Feb 062017
 

Index investing is a great way to build long term wealth. It’s simple to implement, convenient, and you are guaranteed to make the same returns as the market, minus any fees. But is it right for everyone?

Taking a closer look at Index Investing

How Indexes Are Managed

There’s a common theory that retail investors shouldn’t try to beat the market since it’s almost impossible to do over time. But I’m not sure this is true. The “index” isn’t the holy grail of stock selection. Some folks from the S&P Index Committee sit in a room and decide which stocks to include in their index based on a set of criteria with arbitrary measurements. It would be preferable if prominent investors such as Ray Dalio or Warren Buffett were on this committee, but they aren’t. Lol.

The S&P/TSX Composite index is made up of 250 stocks, chosen by the committee. It’s intriguing how only 250 stocks are selected out of the possible 1500+ on the entire Canadian stock market. The methodology for selecting stocks to be included in an index contains guidelines for minimum weight in the market, price per share, market cap, and sufficient liquidity requirements. The index is reviewed quarterly and all Index Securities that, in the opinion of the Index Committee, do not meet certain requirements are removed. And for the S&P 500 stock market index in the United States, anywhere from 25 to 50 changes are made every year. It’s basically a handful of people getting paid to actively manage a list of stocks that they believe represents the overall equity market.

The Paradox of Index Investing

From what I’ve heard, the whole idea of index investing is to match the market’s performance using a passive methodology. But if picking individual stocks will underperform the market most of the time, according to the mainstream, then how can index investing work if it’s based on a managed list of stocks that is updated every quarter based on the decisions of some individuals on Wall Street? Why are they more qualified to pick stocks for the index than let’s say, personal finance bloggers? 😀

I don’t think it would be hard for a handful of competent value and dividend investors to get together, create their own list of 250 stocks, and then beat the S&P/TSX Composite index. Last year Nelson from Financial Uproar hosted a stock picking contest for personal finance bloggers. There were 14 participants, including myself. Our average investment return for 2016 was 30%. We beat all the major indexes in both Canada and the U.S. Since an index is meant to represent the average of the stock market, then all we had to do to beat the market was to just be better than average. 😉 Easy peasy.

Different Objectives

If you’re trying to match the general market’s performance, then the only index fund that would make sense to buy is a total market index fund. This way, there are no individuals who actively decide which stocks you should own. You would simply be exposed to the entirety of the stock market. This is one of the best ways to invest for passive investors, in my opinion. Vanguard has a mutual fund (VTSMX) that tracks the total market index for the U.S. However, if your investment goal is like mine, which is to get the highest return possible on your money, then going 100% index investing doesn’t work.

S&P/TSX indices are designed to be both representative of the Canadian equity market and its sectors, and liquid to support investment products such as index mutual funds, and exchange traded funds (ETFs.) But since this is not my goal, it will not accomplish what I want. This is why I mentioned last month that it’s not important to compare my portfolio returns to the index.

If an index is made from 250 stocks that meet certain requirements, then what if individual investors used a similar but more strict requirements so only the top 50 stocks would be included in their portfolio? This is pretty much what I’ve been doing personally over the last 7 years. 🙂 It may not be appropriate for everyone, but so far it is working for me. This doesn’t mean I’m 100% for choosing individual stocks either. My investing method is about finding the sweet spot between picking stocks and index investing to maximize my overall returns. If anyone is interested I can explain how I do that in a future post.

 

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15 Comments on "A Deeper Look into Index Investing"

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John
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John

Very good article and encouraging to those (we/us/you/me) that can get frustrated trying to talk to people about investing and different ways they should think about it all.

In regards to your RUF, I had read a story that was written in an interview with Pablo’s son. His son had recalled a time that the power had gone out in the house during a storm and Pablo’s daughter had complained that she was cold. Pablo then reached over into one of his cabinets, grabbed a torch, and proceeded to light up nearly $2 million worth of cash to keep his daughter warm. Family over money, am I right?

SmokingIsCoolAgain
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SmokingIsCoolAgain

Your success has been well documented here but why hasn’t it been made into a bigger deal? When you look at the returns of the largest endowments who essentially are competing against each other to chase the highest returns, the highest percentiles aren’t even sniffing a fifth of what you’ve been able to achieve.

Source: http://www.nacubo.org/Documents/EndowmentFiles/2016-NCSE-Public-Tables_Average-One-Three-Five-and-Ten-Year-Returns.pdf

These are groups that literally shell out big bucks for the best money managers on the planet and you are utterly DESTROYING their performance. Have they just not found out about you yet? Seriously!! You should work as a consultant or something, charge out like $250,000/year and offer your services to the likes of Harvard, Yale, or MIT just to name a few. 2 years of that plus your other investment activity and you’ll shoot past your $1M goal!

It’s almost as if you are omitting an important aspect worth considering when comparing the two……….

ross
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ross

lol, ya.

that 30% average was dragged up by a couple of people hitting the jackpot on marijuana stocks.

freedom 35”s result was 16%
VCE returned 20.4%

Jeffrey
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Jeffrey
The one thing that convinced me to give up individual stocks and to go with indexes is: in any given index, say the S&P, the average annual rate of return is driven by a handful of ultra-high performers (let’s say 20/500: the needles in the haystack). Counterintuitively, the main problem of stock picking is not the avoidance of losers (e.g. “I don’t want the TSX 60 because I think Valeant is a bad deal”) from an index: your performance will still be worse than the index’s average return if you miss to pick up both the losers and the extreme winners. So avoiding the bad apples is less important for one’s financial return than making sure to have the ultra-high returners. Going with the index is better because you are guaranteed to have them in. Going with individual stock picking is difficult because it is very hard to tell ahead of time the handful of ultra-earners from the big number of average performing stock. On paper, they look roughly the same (good numbers), but the workings of luck and unexpected opportunity will pull some from the average crowd and make them ultra-winner stocks. So, even if you know how to… Read more »
Ben W
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Ben W

Looking forward to hear how you put together your index

Smart Provisions
Guest

I definitely agree that if a stricter criteria is applied to an index, it is possible to generate higher returns.

One example is the Dividend Aristocrats, they’ve been able to beat the S&P 500 Index most years and are even less volatile.

DivGuy
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Over the years, I’ve always beaten index investments. I don’t need more to prove that I’m better off doing it myself. 😉 However, it’s more time consuming and not all people are whiling to do it. Index investing can be a good alternative for that type of investors. Other than that, I don’t see any advantage!

Cheers,

Mike

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[…] 3. My homie Liquid (or, as his friends call him, Beatbox), takes a closer look at index investing and concludes that while it’s pretty good, there are some downfalls that never get brought up. […]

Matt
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Index investing is a great a way to grow your wealth while minimizing fees. The growth of ETF’s has allowed easy diversification with low fees. See the impact these fees can have on your investments here: http://www.freedomlifeplanning.com/index.php/2017/01/25/index-investing/

Keep the money for yourself and not the fund manager. It’s not about what’s in the index, but about the theory of an efficient market and the index providing easy access to diversification.

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[…] visitors about how reading my blog has made them a lot of money. On my previous post about index investing, one commentator even suggested I charge exorbitant fees to do consulting work, haha. […]

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