Q: If it is true that most investors do not match the returns of the overall market, why not surrender to an "index fund," and make life simple?
On the surface, logic may appear to support such an undertaking, but the more you know about the investment process, and how people approach it in real life, the more you will realize that such a plan may be unsound, and therefore not successful.
Good compared to what
Let's look at two approaches for comparison. If a person were to invest in a dozen or more outstanding individual stocks, buy them one at a time ' as the price of each becomes attractive ' and then if they stayed with that program for the long term, they would likely do well. Some of those stocks might do poorly, some might do very well, but the odds are that such an approach would produce returns in line with overall U.S. corporate growth rates, over long periods of time. And, incremental changes and adjustments could be made when warranted, as time passed.
Now let's consider doing something similar with an "index fund". Buy it when its price appears low, and then stay with it for the long run. If you could do it, you would likely become an investor who did as well as 'the market', although you might lose other important benefits like custom management, tax management, and the ability to produce or adjust income distributions, etc. But in any case, this scenario is a theoretical concept, because people don't do what we have just described. Why? Because people think, they feel, they are influenced by others, events, and a natural desire to 'add value'. They do not buy inflexible assets and hold them indefinitely, and therein are the unavoidable drawbacks, in real terms, of the index approach.
But let's further imagine buying an index fund, again with the idea of keeping up with the market, over the long haul. Let's take the S&P500 for example, as it is a broad piece of the market and it is well known. The first thing you would realize, if you looked at all the stocks in the index, is that it is comprised of many stocks that are inferior, by comparison, and that you would never buy intentionally. You would want to be more selective than that. You would want the quality stocks, but not the weak ones. But index funds don't work that way ? it's an all or none proposition, no matter which index you pick. Further, which index would you pick? Well, that would depend on your needs and objectives, which incidentally, can change as time goes by. You might think that perhaps a small-cap index would be a better choice. Or, perhaps international, or maybe health care, or energy and commodities, or perhaps a mix of REIT's and/or bonds could become desired.
Moving further in this thought process - to surrender to index funds - one becomes aware of how problems develop. For example, what would you do if you later decided that you picked the wrong index? If you decided that you did, and that another index would likely do better from that point forward, how many years would you stay with your original choice? How long it takes to make a change is relevant. But regardless of when, as soon as you make a change, your original premise of matching the market is out the window. It won't matter why you change. Whether it is a tip from a friend, an urging from a broker, or a change in objectives, all will produce the same result. You will sell the index fund originally purchased in favor of another, or in favor of cash because the market appears to be in a tailspin, or because everyone says tech is about to go through the roof or!!!..
Matching the market is only good sometimes
Once you make that change, and there will be many possible reasons, you will no longer have any assurance that your original mission can be accomplished, which was to match the market's performance over meaningful periods of time. One may think they would stay with their original choice, but who can sit there and do nothing when matching the market means losing money everyday, because the market is in a period of decline? The reality is that everyone wants to match the performance of the market, but only when the slice of the market that they have is doing well, and only if it is consistent with your individual objectives, which by definition is a condition that may change. When your index fund is losing value, or underperforming other index funds, you will be tempted to move. This is similar to what happens to sector fund investors, who have historically jumped from fund to fund attempting to improve performance. Unfortunately, no one is smart enough to be successful with such maneuvering, over meaningful periods of time.
There is an alternative to surrendering to index funds: To select, own, and manage individual securities. In a managed portfolio, changes can be made carefully, one at a time, and this approach is based upon ownership. This is critical because when investors think like owners, rather than performance seekers, they behave differently. If they are also under the influence of professional investment management advice, studies suggest they behave much differently. In this approach to wealth building, people are more inclined to think about long-term objectives, and are less influenced by short-term market fluctuations. Just the reverse is true for performance seekers. It is the portfolio owners who are less likely to be shaken out of their investment commitments, because they feel more committed. 'Ownership' is one of the most powerful forces in wealth building.
By comparison, index funds can be easily bought on major exchanges, with much less work and commitment than building a portfolio, and are more closely aligned to a 'renters' mentality. Because they can be sold so easily, they frequently are. Therefore, the temptation to change course becomes unmanageable for many; the invitations to change strategy are endless in this over-stimulated world. But fortunately, there are many investors who have owned, held, and successfully managed quality portfolios, for very long periods. It would be nice if those who bought index funds stayed with them, regardless of circumstances. But there is little evidence that they do. This is a very revealing reality, because the only way to match the market with an index fund is to buy it, and keep it, regardless of unfolding circumstances.
The more experienced an investor is, the more likely they are to realize there is no free or easy way to be a successful investor. The lure of surrendering to an index fund is significant, if not seductive, but so is market timing, short selling, sector picking, day trading, and acting on broker tips. Experience says they all work in theory, but rarely work in practice. Knowing the difference is a real determinate of investment success. Having spent a career studying and learning from the greatest of investment managers, I know that neither Lynch, Templeton, nor Buffett advocate the concept of surrendering to index funds. If they ever do, we will re-examine. But if you have followed the real world logic of this somewhat complicated subject, you will likely realize that they are not likely to do so. Investing is important, difficult, and requires temperament, patience, and experience. Short cuts are like free lunches. One doesn't work; the other doesn't exist.
The bottom line
In closing, when the average investor experiences poor performance, it is not generally a result of insufficient opportunity. The historical long-term market return of about 10% is the evidence that opportunity is present, for those who approach investing realistically. But in the long run, poor performance is often a result of investors behaving in self-defeating ways. There are many ways to describe these behaviors, but most occur because of a desire to make money without exercising patience, or because investors make course changes that hurt, rather than help. Wanting to dismiss this reality is not uncommon. The last thing investors want to admit is that their under-performance is due to their own inconsistent behavior. But it is often true, and the sell-side investment community knows it. Investors can count on endless invitations to change their course. They may come from brokers, the media, or friends. But the pressures to 'do this instead' are unending, and the result is that many investors fail to stay with their commitments. Accordingly, the most important question many investors can ask themselves is: 'Which investment approaches are most likely to help investors stay the course, and which are least likely'? By their very nature, I believe index fund investing falls into the second category, and may in fact top the list.
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