Thank you. A couple of follow-up questions, if you don’t mind:
Do most ordinary investors not do this?
If not, do you know why? Do most people not know about the advantage of index funds? Or do they know, but don’t use them anyway?
If the latter, why don’t they? That seems strange. What makes index funds the “non-default” idea, so to speak? If index funds are known by financial experts to be superior to mutual funds (or other investing strategies), where would an ordinary person get the idea that they should be using anything other than index funds?
An index fund is intended to go up or down y the exact same amount as the entire exchange as a whole. For example, you might hear that the S&P 500 rose a total of 7% last year. If that happened, then your index fund would go up by 7%.
The main reason people don’t invest in index funds is because they want to “beat the market.” They see some stocks double or triple within a year and think “oh man, if only I’d bought that stock a bit earlier, I’d be rich!” So some people try to pick individual stocks, but the majority of laypeople want to let “experts” do it for them.
Mutual funds generally have a fund manager and tons of analysts working there trying to figure out how to beat the market (get a return greater than the market itself). They all claim to be able to do this and some have a record to point to to prove that they have done it in the past. For example, fund A may have beat the market in the previous 3 years, so investors think that by investing in Fund A over an Index fund, they will come out ahead.
But unfortunately, markets are anti-inductive so past success of individual stocks, mutual funds, and even index funds is no guarantee of future performance.
If you look at the performance of all funds over the past 20+ years and correct for survivorship bias (take into account all the funds that went out of business as well as the ones that are still around today), it becomes very clear that almost no mutual funds actually beat the market in terms of your ACTUAL RETURN when averaged over each year.
The final big problems with actively managed funds are fees and taxes. Actively managed funds charge higher percentage rates each year to cover their work. That’s how they make money. They also tend to sell a percentage of your stocks each year and buy new ones in their attempt to beat the market. This gives a certain “portfolio turnover” percentage and the higher that is, the more you have to pay in taxes (capital gains), which lessens your return even more.
The bottom line is that mutual funds claim to be able to beat the market and many do in any given year. People chase the money and pay more in capital gains and fees to try to make a higher return. Over time though, the index fund beats all others in terms of total return over time.
But mutual funds are. I don’t remember the citation, but I recall that mutual funds that do very poorly one year are more likely to do so in the future when you take into account fees and taxes.
Clearly, there are actively managed funds that do consistently worse than index funds, otherwise index funds wouldn’t be able to make money, since financial markets are negative-sum.
If you buy a stock A at price X, somebody must be selling you stock A at price X.
If buying turns out to be a good deal (that is, the discounted dividends Y you collect from holding stock A are greater than X), then selling must turn out to be a bad deal: if the other party held stock A they would have collected the profit Y-X that they forfeited to you. Your gain is their lost profit, therefore the market is zero-sum between investors. Add transaction costs and it becomes negative-sum.
This analysis is simplified by the fact that I didn’t take into account risk aversion and the fact that different parties can discount future utility in different ways (different discount rates or even hyperbolic discounting). But I suppose that when it comes to collective investors such as mutual funds or banks, these parameters can be considered to be roughly the same.
The stock market is not (necessarily) zero-sum or negative-sum as a whole, since money is transferred from companies to investors each time dividends are paid, but the way the investors slice the cake between them is negative-sum.
Not necessarily. First, it depends on the market. Some are zero-sum, and about others one can say that they are NOT zero-sum, but that’s it. They might be negative-sum or positive-sum, depending on the circumstances.
If you just buy a bunch of stocks and hold onto them, on average you’ll outperform cash.
That also depends. Average over what? Which countries and what time periods?
Yes, but taking into account survivorship bias, there are some actively managed funds that do do consistently worse than the market, and eventually fail (and are replaced by other funds that do so)
1) No but I’m doing my best as a columnist for Better Investing Magazine to tell them. Still, lots of money is in index funds.
2 and 3) Actively managed mutual funds put a lot of money into marketing, and the explanation for index funds is probably beyond most people. A huge number of financial experts would be out of jobs if all non-professional investors switched to index funds.
the explanation for index funds is probably beyond most people.
