Index Investing Aversion – Wilful Ignorance?
- Retail investors, who have grown over the last two years particularly, typically use active investing strategies, such as day trading. Historical data has shown that this typically results in diminishing performance.
- The easiest way to near-guarantee long-term performance is through Index Investing , the strategy of holding a diversified portfolio of broad-based investment funds.
- For the adventurous among us, retail investors can also construct their own portfolios that remain aligned with the 'passive' investing agenda.
The last two years have been defined by excessive liquidity and speculation in the markets. Celebrity CEOs, meme stocks, and the surge of SPAC offerings have captured the attention of retail investors across the globe. Retail traders continue to gain a share of US equity trading, rising to 25% in 2021, up from 10-15% in the preceding decade.
These spry, eager investors fall victim to a fallacy as old as time – trying to beat the market – a feat that almost everyone underestimates. Trading strategies, such as the ever-popular 'technical analysis', sprinkled across every student's YouTube dashboard, lure the vulnerable in, promising impractical returns in a short period of time. Participants of such a strategy rush to point out 'Resistance' and 'Support' lines, and fret over indicators such as 'head and shoulders' and the 'falling wedge'.
Take a look at the following graph, where do you think it's going to go?
An advocate of technical analysis might be quick to point out the horizontal lines, highlighting both a resistance (top-line) and support (bottom-line). They may rush to inquire about the stock, certain that this reversal is a sure-sign bullish trend. You may be surprised to find out that in fact, this chart goes on to fall, rapidly .
“Okay,” says the chartist, “when you zoom out, it clearly broke the support line, of course, it would fall!”. This quick reversal of opinion is important to note, but even more paramount is the fact that this chart does not track stock prices at all. Instead, it charts the results of probably the most prominent randomness test, the coin toss. A value of +1 is assigned to heads, with -1 assigned to tails. Eerily similar to a stock chart, right?
Well now the question comes down to, what does this tell us? Luckily for technical analysts, all hope is not lost for their beloved science (art?). There may be additional factors that make it easier to predict future movements, but these methods are difficult to discover, and if you hear about them from an online course, you can almost be certain that their efficacy is severely reduced. A study published in June of almost 1,600-day traders that tracked their activity for one year concluded that only 3% made money.
In an even more interesting display of the downsides to day trading, suppose you invested $10,000 on January 4 th , 1999. Fast forward 20 years, on December 31 st , 2018, had you invested in the S&P 500, this initial investment would be worth $29,845, at an annualized rate of return of 5.62%. However, had you missed just 20 of the best trading days, roughly 1 day a year, your return would have dropped to $9,359, or a return of -6.41%. Extend this out to 60 days, and suddenly your investment has dropped all the way down to $2,144, an annualized return of -7.41%. While historical prices are not indicative of future returns, this fact alone is compelling.
The following table highlights the difference between annual returns between equity investors and index investors over a period of 20 years, beginning with a portfolio valued at $100,000. Fixed-income fared even worse, with Barclays Aggregate Bond Index up 4.98%, while the average fixed-income investor was up only 0.44%. Hence, diversifying across securities while actively trading does not safeguard returns.
What's the solution?
Luckily for us, there's a rather simple, yet effective way of making money in the market. While not the most fashionable, nor interesting, a diverse portfolio comprised of broad-based index funds has outperformed most investors, even hedge funds, over the last few decades. Warren Buffett famously wagered that no one could pick 5 hedge funds that would outperform the S&P 500 over a period of ten years, which Protégé Partners LLC happily accepted. At this stage of the article, I hope this comes unsurprisingly to you – the firm lost the bet.
So what is index investing and how can you participate?
Index investing is a passive investment strategy, with funds usually comprised of simplistic portfolios. Famous index funds such as the Standard & Poor's 500 index tracks the 500 largest companies in America in a format that purchases stocks using a market capitalization weight mechanism. Alternatively, the Nasdaq composite tracks more than 3,700 stocks all listed on the Nasdaq exchange. Common amongst these funds is that they try to replicate the returns of the market benchmark, not outperform it. By purchasing one of these securities, you receive the benefits of diversification, without all the hard work.
Core to this perspective is the fact that index investing is a compelling method of diversifying against risk. Moreover, thanks to Jack Bogle at Vanguard (highly recommend the book ' The Bogle Effect' ), the expense ratios of these funds are generally quite low, with the Vanguard S&P 500 ETF coming in at just 0.03 per cent. In other words, should you invest $10,000 – the total fees collected would equate to just $3 a year.
If you have ever taken a Corporate Finance course, you may remember the term Beta. This is a measure of volatility – or systematic risk – of a security or portfolio. It is generally accepted that a portfolio with a Beta of 1 moves with the market, or at the acceptable level of systematic (undiversifiable) risk. For long-term investors, who seek stable but attractive returns, a portfolio at this level of risk presents probably the most attractive investment vehicle available. You can find the beta of each individual security readily available on services such as Yahoo Finance.
Understanding that the boredom of passivity is not for everyone, we can also seek to construct a portfolio with similar qualities ourselves. Diversifying across industries and nations, the typical investor should include between 30 and 40 stocks in their portfolio. This is the 'golden' portfolio size before one starts to experience significantly diminishing benefits. As a quick helpful tip, given that many of our readers are in their early 20s, based on historical data, you can increase your long-term returns (but equally, the volatility!) by investing in growth stocks.
