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?
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.
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.
Random Useless Fact: