Simple Investing — The Promise and the Risk

Simple Investing, Promise #1 — You can get good returns without spending a lot of time and effort on investing.

Many middle-class workers have jobs and family responsibilities that take up most of their time. They don’t want to be spending their weekends doing investing research. They are looking for a simple way to invest that provides a reasonable return with a reasonable amount of safety.

ABCs of Investing
Conventional indexing possesses a good bit of appeal to such investors. Indexers don’t need to research individual companies. Indexing generally provides good returns. Indexing provides a high amount of diversification, which helps reduce risks.

Simple Investing, Risk #1 — When prices get out of hand, conventional indexing becomes dangerous.

Stocks are far more risky at times of high valuations than they are at times of moderate valuations. This is true for all investors, but it is especially true for indexers.

Indexers are buying the market. So, when the market is risky, indexers hold risky assets. It is possible for those buying individual stocks to mitigate valuation risks through effective stock selection. No such possibility exists for indexers. It is imperative that indexers be made aware of valuation-oriented risks and take steps to mitigate those risks at time of high valuation by lowering their stock allocations.

Simple Investing, Promise #2 — You can leave your investments on autopilot and do well.

Indexing advocates often argue that it is better not to mess about with your investments too much. Investors often are tempted to do the wrong thing, to buy a hot investment just when it is beginning to grow cold or to sell a cold investment just when it is warming up. Indexers often argue that you should put things on autopilot not just because that simplifies investing but also because it enhances your long-term returns.

There’s a lot to this argument. Investments often offer the least long-term value when they are the most popular. Put things on autopilot and you won’t be tempted to do dumb stuff. Also, you’ll never learn whether your investing ideas are good ones or not unless you give them time to demonstrate their merit. Putting things on autopilot is not entirely a bad idea.

Simple Investing, Risk #2 — It’s a mistake to think that there’s no value in learning.

It’s generally smart not to believe that you can outsmart all of your fellow investors. Humility goes a long way in investing. Some investors run far too far with this thought, however. It’s a terrible mistake not to respect expertise.

I have heard indexers question whether Warren Buffett really possesses an edge in picking stocks. This is madness! Those who spend large amounts of time studying investing of course possess an edge. You don’t need to feel bad that you have chosen a “good enough” approach to investing because you don’t have the time to pursue more sophisticated strategies. But please don’t start thinking that there is no value to learning. That cuts you off from the benefits of learning for the rest of your life!

Investing 101

You don’t need to choose between adopting an overhaul of your investment plan every six months and putting things entirely on autopilot. The sensible middle-ground is to be reluctant to make big changes in your plan. But do be open to learning experiences. When you learn something new, of course you should make whatever changes in your plan are needed to reflect your new understanding of what works.

Simple Investing, Promise #3 — Understanding theory is not important.

Indexing advocates often describe their approach as the most “rational” way to invest. There’s something to that. Indexing is backed by a good bit of compelling research.

Many indexers possess only a foggy understanding of what the research really says. But there are many circumstances in which that does not matter. You do not need personally to be familiar with the research to benefit from use of the investing strategies developed as its fruit.

Simple Investing, Risk #3 — Following an approach that you do not fully understand may cause you to ignore warning bells.

The conventional approach to indexing is rooted in Efficient Market Theory. There are many smart people who hold serious doubts today about the merits of Efficient Market Theory. You need to understand the reasons for these doubts to protect yourself from the pitfalls of indexing.

You don’t need to read every academic paper published in the field. You need to know enough about the theory to understand both its strengths and weaknesses and to make an informed call as to whether adjustments to the conventional indexing strategies are needed in your case.

Indexers sometimes refer to themselves as “Know-Nothing Investors.” That makes me uneasy. You don’t need to be a “Know-Everything” Investor” and you certainly do not want to fall into the trap of coming to think of yourself as a “Know-It-All Investor.” Again, it is the sensible middle ground between the two extremes that holds the greatest long-term appeal. How about aiming to qualify as a “Know-a-Little-Something Investor?

Simple Investing, Promise #4 — It will work out in the long run.

Simple Investing

Indexers are told not to worry about price drops because indexing is intended as an investing approach for the long run and in the long run stocks can be counted on to do well. There’s a good bit of truth in that claim. The historical stock-return data indicates that stocks are likely to provide a good return in 30 years.

Simple Investing, Risk #4 — Tomorrow is a long time.

Many investors think that the long-term arrives in 5 years or 10 years or 15 years. The historical data shows that, for those heavily invested in stocks today (this article was posted in January 2007), the long-term may be more than 20 years away. If you are not prepared for poor results that remain in place that long, you should consider lowering your stock allocation until valuations return to more reasonable levels.

Simple Investing, Promise #5 — Indexing permits you to enjoy a share of the productivity generated by U.S. businesses.

On first impression, indexing might seem suspect. How could so simple an investing approach generate such handsome returns? Shouldn’t handsome returns go only to those taking on significant risks?

The reality is that, while indexers don’t like to think of themselves as gamblers, they are taking on a bet. They are betting that the U.S. economy will remain a strong economy for many years. If that doesn’t happen, indexers will be in trouble.

The beauty of indexing is that indexers only need to take on that one bet to obtain a solid return. If you are not confident that the U.S. economy will remain strong, you should not become a conventional indexer. If you are confident that it will, indexing offers you a one-bet way to tap into a strong long-term income stream. Indexing is simple investing because it eliminates the need to take bets on multiple questions and thereby eliminates the need to do research on multiple questions.

Simple Investing, Risk #5 — We are in a time of rapidly changing economic realities.

The U.S. stock market has been generating strong returns for over 100 years. That sounds impressive. It is that long track record that serves as the case for indexing.

Still, things change. Things change faster than ever today. We live in a global era. It might be that indexers should shift to thinking of a global index rather than a U.S. index as their core or even sole holding.

Stress-Free Investing

Indexers claim diversification as one of the benefits of their approach. But how diversified are you if almost all of your assets are tied up in a single type of investment, U.S. stocks?

Why not put some of your money into a U.S. index fund and some into a global index fund? Why not put some of your money into Treasury Inflation-Protected Securities (TIPS), which are a great counter to stocks? Why not put some of your money into individual stocks to provide the benefits of diversification at times when indexing is not generating good returns? Why not look into dividend-paying stocks, or real estate, or commodities?

Indexing is an investing option of considerable appeal. There is something in the mindset of many investors that makes them want to think that they have discovered the One True Way to invest. Indexers seem to be particularly drawn to dogmatism. Resist the urge to become fanatical about indexing and indexing will be more likely to provide you with an approach to simple investing that will stand the test of time.

If today was not a crooked highway,
If tonight was not a crooked trail,
If tomorrow wasn’t such a long time,
Then lonesome would mean nothing to you at all.

–Dylan

 

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