Financial Independence in a High Cost of Living Area

The Problem with Index Fund Investing

Erik Financial Education, Markets, Thoughts of a Mastermind 7 Comments

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This month, July 2018, I’ve decided to embrace my recent non-traditional and alternative thoughts on the personal finance space and talk about a number of things that I’ve been battling with internally about money, the markets and investing. This is the eighth post in this series. Before reading this one, please go back and read the fifth post on What it Actually Means to Invest in Stocks, and the seventh post on why All Assets are Worth Considering. 

“V-T-S-A-X, V-T-S-A-X, V-T-S-A-X!”

If investing was political and had rallies, I’d imagine Vanguard nation members would have be chanting about VTSAX, an extremely low fee index fund.

What is index fund investing, and why is it so great? Simply put, index funds allow you to own thousands of positions and capture the general market trend at an extremely low cost. I like index funds for these reasons: they are supposedly lower risk because they are highly diversified, and the fees are nearly 0. Comparing this to actively managed funds with fees of 1-2% or more, you get much more bang for your buck!

This month, I’m exploring alternative ideas and thoughts in the personal finance space. Index funds are great in all, but there is a problem with them – which I’m going to explain here.

In this post, I’m going to touch on the benefits of index fund investing, why index fund investing works, and the problem with passive index fund investing.

What are the Benefits of Index Fund Investing?

the guide to banking for non-bankersFirst, let’s start with the basics. What is an index fund and what are the benefits of investing in them?

Index funds are a collection of assets which, as a whole, look to replicate the performance of some market or sector.

For example, a stock market index fund would be a collection of many stocks, such that the performance of the index fund would mirror the performance of the general market.

Warren Buffett, John Bogle and many of the other great investors believe investors like us should invest in index funds. There are a few benefits to index fund investing vs. investing in individual securities.

One such benefit of index funds is diversification. It’s unfortunate, but it’s a fact that some companies will fail. It’s also a fact that some companies will outperform others. Humans don’t have crystal balls, and to be able to select which ones will fail and which ones will perform well is nearly impossible.

Instead, with index funds, we can own a piece of many companies, and if some fail, it is fine. We will also own the winners! On average, we will be able to replicate the general market. Over time, the market typically has trended up, and as a result, index funds allow us to able to capture this trend.

Another benefit is a combination of lower fees and out-performance when compared to actively managed funds. Vanguard’s equity index funds average a 0.12% expense ratio vs. 0.62% for actively managed funds. In addition, these index funds have outperformed actively managed funds for many years!

Why pay more for less? Index funds are superior when considering fees and performance over time. In addition, if done passively (i.e. set and forget), your taxes and transaction fees are greatly reduced.

Why does Index Fund Investing work?

In the previous section, we talked about the benefits of index fund investing. But, those reasons are contributing, but not exactly why index fund investing works.

Index fund investing works because the market is supposedly “efficient”. The Efficient Market Hypothesis is a fundamental concept in portfolio management theory, and simply states the prices in the market reflect all information out there on a company. It’s a hypothesis, though it makes sense. (I don’t know if I’m completely on board with it, but that’s a discussion for another day.)

Under this theory, how does the market stay efficient? Theoretically, active investors are constantly looking to determine if the price of assets is in line with expectations or not, and should be buying or selling to “close the gap” between the price and supposed expectation.

Index fund investing works because it follows the trend of the market, and also takes advantage of these active investors who are doing the heavy lifting of price discovery.

What if Everyone Decided to Invest in Index Funds?

Something I like to do is think about different scenarios, take things to the extreme (if necessary), and think about the outcomes (otherwise known as a thought experiment).

Here’s something to ponder: what if everyone decided to invest passively in index funds – what would the outcome look like?

One of the common recommendations for investing in index funds is to dollar cost average (aka buy a little each month), and not touch the nest egg for 20-30 years.

At some point though, if everyone decided to invest in index funds, dollar cost average, and never touch their nest egg, wouldn’t the price of assets just keep rising (without care for the underlying fundamentals?)?

Would this be (dare I say) the beginnings of a Ponzi-like scenario and scheme?

While yes, at some point, people probably will start selling down their assets, the market can’t always go up. Otherwise, it’s not a market.

Index fund investing works because you have active money managers who supposedly “keep the market efficient”, but if those players went away, the market would certainly not be efficient.

The Problem with Index Fund Investing

With this series, I’m trying to spark original thoughts and challenge the status quo. I could be right, or really wrong. At the end of the day, I don’t really care if I’m right or wrong because that’s not why I’m doing it (and as a general principle, part of becoming more knowledgeable is not being afraid to consider the other side and be okay with failing and being wrong).

Here’s the problem with passive index fund investing: with more people doing it, the less “efficient” the market will be, and this exposes you to a concept known as “the herd mentality”.

What do I mean? If everyone is always buying, regardless of price or the underlying value, then your expected returns will be less than prescribed. In addition, The Earth and economy is closed and there is a ceiling to everything.

Buying and buying and buying will just lead to boom, bust, and ruin at some point. It’s basic physics.

