Million Dollar Journey made an interesting post last week in which he listed some points that in his opinion, are the disadvantages of indexing. While I made a detailed comment on that post, I couldn’t resist biting the juicy bait dangled in front of me. So, let’s examine his claims closely:

  1. No downside protection: Investors wanting a smoother ride should allocate a portion of their portfolio to assets that are less volatile than equities such as bonds and cash. There is little evidence that money managers are able to provide downside protection either. Their returns in bear markets is, at best, mixed compared to their benchmarks. Neither are they able to add value through market timing and if anything, the evidence points the other way — mutual funds have low cash levels in bull market peaks and high cash levels in bear market bottoms.
  2. No control over your holdings: It is true indexing doesn’t allow you to overweight Royal Bank and underweight BMO. But, we all know how well control is working out for mutual fund managers, eh?
  3. An indexed portfolio will always be average: It depends on what is meant by “average”. John Bogle estimates that the odds of an index fund outperforming any mutual fund is 95% over 20 years. If that’s average, I’ll take it.
  4. It’s boring: I used to own AIG (NYSE: AIG) (as an aside, luckily, I sold it last year when indexing most of our portfolio) and every year, I try to read the annual reports. It is usually 250 pages long filled with financial arcana — not exactly what most people would consider interesting.

The bottomline for an investor is to earn enough returns to achieve their financial goals — not some arbitrary score of how many indices they beat over their investing career. Jason Zweig recounts an encounter with a group of retirees in Your Money & Your Brain. Mr. Zweig asked the retirees how much returns they earned to retire to Florida and their answer: “Who cares? We earned enough to retire here”. Passive investing gives most people the best odds of doing just that — achieving their financial goals.

This article has 19 comments

  1. Pingback: Debunking “Why Index Investing May Not Be for You” | Investing Intelligently

  2. With the precariousness of the markets around the world, it may be a good bet right about now.
    by: Option trading

  3. Wow, that column certainly did light a fire! 🙂

    Playing devils advocate again, what about those mutual fund managers who have a long history of beating the index? Guys like Peter Lynch (not managing anymore), Francis Chou etc? Value investors like Francis Chou are known to have more cash when markets are high and aggressively invest when markets are low or showing value.

  4. MDJ – it is easy to identify the market beating managers after the fact, but not before they have produced their outstanding results. Now, if I only invested my life savings in Berkshire Hathaway back in ’75…. (I was not born yet, but if only…)

    Options trading is an area that is truly best left to the professionals risking institutional money. Anyone ready to explain the Black-Scholes option trading model? And any rebuttals on Nicholas Nassim Taleb’s arguments regarding the fallibility and fundamental flaws in this and other models used in the markets? Definitely not something the average DIY investor should even consider to consider.

  5. Canadian Capitalist

    FT: Hindsight plays tricks on our minds. Identifying winners after the fact is easy — it’s doing it ahead of time that’s the problem. What are the odds that you can pick a winning manager today among a pool of “good” managers? It’s a hit-or-miss proposition.

    Even in hindsight, it is tough to distinguish a manager who beat the index due to skill from the ones that got merely lucky.

    I’d also caution using past performance numbers for picking managers. The list of hot performers who turned cold is long.

  6. When I first read the third point “An indexed portfolio will always be average” from MDJ, I scratched my head. I knew it was not average return. You know that with indexing, the chances for you to end up in the first decile of return after 20 years is really good!

  7. No downside protection: Isn’t that the case with any investment outside of intrest-paying instruments like bonds or money market funds? If you want downside protection, then hedge, otherwise, don’t invest.

    No control over your holdings: Only if you purely index. Is there something stopping someone from overweighting by simply buying RY stock? Or beefing up the financial area by buying XFNs? There are still ways to play it.

  8. Charles, you’re right, it depends on whether you look at gross returns, or net returns after MERs are taken in to account. I mentioned this a bit in my post…

  9. Being old enough to have been invested during the 2000 -01 slide, I can say that the best investment plan is the one you can leave alone when the markets go south. What that plan is, is a personal choice.

    I applaud MDJ for his objectivity.

  10. >>Now, if I only invested my life savings in Berkshire Hathaway back in ‘75…. (I was not born yet, but if only…)

    Apparently index investors chose to ignore $100 bills on the floor.
    http://www.cnbc.com/id/21834492

  11. Pingback: A Lap Of The Blogs : WhereDoesAllMyMoneyGo.com

  12. A friend and I were talking about Swensen’s approach to investing. I have ordered the book “Unconventional Success” and it is in the mail. We were wondering if a few of you could give a Canadian version of a Swensen portfolio so that we would not have to convert some of our money to US dollars. I am going to start with the e-Series portfolio similar to the Spleepy Portfolio but we were curious what funds we would need to mirror Swensen.

  13. Pingback: Weekly Dividend Investing Roundup - September 6, 2008 » The Dividend Guy Blog

  14. Pingback: Sunday Money Madness | Rich Credit Debt Loan

  15. Pingback: squawkfox » Chickens, Tomatoes, and Links Oh My!

  16. Pingback: Market Correction, Web Hosting and Weekend Reading - Sept 12, 2008 | Million Dollar Journey

  17. Hi CC,

    Have you read Warren Buffett’s article “The Superinvestors of Graham-and-Doddsville”? Here is a link:(http://www0.gsb.columbia.edu/null/CIER?exclusive=filemgr.download&file_id=645551&showthumb=0 .

    How do you explain that these 8 guys Warren bumped into all ended up beating the index by large margins over decades? He knew all these guys would out-perform ahead of time.

    His point is that there is much inefficiency, that the market price is determined by the single most greedy or most depressed investor, and that academics continue to argue that the markets are efficient, while the super-investors of Graham-and-Doddsville continue to beat the indexes.

    Ed

  18. Canadian Capitalist

    Cogsy: There is tons of discussion on currency effects in the archives. I personally prefer direct holding in US stocks because (a) they are cheaper (b) hedging has debatable benefits but certain costs including bad tracking error.

    Ed: I’ve read that article. It’s reprinted in the appendix of “The Intelligent Investor”. Now, I have no doubt that Warren Buffett can tell you who can outperform the market in advance. I only question whether your average investor or advisor can. The overwhelming evidence is they can’t. For instance, check out the travails of Bill Miller:

    http://www.reuters.com/article/bondsNews/idUSN0645707620080806

  19. Hi CC,

    I guess that shows that even pensions funds follow the rule of thumb – 90% of all transactions are stupid. This is exactly why the average investor only gets 1/3 of the return of the funds they own (Dalbar 20-year study).

    They are dumping 3 fund managers that have all beaten the index by wide margins over long periods of time because they have a “tracking error”? These managers only beat the index by being very different from the index – not from trying to track it.

    All the great value managers have underperformed for the last several years. They have been telling us that 2004-8 are just like 1995-9 in that the same sectors keep going up and up far beyond what the fundamentals support, while solid undervalued companies are mostly not rising.

    Only those that hold on through periods of underperformance will get the index-beating returns of the top fund managers.

    Ed