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Tuesday, April 22, 2008

The Problem With Index Funds

If you know absolutely nothing about investing, you should buy an S&P 500 index fund and you'll outperform 95+% of all individual investors.

My individual stock purchases have DRAMATICALLY outperformed the S&P 500 index over a 7 year period. I consider the difference to be statistically significant. My conclusion is that a straight investment in the S&P 500 is flawed.

There is selection AGAINST the S&P 500. When a stock is added to the S&P 500, insiders know ahead of time. They buy stock immediately before the stock is added to the index. This pushes up the price, and the stock is at an inflated price when it is added to the index. This process happens *EVERY* time the index composition changes. This is a huge drag on the index's performance.

Market capitalization weighting isn't ideal for small investors. Investors with large accounts should be concerned about the likelihood that a large purchase will move the stock price. Small investors have no such concern. Equal weighting is more suitable for small investors.

Based on a historic back-test, an equal-weighted S&P 500 has outperformed the market capitalization-weighted S&P 500. This mirrors the "dollar cost averaging" that a typical small investor might perform.

"Dollar cost averaging" means that if a stock you own goes down, buy more. As a retail investor, by the time you hear about "bad news", that information is already reflected in the stock price. Selling a stock after a bad news announcement is pointless. A better strategy is to buy more and wait for the rebound. People typically overreact and sell too much when bad news about a stock is released.

If you are willing to invest $10k in a stock, you are better off investing $5k immediately and waiting for a decline. If the stock goes down 10%-20%, then buy another $5k. If the stock performs well, save the $5k for your next purchase. Similarly, if you've had a stock several years and the performance has been poor, buy more.

On the opposite side, if you own a stock that has substantially risen, sell and reinvest the proceeds elsewhere. If you are concerned that the stock may continue to rise, buy some call options so you'll still benefit if the stock continues to rise. If you are investing in a taxable account, be sure to consider the effect of capital gains. Capital gains taxes means that you might be selling a stock for only 85%-90% of the actual sale price, depending on the size of the gain and your state tax rate.

If you're investing in a taxable non-IRA account, it practically never pays to sell. When you take into account the effect of taxes, you're really selling for a discount to the current market price. Unless the stock price has risen so much that you are no longer properly diversified, you should try to avoid selling. If you are investing in an IRA, you don't need to be concerned about the effect of capital gains taxes. You can be a more aggressive seller if you're investing in an IRA.

A straight index fund investment does not dollar cost average. It will hold the same amount of each stock no matter what. An index fund won't sell when a stock goes up, nor buy more when the stock declines. Using intelligent dollar cost averaging, you can outperform the index.

You might be concerned about "But what if the stock is an Enron, and will go bankrupt." For every stock like Enron, there are many more stocks like Akamai, which go down to $0.50/share and then recover to $50/share. If a stock is pulling an Enron, it will typically fall to bankruptcy in 3-6 months. If you space out your purchases, you run less risk of being "Enron-ed". If you were an Enron shareholder and following my advice, you would have sold some of your shares when Enron was at its peak. I advise spacing your purchases in a falling stock at least 3-6 months apart, to avoid being the victim of an Enron scenario.

Also, I believe that I can pick stocks better than randomly. I understand financial companies and technology/software better than most, so I can make good investments in that area.

If you invest in an index fund, your cost is around 0.20%/year. If you adopt a long-term buy-and-hold strategy, you can get your costs to 0.05%/year or less. Further, index funds do pay some transaction costs when they buy or sell shares, which aren't included in the expense ratio. Index funds sometimes loan out their shares for short selling. This suppresses the stock price, but the short sale fees are supposed to be reinvested in the index fund.

If you hold individual stocks, you have more control over when and how much you realize capital gains and losses. Most index funds are sitting on huge realized capital loss credits from 2000-2001; those credits will expire soon.

Overall, I believe a knowledgeable and disciplined investor can outperform the S&P 500 index by 2%-5%/year, without much effort.

I'm actually deeply concerned that gold is the best investment. I'm seriously considering the possibility that stocks do *NOT* give a positive inflation-adjusted return for their shareholders, if the price of gold is your index of inflation.

1 comment:

Paul Douglas Boyer said...

When comparing your investment's performance against an index fund, you must also take into account the "risk" of your investment. Typically, this risk is measured as the annualized standard deviation. There is also a measurement that compares two investments with differing returns and risk in a standard way and that is the Sharpe Ratio. A higher Sharpe Ratio indicates you are achieving better performance per unit of risk.

Buying individual stocks makes no sense because of the higher risk. Not only does it include market risk, but it includes the risk of the individual company doing something stupid. The investor is not rewarded for taking this kind of risk. Index funds reward all of the risk taken while minimizing individual company risk.

Using the S&P 500 as a benchmark is misleading. Studies have shown that small cap companies and so-called value companies have higher returns over the long term. Since the S&P 500 is the largest companies, it will have lower returns. Additionally, you are taking on currency risk by investing exclusively in US companies.

A better benchmark would include a combination of indexes from across all capitalizations and all countries. Also throw in some REITs and perhaps some commodities in small quantities.

You can throttle the risk up or down of such a portfolio by weighting the small cap value stocks more or less and of course by subtracting or adding bonds and fixed income.

If you have a properly designed portfolio of index funds with this level of diversity, you will have a much harder time finding something with a higher Sharpe Ratio over the long term.

Gold works when a currency is being devalued. Equities do too. And they also have earnings. Equities win over the long term. By long term, I mean at least 20 years.

You should compare your investments against a portfolio of index funds using the benchmarking tool at http://www.ifa.com/portfolios/PortReturnCalc/index.aspx. They sponsor my show and have great science to show active investing loses to passive.

This Blog Has Moved!

My blog has moved. Check out my new blog at realfreemarket.org.