What Index Investing Has in Common with Super-Investors

In the last post, we explored what traits many super-investors had in common. In this post, we will now compare those traits to the advantages of index investing to see a pattern of what traits work for earning the best investing returns.

Index investing should be the default position of anyone who wishes to invest, but does not know the first thing about investing.  The theory of index investing is based upon owning the whole market and gaining the diversification that goes along with that.  Some of the common arguments for index investing are:

• Most money managers underperform the market.  In aggregate, they underperform by about the average of their management fees.
• All participants in the market must perform at the market average (because in total they are the market).  So why not guarantee that you will earn market returns rather than taking the chance that you will fall in the bottom 50%.  This is especially the case when someone does not have specialized knowledge of an industry or of the internal workings of the market, or a privileged position within the market (such as a market maker, for example).
• The market is believed by indexers to be “efficient”, meaning that no one can gain an edge because the market pretty much instantly takes every bit of available information into account and arbitrages away any advantage.  For example, if someone knew a stock A was guaranteed to be underpriced relative to a stock B, they could buy stock A and sell stock B and realize a near riskless profit.  The players in the market would exploit this advantage until the prices of A and B adjusted to make this trade neutral.
• Index investing causes turnover to be lower in a portfolio.  Turnover often results from people selling winners that could have run even higher, but people want to take profits while they can.  Anyone who took profits on Coca Cola at any point in the last 100 years likely regrets that action, since they would have made so much more had they continued to hold.  Further, you realize capital gains taxes when you sell.  So those that have higher turnover, actually reduce their after tax gains because they pay more tax.  Unrealized gains in long term buy and hold investments can be used to grow even more money while they remain held.
• Behaviorally, indexes can encourage good investing habits.  Since you think of the S&P500 index fund as one thing rather than a basket of 500 things, you tend not to pay attention to the 10 stocks out of that 500 that are up 300% or down 90%.  Instead you continue to hold the index through thick and thin.  

Bogleheads.org has an extensive forum and wiki for discussion of index investing.  I would highly recommend reading their forums.  Be aware that they can be a bit fanatical about indexing as being the only way to invest.  Like most ideas that gain such staunch adherents, there is much truth in their wisdom, but as with any one-sided ideology it is an incomplete understanding.  We can take the best parts of index investing to make an even better strategy, and we will be exploring this extensively here and in future posts.

Suffice it to say, that I can provide directly, 3 examples of index beating strategies, using a favorite of index investors, the S&P500:

1. Steel companies have awful returns on capital and are horrible businesses to run because they require lots of the cash to be re-invested in the company just to keep the steel mill running.  In many years, profit margins are so thin or negative, that the company must incur debt and/or realize losses that deplete its cash reserves.  If you held steel mills for the past 100 years, you vastly underperformed the market.  It is very likely, given their economics, you would continue to underperform over the next 100 years.  It’s not that steel mills aren’t economically valuable.  They generate immense value for society.  But none of that value accrues to the steel mills as they compete with one another on price just to stay in business.  One could construct an S&P 500 index that excludes only steel mills and have an index that then outperforms the S&P500.  Repeat with similarly awful industries and eventually you will end up with a meaningfully better self-built index than the S&P500.
2. The annual turnover of the S&P500 is about 4.4% on average.  This means, about 4.4% of the companies will leave the index, and new companies will be included based on the rules for constitution of the S&P500.  When a company is booted from the index, it forces the index fund to sell the stock recognizing a taxable capital gain.   Further, the rules can be somewhat arbitrary for when a company leaves and is included.  Several companies have been booted from the index only to return later after much growth has already happened during the period when the index fund did not hold that stock.  Jeremy Seigel has shown that if you held the S&P 500 original stocks from 1957 and never bought or sold (0% turnover), you would have trounced the S&P500 return.  Similarly, the ING Corporate leaders trust also known as the ghost ship portfolio, maintains a very low turnover portfolio of a collection of 1935 dividend paying stocks and their spinoffs, combinations, etc.  Despite its annual management fee of 0.5% (much higher than index funds) it absolutely trounced the performance of the S&P500 index.  Turnover seems to matter a great deal.
3. The S&P500 is a cap weighted index. This means you buy much more of the most highly valued top 10 companies in the S&P in terms of dollars.  This has been recognized in recent years and value weighted indexes have made their appearance.  However value weighted index funds have higher expenses because they must be more actively managed.  You can easily manage a similar list of companies in your own portfolio by simply buying those on your list that you have the least percentage of your portfolio allocated to, or by buying those stocks that are most undervalued by some series of measures.