I don’t know, the simple explanation for index funds is “on average, you will get the market average. So why not avoid the fees?”, though it requires people being self-aware enough to recognize situations where they are, in fact, average.
But the actively managed mutual fund you are considering investing in has consistently outperformed the market even when taking into account taxes and fees.
But the actively managed mutual fund you are considering investing in has consistently outperformed the market even when taking into account taxes and fees.
Am I above average at picking actively-managed mutual funds?
What if you are the kind of person who is above average in most things. It’s far from obvious why you shouldn’t think you would be above average at picking stocks or mutual funds.
What if you are the kind of person who is above average in most things.
Why, thanks for noticing. ;) This is where the self-awareness comes in, and I agree if you can’t rely on that then you do need to build up the argument that the financial advisors and active managers are not worth their cost.
Not an economist or otherwise particularly qualified, but these are easy questions.
I’ll answer the second one first: This advice is exactly the same as advice to hold a diversified portfolio. The concept of an index fund is a tiny little piece of each and every thing that’s on the market. The reasoning behind buying index funds is exactly the reasoning behind holding a diversified portfolio.
For the second question, remember the idea is to buy a little bit of everything, to diversify. So go meta, and buy little bits of many different index funds. But actually, as this is considered a good idea, people have made such meta-index funds, that are indices of indices, that you can buy in order to get a little bit of each index fund.
But as an index is defined as “a little bit of everything”, the question of which one fades a lot in importance. There are indices of different markets, so one might ask which market to invest in, but even there you want to go meta and diversify. (Say, with one of those meta-indices.) And yes, you want to find one with low fees, which invests as widely as possible, etc. All the standard stuff. But while fiddling with the minueta may matter, it does pale when compared to the difference between buying indices and stupidly trying to pick stocks yourself.
The concept of an index fund is a tiny little piece of each and every thing that’s on the market.
This is not true. An index fund holds a particular index which generally does not represent “every thing that’s on the market”.
For a simple example, consider the most common index—the S&P 500. This index holds 500 largest-capitalization stocks in the US. If you invest in the S&P500 index you can be fairly described as investing into US large-cap stocks. The point is that you are NOT investing into small-cap stocks and neither you are investing in a large variety of other financial assets (e.g. bonds).
Yes. What I wrote was a summery, and not as perfectly detailed as one may wish. One can quibble about details: “the market”/”a market”, and those quibbles may be perfectly legitimate. Yes, one who buys S&P 500 indices is only buying shares in the large-cap market, not in all the many other things in the US (or world) economy. It would be silly to try to define a index fund as something that invests in every single thing on the face of the planet, and some indices are more diversified than others.
That said, the archetypal ideal of an index fund is that imaginary one piece of everything in the world. A fund is more “indexy” the more diversified it is. In other words, when one buys index funds, what one is buying is diversity. To a greater or lesser extent, of course, and one should buy not only the broadest index funds available, but of course also many different (non-overlapping?) index funds, if one wants to reap the full benifit of diversification.
the archetypal ideal of an index fund is that imaginary one piece of everything in the world.
Maybe in your mind. Not in mine. I think of indices (and index funds) as portfolios assembled under a particular set of rules. None of them tries to reach everything in the world, in fact a lot of them are designed to be quite narrow.
A fund is more “indexy” the more diversified it is.
I still disagree. An index fund’s most striking feature is that it invests passively, that is its managers generally don’t have to make any decisions, they just have to follow publicly announced rules. I don’t think a fund is more “indexy” if it owns more or more diverse assets.
In other words, when one buys index funds, what one is buying is diversity.
Sigh. Still no. You’re buying a portfolio composed under certain rules. Some of these portfolios (= index funds) are reasonably diversifed, some aren’t, and that depends on how do you think of diversification, too.
The “classic” index fund, one that invests into S&P500, is not diversified particularly well. It invests in only a single asset class in a single country.
An index fund’s most striking feature is that it invests passively, that is its managers generally don’t have to make any decisions, they just have to follow publicly announced rules. I don’t think a fund is more “indexy” if it owns more or more diverse assets.
