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The end of indexing?
Question: Chris, My wife and I have been following your advice (and the advice of many others) for retirement investing for years. We have about 15 years until we hope to retire (of course, hope is the operative word there, since the gallows humor going around these days is that "80 is the new 65"). Basically, we buy broadly diversified index funds on a monthly, dollar-cost averaged basis, and we hold (about 65% equities and 35% bonds). I'm watching the beginning of yet another bloodbath day for the stock market this morning (October 24) and I've recently started to question this buy and hold strategy. It really hasn't work for the S & P over the last decade or so. With pundits throwing around opinions like "there won't be another secular bull market for a long time, but there will be cyclical bull markets in the coming years," isn't an active buy and sell approach a better one, and, if so, how does the average investor participate in that approach? Richard, Bozeman, MT
Answer: Another gallows joke I've heard is that a "walker" is the new corporate benefit.
On to your question: One personal finance lesson not to take away from recent experience is that indexing is a mistake. Yes, I imagine you're hearing talk about how professional money managers can avoid the investment carnage by trading adroitly. That's reminiscent, at least to me, of comedian Will Rogers famous quip, "Buy stocks that are going up. After they have done that, sell them. If they ain't going to go up, don't have bought them." Or, as Rex Sinquefield, chairman and chief investment officer at Dimensional Fund Advisors, once said: "There are three classes of people who do not believe that markets work: the Cubans, the North Koreans, and active managers."
There's no reason to believe that actively managed mutual funds will systematically do better after fees in this market--or any other market for that matter. (And a lot of hedge funds--managed by the best and brightest--are getting wiped out these days. It's one reason the stock market is so volatile.) In a sense, Wall Street takes its cut everytime an actively traded mutual fund or managed account makes a bet, and their take slices into returns. "Meanwhile, Wall Street's Pied Pipers of Performance will have encouraged the futile hopes of the family. ... will be assured that they all can achieve above-average investment performance - but only by paying ever-higher fees. Call this promise the adult version of Lake Woebegon."
Who wrote that? Ralph Nader? No, it was Warren Buffett, the greatest stock picker in modern times. He's spot on.
The expense ratios on index funds are razor thin--ranging between, say, 0.10% and 0.20% for a broad-based equity index fund vs. 1.0% to 1.5% for a comparable actively managed funds. Over the years, that fee advantage adds up. Then there is the cost of time. You have to ferret out good mutual fund money managers, or pick out stocks on your own, and then monitor them closely. That's tough to do. In a letter to shareholders Buffett made a strong case for the kind of value oriented stock picking approach that he practices--which is knowledgeably poring over balance sheets and studying management. But if truly understanding a company isn't your passion, then use index funds, he advised. "By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals," Buffett wrote. "Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb."
About the author
Christopher Farrell is economics editor of Marketplace Money, a nationally syndicated one-hour weekly personal finance show produced by American Public Media.
Wow, thank you NW. Your explanation was brilliant, easy to understand and makes sense. People have to remember that money managers only make money if you need them. They benefit from people getting all worked up and emotional over the market. Decisions should never be made out of fear. Most people get stuck looking at just the short run and forget that what is important in investing is the long run. Investments are a long run endeavor. And like you said, the percentage fall from the peak is not important unless you bought your entire portfolio at the peak. Thank you for the heads up on the article.
Broad index investing is still good if you dollar cost average and you have time to buy and hold. As Charles Bird points out in his Nov 10 post, investment horizons are important. This is supported by a bit of history.
Here's a view of the S&P 500 Highs and Lows from it's peak in late 1968. I used closing values and not intraday values when establishing these dates and percentages.