There are many more examples of ways to construct a personal index fund or series of stocks that outperforms existing index funds.  We will discuss this as we learn these methodologies in future posts.  Now that we have discussed what some advantages and limitations of index funds are, let us pull together the common threads of what makes index funds provide superior return to most investors.  We will use this later when we are building our own strategy to push that strategy to higher returns over time.  Index funds confer both actual and psychological benefits to the investor that result in earning better after tax returns over time than short term behaviors.  These include:

• Index investing can essentially be a core ethos for investing, giving the investor a north star to point towards, and confidence in times of trouble to be able to stick with the discipline necessary for good long-term investment returns.
• Index funds can be used to maintain discipline in investing.  You tend to think of the index fund as one thing (even though it isn’t), and don’t panic when one stock within the index drops 90%, or sell when another stock goes up 200%.  This psychological trick helps you over the long term.
• Index investing is a simple set of strategies that can be easily implemented in practice.  Some like to make it more complicated, but for the most part, these strategies are relatively easy to execute and manage for the long haul.  This can assist in maintaining discipline, avoiding the temptation to get fancy as well as in avoiding the latest investing fad.
• Index funds provide lower turnover relative to the typical active investment strategy or mutual fund.  Low turnover helps maintain tax efficiency to produce the highest after tax returns, which are the only returns that matter to your wealth.  It also allows winners to continue to run and generate returns.
• Index funds facilitate a buy and hold mentality.  Because the underlying stocks within the index are opaque to you, you don’t worry about trying to manage the individual components.  Automatic investments in a pre-determined set of indices along with auto-rebalancing are available to basically put your strategy on auto pilot and make it boring or less like gambling.  This makes it less likely for you to want to constantly manage the process and “gild the lily” so to speak.  A buy and hold mentality allows winning stocks to run and continue to make gains, while also maintaining maximum tax efficiency.  Capital gains taxes are delayed for many years allowing that capital to earn more return in the meantime.
• Index funds can give near maximal diversification with a simple strategy.  There is little risk of a single event catastrophic loss.  The investor can be confident buying and holding for long periods of time, even if there were severe temporary stresses in the system leading to the failure of a number of individual companies.
• Index funds can provide peace of mind.  You don’t panic sell as much with an index fund during a market crash due to the diversification.  This is still a danger for skittish investors, but less so with an index fund.  In order to persevere in investing, you must be able to avoid panic selling during market crashes.
• Index funds allow investors without any knowledge of how to analyze companies a method of investing that is guaranteed to earn market rates of return with maximal diversification and protection from loss.
• Index funds can help encourage time in market and discourage timing the market.  While some still try to time the market with index funds, there are automated index investing processes from automatic saving / paycheck deduction, to automatic allocation, to auto re-balancing to help investors avoid this temptation.  In addition, the comfort of earning guaranteed market returns without worrying about trying to outperform or avoid underperformance also bolsters the investor against the desire to time the market.
• Index investing strategies can allow for diligent saving and investing at regular intervals.  It is easy to put a fraction of a paycheck away automatically each pay period.  It is also easy to dial in allocations to various indices, as well as to auto-rebalance every so often.  With target retirement funds, all of this is even done for you within the fund.
• Index investing minimizes expenses.  Expense ratios tend to be extremely low.  Buy and hold tends to be encouraged, thereby minimizing taxes.
• Index investing can minimize volatility from idiosyncratic risks of individual stocks.  Coupled with allocation amongst several types of indices with low or negative correlations, volatility can be further reduced.  This can allow the investor to be more psychologically comfortable with a high allocation to stocks for the long term, which will usually earn higher inflation adjusted after tax returns over time than a high allocation to bonds.

If you compare this list of advantages to the list of traits of past successful investors that I discussed previously, you will notice a pattern of successful behaviors emerging as the two lists closely parallel one another.  We are going to use this pattern as we build our investing strategies in future posts.