Not so much.