The Absurdity of Index Investing

March 13th, 2014 by Potato

Many people don’t believe in index investing, looking instead for ways to beat the market and eke out those last few percentage points of return.

I get it: index investing is an absurd concept. Most popular indexes were never intended to be investment products: they were simply a way to try to get an average figure for the stock market so journalists could succinctly report what was happening on Wall/Bay St. when filling the paper and TV screens with non-actionable noise (…I mean news). That such an arbitrary collection of companies should end up being the most highly recommended way to invest seems to stretch credibility.

“Surely,” the argument goes, “out of 500-some companies I can find 10 that are obviously going to do worse than the average and exclude them, and find 10 that are obviously going to out-perform and over-weight those, and then I’ll out-perform indexing.” And I don’t know — maybe you can. But likely not, at least not without so much work (or paying someone else to put in the work) that the costs undermine the gains. And if you can maybe get the extreme outliers, the temptation is to keep going with the tweaking until long past the point where any move you make is more likely to be wrong than right. It’s a losers’ game.

Still, the mind rebels against the concept.It can’t be that indexing works, after all, there’s a whole profession created around the idea of investing through active management. If the argument that the active investors are the market — so the average active investor gets the average market return less fees — were true then a whole industry by rights should not exist. But it does, therefore there must be something better than active investing, QED. The studies exist though: the best data is on mutual funds, which by a very large margin do not beat their indexes net of fees.

Of course, we live in a crazy, irrational world. The lure of the possibility of doing better (and rubbing your peers’ noses in it), of finding that fund manager who’s secretly the next Buffett, Lynch, or Soros is irresistible to many. We’ve all heard of those guys who made it big by just having the right idea at the right time — whether it was a tech company, a mining stock, or shorting the housing market — and we’ve all got ideas of our own. We’re greedy, and there’s a driving need to be better, even if it means taking risks to get there. Setting out to be average is a tough nut to swallow, even if doing so actually makes you an above-average investor who can more easily avoid the emotional foibles of the masses.

Or maybe your salescritter moves the goalposts and instead of promising better returns instead breaks out language regarding absolute returns or lower volatility. That can be shockingly persuasive: even though human drivers can make all kinds of deadly errors, nobody wants a robot car on the road. The thought that some human agency is driving your portfolio — even if they’re driving it into the ground — can seem more reassuring than the thought that you have turned everything over to a passive sampling of global capitalism.

And even when you’ve heard about how “fees matter”, the fees sound so very small — single-digit percentages or even “basis points” — that it’s hard to believe the effect is so profound. Surely paying 1% to this really smart-sounding guy will be worth it when he out-performs, right? It was to the people who invested five years ago…

Yes, past performance is no guarantee of future results, but — aha! — doesn’t that also apply to index investing being the way to go? And looking at past results is so important as it’s one of the few pieces of data accessible, and we have to look at something — investing should be work. That’s a law of nature or something, right? No: it’s hard to accept, but making things easy and uncomplicated is a virtue. If it makes it easier to stick to your plan and not panic or screw things up through human error, then that’s a further way that indexing is a good approach to take (and to recommend). Rather than procrastinating on a hard method that’s likely going to underperform, it’s really easy — and satisfying — to push someone just getting started towards indexing.

Then, after all the absurdities and cognitive biases have been stripped away, you see that indexing isn’t quite so absurd after all. A cap-weighted index minimizes the amount of rebalancing that has to happen on an ongoing basis as valuations fluctuate. Big indexes are well-diversified, and even if they were meant for reporting more than buying, they work quite well if there’s some scale involved (which Vanguard, Horizon, BMO, TD, Tangerine, or iShares can easily provide). Because there’s nothing else to compete on (the vendors want to track the same thing as closely as possible) the fees get cut as close to zero as possible.

Even after accepting that indexing is the way to go, that urge to outperform and make it into work can remain. We all know someone who uses ETFs to invest, but is not in any sense a passive index investor. They may try to time the market, or just over-fit their asset allocation model, digging up ever more specific sector and individual country funds to own, with their portfolio allocated down to fractions of a percent. There are some who acknowledge the happenstance origins of indexing, and who try to create better indexes (fundamental, value-tilted, etc.) that still embrace the core principles of broad diversification and fee minimization.

Though no matter what path led to the indexes we have, in the end it’s the best strategy available for the vast majority of people investing for the long run.

3 Responses to “The Absurdity of Index Investing”

  1. Michael James Says:

    Well said. My feeling that it must be possible to beat index investing is starting to fade. I’ve explained the reasoning behind index investing so many times that it seems to have sunk part way into my automatic brain system.

  2. Sandi Says:

    This deserves a slow clap. “Investing should be work” one of those biases I forget to address when I’m talking about indexing. Well done.

  3. Juan Refrito Says:

    It’s one of the things I like about TD e funds — they’re not ETFs so aren’t suitable for active trading. The MER is obviously a little higher than comparable ETFs, but I like the restraint/constraint they impose in terms of protecting me from the temptation to make an active play. In short, I find they help protect me from myself.