Yup. Take an actively managed fund that seems to be indexy by ygert’s standards today. It might not be so indexy tomorrow.
I’m one (PhD in economics) and yes and ordinary investors should use low fee index funds.
Thank you. A couple of follow-up questions, if you don’t mind:
Do most ordinary investors not do this?
If not, do you know why? Do most people not know about the advantage of index funds? Or do they know, but don’t use them anyway?
If the latter, why don’t they? That seems strange. What makes index funds the “non-default” idea, so to speak? If index funds are known by financial experts to be superior to mutual funds (or other investing strategies), where would an ordinary person get the idea that they should be using anything other than index funds?
An index fund is intended to go up or down y the exact same amount as the entire exchange as a whole. For example, you might hear that the S&P 500 rose a total of 7% last year. If that happened, then your index fund would go up by 7%.
The main reason people don’t invest in index funds is because they want to “beat the market.” They see some stocks double or triple within a year and think “oh man, if only I’d bought that stock a bit earlier, I’d be rich!” So some people try to pick individual stocks, but the majority of laypeople want to let “experts” do it for them.
Mutual funds generally have a fund manager and tons of analysts working there trying to figure out how to beat the market (get a return greater than the market itself). They all claim to be able to do this and some have a record to point to to prove that they have done it in the past. For example, fund A may have beat the market in the previous 3 years, so investors think that by investing in Fund A over an Index fund, they will come out ahead.
But unfortunately, markets are anti-inductive so past success of individual stocks, mutual funds, and even index funds is no guarantee of future performance.
If you look at the performance of all funds over the past 20+ years and correct for survivorship bias (take into account all the funds that went out of business as well as the ones that are still around today), it becomes very clear that almost no mutual funds actually beat the market in terms of your ACTUAL RETURN when averaged over each year.
The final big problems with actively managed funds are fees and taxes. Actively managed funds charge higher percentage rates each year to cover their work. That’s how they make money. They also tend to sell a percentage of your stocks each year and buy new ones in their attempt to beat the market. This gives a certain “portfolio turnover” percentage and the higher that is, the more you have to pay in taxes (capital gains), which lessens your return even more.
The bottom line is that mutual funds claim to be able to beat the market and many do in any given year. People chase the money and pay more in capital gains and fees to try to make a higher return. Over time though, the index fund beats all others in terms of total return over time.
But mutual funds are. I don’t remember the citation, but I recall that mutual funds that do very poorly one year are more likely to do so in the future when you take into account fees and taxes.
Clearly, there are actively managed funds that do consistently worse than index funds, otherwise index funds wouldn’t be able to make money, since financial markets are negative-sum.
Financial markets are positive-sum. If you just buy a bunch of stocks and hold onto them, on average you’ll outperform cash.
If you buy a stock A at price X, somebody must be selling you stock A at price X.
If buying turns out to be a good deal (that is, the discounted dividends Y you collect from holding stock A are greater than X), then selling must turn out to be a bad deal: if the other party held stock A they would have collected the profit Y-X that they forfeited to you. Your gain is their lost profit, therefore the market is zero-sum between investors. Add transaction costs and it becomes negative-sum.
This analysis is simplified by the fact that I didn’t take into account risk aversion and the fact that different parties can discount future utility in different ways (different discount rates or even hyperbolic discounting). But I suppose that when it comes to collective investors such as mutual funds or banks, these parameters can be considered to be roughly the same.
The stock market is not (necessarily) zero-sum or negative-sum as a whole, since money is transferred from companies to investors each time dividends are paid, but the way the investors slice the cake between them is negative-sum.
Not necessarily. First, it depends on the market. Some are zero-sum, and about others one can say that they are NOT zero-sum, but that’s it. They might be negative-sum or positive-sum, depending on the circumstances.
That also depends. Average over what? Which countries and what time periods?
Survivorship bias means that most existing funds can have beating index funds in the past.
Yes, but taking into account survivorship bias, there are some actively managed funds that do do consistently worse than the market, and eventually fail (and are replaced by other funds that do so)
1) No but I’m doing my best as a columnist for Better Investing Magazine to tell them. Still, lots of money is in index funds.
