There’s a lot of noise/criticism about index-investing. This noise comes from active investment managers (obviously) and they argue that index-investing is just as risky as investing in regular stocks. The best you can do, they say, is get an average return (the return of the S&P 500). No, they say, you should stick with active investment managers and pay them so you can get a better return than the market average.

This is ludicrous. Trying to scare people away from indexing serves only one group and that’s the active investment community. Index investing is one of the best way’s to invest your money in the long run. However, it’s not as simple as just investing a large amount in the S&P-500 index once and then hoping for the best. The trick is dollar-cost averaging.

1. The criticism of indexing

Index investing got started in the 70’s with John Bogle. He was a big proponent of investing your money in a mutual fund that follows an index. Why? Because you don’t need a highly ‘skilled’ and payed fund manager to analyze tons of companies and pick the right ones. You simply look at the composition of, for instance, the S&P-500 and allocate money in the same proportion of companies as the index is comprised of. This way you are guaranteed the same return as the index and you don’t have to charge people a high fee because costs for this are pretty low.

2. So what’s the problem?

Well, of course, Mr. Bogle’s proposal was met with massive ridicule and criticism. It was supposedly un-American to be a passive investor and take satisfaction in getting an average return. Even today people argue that investing passively in an index is risky because there are long periods of time where the market has gone nowhere, lost decades, etc. Take a look at the following chart:

sp_2000_2010_2

At the beginning of 2000 the S&P500 index was around 1400. At the end of 2010 it was around 1200.

  • ‘That’s -14% after 10 years!’
  • ‘If you would’ve invested $10,000 in the market in 2000 you would’ve had $8,600 in 2010!’
  • ‘The market did nothing!’,
  • ‘Index investing is horrible!’

This kind of ‘exposition’ is nothing more than scaremongering.

First of all, the companies in the S&P-500 pay a dividend, so had you actually invested $10,000 in 2000 and done nothing further, you would’ve had around $10,600 in 2010. That’s not a great return, I’ll give you that, but it’s not negative!

Furthermore, this shows a worst case scenario. We started our investing example at the top of the market during the dot-com bubble, invested once, and pulled out our money after the Great Recession. And still you had a positive return! (by doing nothing).

Now let’s take a look at a regularnot-worst case scenario‘ example. We will apply something called dollar-cost averaging now. This is a fancy term for saying: ‘invest money for a longer period of time by making periodic (monthly) payments, not one big payment at the start.’

Let’s say you had $10,000 in a savings account in 2000 and started investing by putting a monthly $77 from your savings account into the S&P-500 index and every month you increased your monthly investment by 0.1% (because of the time value of money, we will not get into this here). At the end of 2010 you would’ve invested a total of $10,951 and actually had a total of $12,810. That’s a 16% return, not -14%! (In actuality, you would have had even more because the money in your savings account would give you a certain interest as well, but that’s beside the point and might drive focus away).

Don’t worry if you can’t follow all the numbers. The main point to take away here is: ‘Don’t look at graphs and make assumptions.’ Calculating returns is more complicated than just showing someone a colorful picture of a market going up or down. If you want to calculate returns you need tables with numbers, not pictures.

Now, we can obviously make an argument that dollar-cost averaging works equally well with actively managed funds. And this is true. The previous (somewhat lengthy) explanation was there to show you that the argument ‘the market did nothing’ is not a valid argument against index-investing. That is not to say that we now have a valid argument for index investing.

3. What are the arguments for index investing then?

Two main things. [1] Costs and [2] Ease.

3.1. Costs

The Vanguard 500 Index Fund Admiral Shares (VFIAX) tracks the S&P500. It has an expense ratio of 0.04% annually (link). The average mutual fund charges 0.78% and some active funds charge 1+%. So by investing in the index fund (or the equivalent ETF) you already save upwards of 0.74% yearly.

Add to this that the performance of actively managed funds is abysmal. About 66% of mutual funds under-perform the S&P500 on a yearly basis and, more than 80% of actively managed funds under-perform the benchmark over a 15-year period.

This makes sense of course. Active managers as paid a salary in the form of a fee. It doesn’t matter if they return 10%, 20%, or – 20%, they will get their fee. As long as they don’t do any weird things (though, it’s often the weird things that make the big returns). So from a motivational point of view, active managers seem to be set up for failure. This shouldn’t be very appealing to people who want to invest large amounts of money with them.

3.2. Ease

The ease of investing in an index-fund is attractive. When you pick your own stocks, you need to spend a lot of time learning accounting concepts. You might also need to read a lot about economics, history, and psychology. Even then there is no guarantee that you will do any better than the index. Think about it, there are thousands of active managers around the world spending the equivalent of a full time job analyzing stocks and only a small portion of them is able to outperform index-funds. What makes you any better?

If you don’t want to spend your week analyzing small and obscure companies, just buy the index and forget about it. You can then devote your time to what’s meaningful to you in life. As John Bogle himself said:

“Don’t look for the needle in the haystack. Just buy the haystack”
John Bogle, The Little Book of Common Sense Investing

4. There is no value in analyzing stocks then?

Quite the contrary. I believe that devoting your time 100% to analyzing markets and having a long-term horizon will give you an edge and will create satisfactory results. Just like with any subject you study, passion and persistence are key. But this is what an equity analyst does. Not a day-trader or active manager. So yes, being an equity analyst is fine and even productive.

5. To sum up

If you are 30 years old and starting to save for retirement. Spend less than you earn and put the savings in an index fund (Vanguard 500 Index Fund preferably). Don’t touch it for at least 15 years and be sure to add monthly (or at the very least, yearly) to it. It sould give you between 6% and 10% annually over the longer term. Way better than any current savings-account interest rate.

Sources:

  • The Little Book of Common Sense Investing (by John C. Bogle)