Pros and Cons of Index Investing

Set forth below are five reasons why I like index investing and five reasons why I don’t (at least not as it is generally practiced today).

The first thing I like about index investing is that it greatly simplifies investing.

Index Indexing Pros and Cons

When you buy shares in an index fund rather than purchasing individual stocks or buying shares in a mutual fund, you don’t have to do much research because you are electing to participate in the gains earned by all the companies whose shares are in the index rather than to try to pick the winners. Time is precious to today’s middle-class worker. An investing approach that saves us time by simplifying the process by which we make investment decisions thereby provides us with a significant benefit.

The second thing I like about index investing is that it protects me from making big mistakes.

I believe that it is possible by engaging in extensive research to pick stocks that do better than average and thereby to earn better-than-average investing returns. I see a significant risk in trying to do that, however. I don’t spend all the hours of my days studying investments. So there is a chance that, if I relied on my own research in picking stocks or funds, I would fail to consider something important. That could cost me a lot of money.

With index investing, that can’t happen. I might not earn the highest possible returns. But index investing generally permits me to earn solid returns without taking on risks that I prefer not to take on.

The third thing I like about index investing is that it is an approach to investing that makes sense.

Index investing is not gimmicky. There are no charts you have to study to be a successful index investor, no patterns you need to uncover. You hand over your money and you obtain a stake in the success of all businesses covered in the index. Index investing is a no-muss/no-fuss approach. It’s a common-sense approach. It’s a get-rich-slow approach. All of that appeals to me.

This is why indexing is supported by some of the greatest minds in the investing field–people like John Bogle, William Bernstein, and Scott Burns. These guys are smart enough to see that you generally don’t need to outsmart the market to do well with your investments, you just need to be part of the market, to participate in the market.

The fourth thing I like about index investing is that it generally provides solid returns.

The first three arguments in favor of index investing wouldn’t count for much if it was required of indexers that they satisfy themselves with paltry returns as the price of enjoying this simple, risk-diminished, sensible approach to investing. But the reality is that indexers often earn highly appealing long-term returns.

Indexing

The historical annual real return on U.S. stocks is a number close to 7 percent. That’s a mighty attractive return.

If I can obtain 7 percent returns without having to take on significant risks and significant research work, I am inclined to take the deal. It doesn’t seem likely to me that I could reliably obtain returns much higher than that even if I were willing to put a good deal of energy into the task of doing so. If the easy way to invest provides “good enough” returns, it doesn’t make sense to travel the more difficult and uncertain path.

The fifth thing I like about index investing is that it is a humble approach to investing.

Indexers are acknowledging up front that they cannot outsmart everyone else. If they thought they could, they would want to show off their skills by becoming The World’s Greatest Stock Pickers. The humble nature of the index investing project inspires confidence in it.

Remember that Eagles song about what a peaceful, easy feeling it is to have both feet on the ground and thereby to be assured that something you are a bit excited about won’t let you down? Index investing provides that peaceful, easy feeling to those who employ it as their investment approach, and not too many other investing strategies do. That peaceful easy feeling is worth something.

The first thing I don’t like about index investing is that it has become a less humble investing style in recent years.

It’s hard for the successful to stay humble. Success breeds pride. Indexing has been a highly successful investing strategy in recent decades. A good number of indexers have become too proud of their approach, in my view.

Some indexers have begun to think that their approach is too obviously better than all the alternatives and have become rigid in their views of how index investing must be carried out. There is a certain dogmatism in much of what indexers proclaim about their investing strategies today.

Index Fund Investing Pride comes before a fall, and I worry that the success that indexers have experienced in recent years may have fostered an arrogance that will prove to be dangerous to their hopes of long-term investing success.

Indexers are smart investors, as a rule. Perhaps some indexers are too smart. Indexers have enjoyed a nice long ride of success in the U.S. markets, and because their investing approach is one backed by a good number of academic studies, indexers tend to attribute their success to their particular abilities to understand things that those following other investment strategies do not. It could be that index investing has just enjoyed a good run and that the steadfastness of followers of this approach is going to be put to severe tests in years to come.

To the extent that indexers have become hostile to the merits of arguments made by those following other investing approaches, they could bring discredit on the indexing approach in days to come. There is no one perfect investing approach, in my view.

The second thing I don’t like about index investing is that the conventional indexing approach does not permit consideration of the effects of changes in valuation levels.

The price you pay for an asset affects the long-term return you will obtain from investing in it. I don’t see any way around that reality. It is something that must always be true. So I never feel comfortable investing without first checking out whether the thing that I am investing in is undervalued, fairly valued, or over-valued.

Indexing purists do not take the valuation levels of the stock indexes they invest in into account when making their investment decisions. I do not see any reason why indexers could not take valuation into account. The point of indexing is to be sure to earn the returns earned by the market as a whole by investing in the market as a whole rather than in individual companies in it. There is no reason why one could not increase one’s investment in the market as a whole at times of low valuation and decrease it at times of high valuation. In theory, index investing is compatible with valuation-informed investing. In practice, however, many indexers are hostile to the idea of adjusting one’s stock allocation in response to increases and declines in stock prices.