2 and 3) Actively managed mutual funds put a lot of money into marketing, and the explanation for index funds is probably beyond most people. A huge number of financial experts would be out of jobs if all non-professional investors switched to index funds.
I don’t know, the simple explanation for index funds is “on average, you will get the market average. So why not avoid the fees?”, though it requires people being self-aware enough to recognize situations where they are, in fact, average.
But the actively managed mutual fund you are considering investing in has consistently outperformed the market even when taking into account taxes and fees.
Am I above average at picking actively-managed mutual funds?
What if you are the kind of person who is above average in most things. It’s far from obvious why you shouldn’t think you would be above average at picking stocks or mutual funds.
Why, thanks for noticing. ;) This is where the self-awareness comes in, and I agree if you can’t rely on that then you do need to build up the argument that the financial advisors and active managers are not worth their cost.
For ordinary investors won’t there still be an issue of buying these funds at the right time, so as not to buy when the market is unusually high?
You can migitate the problem by making the investment gradually.
Yes
Two questions:
Doesn’t this ignore the very important question of “which indices?”
Is this advice different from the “hold a sufficiently diversified portfolio” one?
Not an economist or otherwise particularly qualified, but these are easy questions.
I’ll answer the second one first: This advice is exactly the same as advice to hold a diversified portfolio. The concept of an index fund is a tiny little piece of each and every thing that’s on the market. The reasoning behind buying index funds is exactly the reasoning behind holding a diversified portfolio.
For the second question, remember the idea is to buy a little bit of everything, to diversify. So go meta, and buy little bits of many different index funds. But actually, as this is considered a good idea, people have made such meta-index funds, that are indices of indices, that you can buy in order to get a little bit of each index fund.
But as an index is defined as “a little bit of everything”, the question of which one fades a lot in importance. There are indices of different markets, so one might ask which market to invest in, but even there you want to go meta and diversify. (Say, with one of those meta-indices.) And yes, you want to find one with low fees, which invests as widely as possible, etc. All the standard stuff. But while fiddling with the minueta may matter, it does pale when compared to the difference between buying indices and stupidly trying to pick stocks yourself.
This is not true. An index fund holds a particular index which generally does not represent “every thing that’s on the market”.
For a simple example, consider the most common index—the S&P 500. This index holds 500 largest-capitalization stocks in the US. If you invest in the S&P500 index you can be fairly described as investing into US large-cap stocks. The point is that you are NOT investing into small-cap stocks and neither you are investing in a large variety of other financial assets (e.g. bonds).
Yes. What I wrote was a summery, and not as perfectly detailed as one may wish. One can quibble about details: “the market”/”a market”, and those quibbles may be perfectly legitimate. Yes, one who buys S&P 500 indices is only buying shares in the large-cap market, not in all the many other things in the US (or world) economy. It would be silly to try to define a index fund as something that invests in every single thing on the face of the planet, and some indices are more diversified than others.
That said, the archetypal ideal of an index fund is that imaginary one piece of everything in the world. A fund is more “indexy” the more diversified it is. In other words, when one buys index funds, what one is buying is diversity. To a greater or lesser extent, of course, and one should buy not only the broadest index funds available, but of course also many different (non-overlapping?) index funds, if one wants to reap the full benifit of diversification.
Maybe in your mind. Not in mine. I think of indices (and index funds) as portfolios assembled under a particular set of rules. None of them tries to reach everything in the world, in fact a lot of them are designed to be quite narrow.
I still disagree. An index fund’s most striking feature is that it invests passively, that is its managers generally don’t have to make any decisions, they just have to follow publicly announced rules. I don’t think a fund is more “indexy” if it owns more or more diverse assets.
Sigh. Still no. You’re buying a portfolio composed under certain rules. Some of these portfolios (= index funds) are reasonably diversifed, some aren’t, and that depends on how do you think of diversification, too.
The “classic” index fund, one that invests into S&P500, is not diversified particularly well. It invests in only a single asset class in a single country.
Yup. Take an actively managed fund that seems to be indexy by ygert’s standards today. It might not be so indexy tomorrow.