Indexing Without the Emotional Baggage

Indexing is here to stay.

The world of investing has changed in recent decades. It used to be that most people who invested in stocks were people with a lot of money or people who enjoyed learning about stocks. In recent decades, middle-class workers have been given the responsibility of financing their own retirements. Now the majority of stock investors are people who would rather be doing something else, people who are not going to take the time to research companies to the extent needed to make effective investment choices.

Indexing

John Bogle filled a great need when he began promoting the indexing concept back in the late 1970s. He started a revolution in investing. There’s no turning back. Indexing is here to stay.

The conventional approach to indexing has failed us.

Indexing is here to stay. But the conventional approach to indexing is not. The conventional approach has failed us big time. It is headed for the ashcan of history.

How can I say that? Didn’t indexing produce good results for its followers throughout the length of the longest and strongest bull market in U.S. history?

It did indeed. That’s the problem.

To index is to tie your fortunes to the fortunes of the market as a whole. The market’s performance was amazing throughout the 1980s and 1990s. We have never before in the history of the U.S. market borrowed so much from future returns. By the end of the 1990s we had reached a place where the last thing in the world that any rational investor wanted to do was to tie his fortunes to the fortunes of the market as a whole.

The very thing that made indexing the most appealing approach imaginable for 18 years has made it the worst approach imaginable for the past eight years and into the foreseeable future for a long time to come. Indexing gave investors not too interested in learning how stock investing works a nice ride for 18 years. Now it is crushing them. This cannot continue. To survive (and indexing must survive), indexing needs to be reformed. We need a new and more reasonable approach to buying into the market return.

It is the perceived connection with Passive Investing that causes all the trouble for indexing.

We’ve been discussing the realities of long-term investing for six years now on the Retire Early boards. As time has gone on, things that were once puzzles to me have become increasingly clear. The most puzzling question has been — Why are so many indexers such hate-filled investors?

If you need background on the hate that has evidenced itself, please take a look at the article entitled “Stock Panic Up Close and Personal” in the “Stock Drunk” section of the site. I have from the early days viewed it as important to discover the cause of the hate, the fury, the anger, the contempt of the committed follower of indexing. Why should such a wonderful investing strategy (indexing does a truly wonderful job of providing a high level of diversification at low cost) cause many of its followers to go so completely bonkerishisly nutorific? What’s that all about?

It hit me in recent months (this article was posted in April 2008) that the problem is the perceived connection between indexing and Passive Investing. It embarrasses me that it has taken me so long to see this. It is the most obvious thing. But such is our fallen human nature that we possess a great capacity to overlook the obvious. I see now, after six years of this, that there is nothing wrong with indexing that cannot be fixed by disassociating it from Passive Investing.

The Loser's Game

Passive Investing is mindless investing. It means sticking with the same stock allocation regardless of dramatic price changes (which of course translate into huge changes in the risk associated with stock investing). I have never seen anyone make a rational case for Passive Investing and at this point I very much doubt that I ever will. It’s like trying to make a rational case for going off on a quest for the fountain of youth or for trying to build a perpetual motion machine or for seeking to discover the incantation that turns coal into gold. Passive Investing is a Get Rich Quick scheme. No one is ever going to be able to make a rational case for a Get Rich Quick scheme. It just ain’t gonna happen.

That embarrasses those who follow the conventional indexing approach. I have seen zero evidence that the sorts of people attracted to indexing are dumb. Quite to the contrary, my sense is that this group is comprised of some of the smartest investors out there. So I don’t accept the idea that they do not see that Passive Investing is a Get Rich Quick scheme. Of course they see it. Again, that’s the problem.

They see it and they don’t see it.

Indexers know that Passive Investing can never work in the real world. Anyone capable of earning a few hundred dollars to invest can see this on an intellectual level. But indexers very, very, very, very much do not want to acknowledge to themselves or to others that they understand this. Humans are drawn to Get Rich Quick schemes. We like them — until the day comes when they crush us.

Investors following the conventional indexing approach know that Passive Investing is nonsense and they also know that this is something that they very much do not want to acknowledge. Acknowledging the reality would require them to take action to protect their portfolios. Taking action to protect their portfolios would mean giving up hope in the Get Rich Quick scheme.

So they react violently to any realistic discussion of the flaws of the conventional approach. If they were discovering these flaws for the first time, they would be interested in hearing about them. That’s not the way it is. The conventional indexers knew about the flaws on the day they bought into this doomed approach. Their denial of the flaws is a source of embarrassment and pain and self-loathing. They don’t want to be reminded. Their course is set. Their minds are closed.

Until the realities force a reevaluation of “ideas” formed during the most out-of-control bull market in the history of the nation.

There is no necessary connection between indexing and Passive Investing.

Indexing Only Works in Bull Markets

There are many people who view indexing and Passive Investing as virtually synonymous terms. Passive Investing is indexing and indexing is Passive Investing. Is it so?

It’s not so. It’s not even a tiny bit so.

To index is to purchase shares in a fund containing shares in all the companies in a particular market. The purpose of indexing is to obtain diversification at low cost. That’s it. It’s a wonderful “it” but I don’t see why there needs to be any more to it. I see no reason whatsoever why Passive Investing needs to come into the picture in any way, shape, or form.

I’m sure that there are historical reasons why Bogle thought it was a good idea to connect the indexing concept to the Passive Investing concept. What a terrible, terrible mistake! My guess is that he wanted to keep indexing very simple. There is no need for indexers to research companies. By tying indexing to Passive Investing, Bogle constructed an approach in which it wasn’t necessary for indexers to pay any attention to valuations either. He took the quest for simplicity too far. He ruined indexing (at least his formulation of it) with this extremely unfortunate decision.

Bogle is ultimately responsible for the hate that many indexers feel today toward any reasoned discussion of the long-term investing realities. I certainly don’t think that he did what he did knowing where it would lead. In the early days his focus was probably just to get indexing off the ground. Stock prices were low in those days. My guess is that it never crossed his mind that a day would come when we would reach the la-la land prices that have applied in recent years.

Indexing Doesn't Work in Bear Markets

In any event, it was a mistake. Bogle did something wonderful in coming up with the indexing concept. He did something terrible in tying the concept to the Passive Investing concept. To save indexing, we need to disentangle the two concepts. Indexing works. Passive Investing doesn’t. We need to make clear to those interested in the indexing idea that there is no need for them to give up their ability to think clearly to join the indexing revolution.

We need to urge a new approach to indexing, an approach that makes sense, an approach without the emotional baggage indexing has taken on in its currently popular form. I call this new approach Valuation-Informed Indexing. It’s what works — both emotionally and financially.