What Is an Index Fund? So the conventional sort of index investing is not for me. The failure to take the effect of valuations into account cancels out many of the things I most like about the indexing approach. Fail to take valuations into account and you incur significant risks of big losses. The great appeal of indexing in my mind is that it provides one with the ability to obtain good returns with ease and by taking on acceptably limited amounts of risk. Ignore valuation, and the potential return drops while the potential loss increases. Not good.

The third thing I don’t like about index investing is that it causes the investor to lose sight of the connection between corporate profits and the investing returns he enjoys.

Investing returns don’t fall from the sky. They have to be earned by the companies in which you are invested. This is an obvious truth when you invest in individual companies. Those who invest in individual stocks often read accounts of new products that their companies are coming out with and plans their companies have to market more effectively, and so on. This is good. Reading about how profits are earned keeps the investor focused on what matters in investing–profits. Profits are what make the investment machinery continue turning around.

Indexers would never explicitly deny the importance of profits. But there is something about index investing that seems to cause some investors at some times to lose sight of the connection between profit-making and investor returns. I often use analyses of how stocks have performed in the past to form assessments of how they are likely to perform in the future. On a number of occasions, I have seen indexers dismiss the significance of the historical stock-return data, arguing that there is no way to know with precision how stocks will perform in the future and therefore it is not worth making use of the data to form any assessments whatsoever. I view this as a dangerous attitude for an investor to take.

The dangerous viewpoint that I am making note of here is not held only by indexers. But my impression is that it is more common among them than it is among investors who invest in individual stocks. I believe that the root of the problem is that indexers operate at one level of abstraction up from where stock pickers operate. Stock pickers must study the underlying companies in making their investment decisions. Indexers don’t need to do this, and often don’t. The result is that they tend to lose sight of some of the basic realities of investing and get caught up in all sorts of ivory-tower mumbo-jumbo jizz-jazz.

Stock Indexes

Academic studies often have great value. Please don’t interpret these words as me giving my endorsement to any sort of Know-Nothing School of Investing. Still, there are solid academic studies that study serious questions in serious ways, and there are silly studies that say things that cannot possibly be so in the real world. My experience is that indexers are more inclined to fall for the nonsense gibberish stuff than are investors who roll up their shirtsleeves and do a little bit of personal investigation of how it is that the companies they are investing in earn their profits.

Index investing is easier because it does not require study of the ins and outs of the companies generating the investment returns. There’s often a price to be paid for taking the easy road. Those making use of index investing need to be especially careful to keep their thinking about what works in investing rooted in real-world considerations. Nice theories backed by nice charts and nice tables and nice rows of numbers don’t pay the electric bill if they are based on silly la-la land assumptions.

The fourth thing that I don’t like about index investing is that it is too mechanical and rigid an investing approach, at least as it is practiced by purists.

I think indexers are on the right track, for the reasons cited above. But I think that it is far too early in the game to be thinking that we have perfected the indexing approach to investing. I like index investing. But I think it can be improved.

Indexing purists argue that investors should follow an indexing approach not just with a portion of their portfolio, but with all of the money they invest in stocks. I’m not so sure. Indexing purists argue that investment advisors can never serve a constructive role. I’m not so sure.

I see some benefits in some circumstances in picking individual stocks. I see some benefits in some circumstances in seeking the advice of an investment advisor. I am uneasy with dogmatic know-it-all pronouncements re what works in investing. I think it makes sense in many circumstances to mix strategies. My view is that dogmatism and investing, like drinking and driving, don’t mix well.

The fifth thing that I don’t like about index investing is that indexing purists place too much stress on numerical calculations and too little on the emotional side of investing.

Most indexers refer to themselves as long-term buy-and-hold investors. History indicates that it is a lot easier to talk the buy-and-hold talk than it is to walk the buy-and-hold walk. I would like to see much more interest among indexers in learning what it takes to become a true buy-and-hold investor.

index fund strategies

My belief is that the key to being a true long-term buy-and-hold investor lies in adjusting one’s stock allocation with changes in valuation levels. Most investors fully intend to follow a buy-and-hold approach when they make their initial portfolio-allocation decisions. Few appreciate how devastating the losses are that historically have been suffered by those who made big bets on stocks at times of high valuations. By lowering your stock allocation a bit at times when the risks of devastating losses are greatest, you protect yourself from the biggest downside of stock investing, and thereby qualify yourself for the stunning long-term returns available to those who invest in such a way as to make their hopes of being proven true buy-and-hold investors realistic ones.

The  emotional aspects of investing in stocks affect the long-term returns obtained. Index investing advocates often give far too little attention to one of the most important questions that middle-class investors need to have answered for them to be able to invest successfully for the long term–“How much should I be lowering my stock allocation at times of high valuation?”

Middle-class workers seeking to win financial freedom early in life should learn about index investing, in my view. I see it as an investing approach with much to offer. That said, I urge against putting too much faith in the sometimes extreme claims put forward by purist indexers. Indexers are smart, but they have not got it all figured out yet by a long shot. Please be especially wary of claims that it is safe to go with high stock allocations at times of high valuations. The historical stock-return data indicates that the risks of investing heavily in stocks at times of high valuations have been greatly understated.

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