Don’t Be a Turkey

One of my favorite authors is Nassim Taleb. He is an author, philosopher, mathematician, former trader, and all around thought provoking individual. In one of his books, The Black Swan, he talks about the turkey problem:

“Consider a turkey that is fed every day,” Taleb writes. “Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say.

“On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”

thanksgiving turkeyWhile I don’t necessarily see this drastic of a possibility to occur in the market, to say that the probability is 0 is to also make a mistake.

The previous post in this series was talking about how it’s important to have a strong financial base, but also consider all assets. Considering all assets, having a safety net, and allowing for the possibility of failure of one asset will allow real financial independence and resilience.

Thinking Critically is Key

There’s a few things here I want to touch on before concluding.

First, as I mentioned in the previous post, investing in stocks has been a great way to build wealth in the past, and something I do in my investment portfolio. With these posts, I’m not saying investing in stocks is a bad thing. Rather, I’m trying to inspire unique and original thoughts for you to think about in personal finance life.

Second, investing passively in low cost index funds has been, and probably will be, a solid investment going forward. With that said, if it becomes too prevalent in the future, there could be very wild swings in the market (and also the possibility for manipulation and a lack of liquidity overall). There’s no such thing as a free lunch (even though many people hype index fund investing like it’s a gift from a higher power).

Third, speaking a little more in general, something I’ve been talking a lot about lately on this blog is thinking critically about your situation. Everyone is different – everyone has different life experiences, perspectives, upbringings, and goals. Sadly, following the herd blindly will not result in success. Instead, following what you believe, and have researched, works (and maybe that is following the herd) will lead to success.

Concluding Thoughts on Index Fund Investing

With some of these posts in this series, there isn’t necessarily a conclusion, but more food for thought.

Index fund investing isn’t going away, and it’s a great way to invest and diversify your investments.

Am I going to stop using index funds in my investment portfolio? No. Am I considering other assets and thinking more about my asset allocation, strategy, and the market going forward? Yes. Am I trying to think critically in everything I do? Yes.

At the end of the day though, thinking critically is important in everything you do. The markets don’t care if you succeed or not. It’s okay to re-balance your portfolio, it’s okay to assess the risk of your portfolio and see if there is anything you can do to navigate potential storms, and it’s okay to challenge yourself and your thoughts.

Remember the turkey. Don’t be a turkey 😉

In the next post, I’m going to dive back into talking about the economy and environment.

Thank you for reading,

Erik

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Comments 7

  1. I’m one of those guys chanting VTSAX. And late at night, I wonder if this is wise. I think your argument about everyone jumping into index funds introducing market inefficiencies is well considered, but as we approach this condition, the concomitant arbitrage opportunities will make some securities analysts very rich. But I’m not Warren Buffet or Ben Graham. This will tempt the greediest of index investors into seeking their own arbitrage opportunities. And this will pull money out of index funds and make the market more efficient.

    Index funds are NOT like Ponzi schemes because their value is predicated upon the value of the underlying companies. If American businessmen manage to profitably engage in business, they’ll post dividends that will make their way eventually into VTSAX. In the best case, I’ll have enough to live off VTSAX dividends alone.

    I know the rate is very low, but I’m hedging against inflation, because inflation will increase the book value of the constituent equities.

    I’m not an expert in this, so if my thinking is obviously flawed, please hit me up the side of the head.

    1. Post
      Author

      I’d argue that the rate of inflation is much higher than shown by the wonky calculations produced by the central banks. I like http://www.shadowstats.com/ for example in showing the discrepancy.

      And to comment on the Ponzi scheme comment, I did that a little tongue in cheek and yes, you are correct that not everyone will pile in because there will always be people who think they can do better than the market (and then theoretically keeping the market efficient).

      Thanks for the comment. This gave me some interesting thoughts to think about myself 🙂

  2. I think the likelihood of everyone going indexing is 0, simply because the inefficiencies it might create would in itself drive people to active management. IE. Inherently in the system there is a balance. Too much passive and an opportunity to make money as active opens up, and the market shifts that way.

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      Author
  3. Hi Erik,
    VTSAX chanter here too. Interesting article though. I suppose I could make the same argument with individual stocks too…wouldn’t the same ‘chaos’ result if there were no index funds and everyone adopted a Buy & Hold stock mentality, living off dividends and passing stock down to their children? The market won’t let it happen as fulltimefinance noted above. And of course people still need to sell funds (stocks) for any number of reasons.

    I didn’t think that VTSAX requires the market to be efficient – I thought it only buys stocks when the net inflow to the fund is positive, as it just holds the market weight. Some indexes e.g. S&P 500 are different than total market funds so are required to buy/sell independent of fund inflows based on independent changes to the index. So that’s given me a reading assignment this weekend 🙂

    Best wishes,
    -DL

    1. Post
      Author

      🙂 It’s an interesting thought experiment and is challenging me (and it sounds like you as well) to dive into the understanding of what ACTUALLY we are investing in and what scenarios could result in issues.

      Thanks for stopping by DL

  4. Pingback: Index Investing Economy – Retire In Progress

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