11/29/68 Peak to 05/26/70 Trough to 3/6/1972 Recovered (lost 36.1% peak to trough)
01/11/73 Peak to 10/03/74 Trough to 09/02/82 Recovered (lost 48.2% peak to trough)
08/24/87 Peak to 12/03/87 Trough to 07/26/89 Recovered (lost 33.5% peak to trough)
03/23/00 Peak to 10/09/02 Trough to 05/30/07 Recovered (lost 49.2% peak to trough)
10/09/07 Peak to 10/27/08 Trough to ... (lost 45.8% if the bottom of 848.92 holds)
If you go back and look at these big historical market swoons more closely you'll see that once the market begins to recover (not just bounce up and down like it is doing right now) that it recovers a lot in a very short period of time and then meanders upward after that before reaching a peak and then starting the cycle again. I like to keep four things in mind for my indexed portfolio.
1) Stay in a broad index like the S&P 500. Sectors can stay down a lot longer than broad indices.
2) Buy small chunks regularly, i.e. dollar cost average.
3) Focus on my personal time horizons and the market time horizons.
4) Consider life-milestones for when to rebalance, i.e. move appropriate amounts OUT of stocks as personal time horizons get shorter.
I think many Index buying investors tend to look at the percentage drop from market peak to market trough which is a bit misleading unless you happened to buy only on the peaks. The S&P 500 most recently peaked on 10/09/07 at 1565.15. Its trough to date was 10/27/08 at 848.92. (Again, I am using market close values and not intraday values.) That's a 45.76% drop in value of the index. However, if you have been dollar cost averaging then it is not <i>your</i> drop in value. To understand your drop in value you need to look at the total principal you've paid in <b>excluding</b> any gains and dividends that you have been reinvesting. Take what you've put in and subtract it from the total value of your fund today. That will be your real drop in value assuming you get a negative number. I think you'll find your position in the index fund to be much more tenable if you look at it through this lens.
By way of example my own situation is that I have used dollar cost averaging with reinvestment of all gains (capital and dividends) in an S&P 500 Index fund. My principal, invested more or less evenly since February 2000, is down 9.8% as of today. That may sound terrible but compared to the 42.6% that the S&P has fallen from its peak to today's close at 898.95 is it really so bad? Further, my S&P Index investment principal will be back to 100% when the S&P 500 hits 1006, a roughly 12% increase from today's close. There is no doubt in my mind that the S&P 500 will regain and pass its peak of 1565.15. If I were to stop investing today, my original principal will have increased by 60% once the S&P regains to 1565 even without counting future reinvestment of any cap gains and dividends dispersed by the fund.
To reinstill your faith in indexing vs. actively managed funds I suggest reading these remarks by Vanguard founder John Bogle, paying particular attention to section IV "Regression to the Mean".
<a href="http://www.vanguard.com/bogle_site/lib/sp19960508.html" target="_blank">Be Not the First... Nor Yet the Last</a>
One thing to remember... Investing is not the same as Trading. Most of what you read and hear in the popular media is aimed at Traders. There's nothing wrong with Trading. But it is different from Investing and the strategies used in Trading don't align to the simbiotic investment strategies of Dollar Cost Averaging, Indexing, and Buy-Hold-Rebalance. Personally I like investing because while it does require regular attention it doesn't require the daily attention and constant research that Traders must maintain to avoid missing big moves in individual stocks or funds.
Good Luck Investing!
Maybe so. but... I have the old value line chart from 2000. If you extend the line ( as I did in 2000) extrapolating earnings you might conclude as I did in 2002 that the stock market was likely to be flat for about 10 years. Again typically the market goes through 20 year periods of very good growth followed by 15 year periods ( these are averages) of backing and filling. I put some money in the market in 2002-2004 when interst rates were so low that classic dividend paying growth stocks were better than money markets. but mostly I just held my $. On Oct. 10 I bought a bunch of stuff. This is probably too early as auto sales have not yet bottomed( I used to forecast auto sales) but honestly the stock market has been overvalued for a good 15 years using these simple regressions. Now to me it looks fairly valued If you have 40 years to retirement then one should probably not worry. 20 years probably ok. 10 years, if the overall p/e is low then buy. but I'd be very leery of putting a large amount of your assets in the market when the market is high and you are in your 50's. Just my opinion
