To Index or not to Index, That is the Question

I spend an inordinate amount of my time explaining to Indexers (those that tout that indexes are the only way to be effective with their investments) that there is SO much more to consider than simply buying an index. The main reason for the argument is costs. Indexes usually represent the cheapest options for packaged investments. John Bogle (the inventor of Vanguard and the index fund) has made a fortune by selling the concept of "cheap". Cheap is an attractive concept because it is simple to understand and easy to implement, but just like other things in life, cheaper is not always better. The argument goes lke this: 70% of mutual fund managers fail to beat the indexes so what does the extra cost buy me? Under performance? I personally hate mutual funds for many reasons, but that is a subject for another day, today I will focus on why "indexing" is a mistake in my opinion.

Index funds always 100% of the time under perform the index they represent. This is because you cannot invest directly into an index, therefore you must buy it in a  mutual fund, or an ETF, or individually buying each stock in the index. All three of these methods incur costs, so your performance will always be less than the index by the costs associated in acquiring your position. In order to get the index result, you must remain in the index 100% of the time, through all recessions and market turmoil. If not, the typical investor pays what is called the "investor behavior penalty". There have been many studies done on this subject and the results are shocking, a study done by Dalbar in 2011 showed the typical "stock fund" produced a return of 9.2% per year, while the average stock fund investor only earned 3.5%. The reasons quoted were:

• Pouring money into the latest top-performing manager or asset class, expecting the winning streak to continue

• Avoiding areas of the market that have performed poorly, assuming recovery will never occur

• Abandoning their investment plan by attempting to successfully time moves in and out of the market, a near impossible feat 

Successful investors throughout history have understood that building long-term wealth requires the ability to control emotions and avoid self- destructive investor behavior. 

Many of these so called index investors talk a big game and say that they are the exception, however my experience with them is just the opposite. If you were a true indexer from January 1, 2000 through December 31, 2010 (a full decade) you would have made nothing. The S&P 500 opened at 1425 to start that decade and finished the decade at 1282. If you include dividends, you barely broke even. Almost no one I know performed that poorly during that time frame. Indexers always look backwards (hind site is 20-20) and claim they were smart enough to avoid that decade. Il leave that up to you whether you believe that or not.

The next issue is volatility. Volatility actually eats your money. The way to maximize your volatility is to stay invested in indexes. The below illustration shows how erosive volatility is:

Let’s look at this example of 3 portfolios over a period of 6 years. All three portfolios have an average return of 5% over the 6 year period. Portfolio B experiences 10% more volatility each year than portfolio A; both in the up and down years. Portfolio C experiences 25% more volatility than Portfolio A.

Portfolio                                     A              B                C

Year 1                                       +5            +15            +30

Year 2                                       +5             -5              -20

Year 3                                       +5            +15            +30

Year 4                                       +5             -5              -20

Year 5                                       +5            +15            +30

Year 6                                       +5             -5              -20

Arithmetic Average                +5             +5              +5

$100,000 Invested

Value                                   $134,010    $130,396    $112,486

You will notice the greater the portfolio volatility the lower the value of the portfolio. Remember the average return is the same (5%) for all the portfolios. Yet because of compounding the ending values of the portfolio are quite different. Volatility has a large negative effect on actual spendable cash in the portfolio; therefore it’s important to implement portfolio risk control strategies. 

I hope that I have made it clear that the best strategy to long term investing is to manage risk. Indexes are not a strategy, If an investment makes sense for your risk profile then it will perform best for you. In the end, as an advisor, I never use indexes as a measurement because the only way to achieve those results is to accept the incredible volatility that accompanies indexing. It is clear that you may have a mathematical return to brag about, but I will have more actual dollars to spend......you can't spend a return!