August 25, 2014

Five Myths and Misconceptions about Indexing

• Myth #1: Indexing only works in efficient markets
• Myth #2: Who wants to be average?
• Myth #3: You get what you pay for—Higher cost + Higher ratings = Higher returns
• Myth #4: Market-cap weighting overweights the overvalued
• Myth #5: Index funds underperform in bear markets

The myths I want to highlight are #2 and #3.

Ive had many people say to me that they dont want to settle for average returns which are what they believe index investing provides. However, this is not the case. Indexing provides average gross (before expenses) returns, but once costs are deducted, indexing provides superior net returns (which are what you actually take to the bank). Heres how Vanguard puts it:

The reality is that index funds, in their attempts to deliver the average returns of all investors in a particular market, have delivered far-from-average performance.

An important reason for this is cost. Indexing has proven to be a low-cost way to implement an investment strategy, lending a significant tailwind in producing above-average returns over the long term relative to higher-cost active strategies. For example, 84% of active small-cap blend funds and 71% of active emerging-market funds underperformed low-cost index funds for the ten years through 2013.

Can some investors beat index investing? Yes. Can a very few do it again and again for decades? Yes, but only a handful. Does doing so require a good amount of skill, time, nerves of steel, and even luck? Yes. In other words, most people (even professional fund managers) cant beat indexing — the odds are stacked against them. So why try? Instead, spend your time and effort working on growing your career — something you can impact and which will yield much bigger dividends in the long term.

Closely tied to the net return is costs, which Vanguard addresses in myth #3. Their thoughts:

The higher the price, the better the product myth is another intuitive, everyday maxim. In investing, it would seem to be translated as: We can expect to enjoy higher returns from expensive or highly rated managers.

However, the reality in investing is that this seemingly commonsense relationship is reversed—you often get what you dont pay for (that is, higher performance is frequently equated with lower cost). Perhaps even more unintuitive is that highly rated funds have actually underperformed their lower-rated peers.

They then show a couple of charts that illustrate these points of view.

I know Vanguard has a vested interest in promoting index investing so the arguments are far from biased. But that doesnt mean they arent valid or true. The reasons above (plus others) are the reasons I have invested in index funds for over two decades now. And I dont plan on changing anytime soon.

How about you? Whats your key financial investment these days?