Let's talk about the long term effectiveness of index funds

[TopHatFox]

Index funds are and have been useful over the past ~half-a-century because they tend to offer minimal fees, taxes, and the overall market return of the index, which, for the US Total Stock Market Index, happens to have been massively positive--on average--over the past century and into the foreseeable future. In fact, index funds are so useful that using them a la Boggle-heads [Bogleheads], one could outperform the majority of professional and individual investors investing in fee-based mutual funds or individual investments. This is all while freeing index fund investors to focus on other things besides analyzing companies' prospecti and other due diligence.

Question is: would total US equity index funds, for example, continue to provide a average 6% real return if the long term average growth of US equities decreases and plateaus indefinitely? Would learning how to invest effectively in individual equities serve better in that scenario?

Can learning how to invest effectively in individual equities outperform index funds over the decades in the current scenario of continual growth? I have read no, but I remember reading Jacob's writing that all he needed to do was seek established, reliable companies to invest in, not predict the market and act on the likely unreliable prediction.

[Tyler9000]

Not all index funds are equity funds. There are plenty of index funds for bonds, commodities, real estate, cash, etc., so the outlook for a portfolio that uses index funds is more a question of asset allocation than anything else.

Now there are certainly other ways to invest than using index funds. Dividend growth is a good example, and there are plenty of others. But IMHO the primary goal should be to build a sustainable portfolio that works for your needs, not to beat the index or anything else.

I think a lot of it comes down to personality. When feeding the family, are you a farmer or a hunter?

[steveo73]

My opinion is that index funds are the best option. As Tyler states its not about being 100% equities either. Its about getting the right asset allocation, diversification within that asset split and minimising your fees.

Will 6% returns continue ? Who knows.

[IlliniDave]

Index funds will return whatever the market they track return. If those markets are flat, index funds will be flat, as will the returns of the average individual equity investor. All the investors in the aggregate make what the market makes less whatever costs they incur.

Can the investor who builds his own portfolio "beat the market" (or the segment of the market he invests in) over decades? Yes, he can. It is not impossible. But will he? The evidence out there suggests it is unlikely.

And a nit. It's Bogleheads, not Boggle-heads, though the later may describe some of us

[bad_LNIP]

If the market is flat, market returns are likely going to be flat. You may be able to find a few special opportunities stock picking, but that is what everyone is trying to do and generally failing miserably at.

I would sell cash secured puts/covered calls. You get a bit better income and returns for doing so than just buying and holding.

[vexed87]

Beating the market may well be essential in the future if your are relying on stocks to deliver a ROI to fund your retirement...

I read the 'Crash Course' and it completely flipped my perspective on index investing. A good read, and for anyone considering index funds, it's a must read really as I think the world needs a reality check.

If we have a few decades of economic flatlining or worse, complete depression due to the fallout of peak oil then having your wealth stored in index funds will be a bust, and you may never get back what you put in.

Value investing is the logical approach to making money when the markets are performing poorly. Make it your mission to learn how to do this well if you absolutely must store your wealth in the stock market.

[MarginVariation]

Jacob has touched on this subject in one of his previous posts that a stock market is not some automatic generator of wealth. Cash flow is more important than net worth

Outside of this forum, if you head over to bogleheads, MMM or reddit the dogma is to buy & hold (hope) citing long run returns.

If your asset base is large enough, learning to invest with an improvement of 100 or 200 basis points, will yield great returns compared to the cost (your time). If individual stock picking yields 200 basis points in long run returns and it cost you 200 hours to learn, is your hourly rate worth it? This of course depends on how large a pool you have to invest.

No one can tell you with certainty which method will work going forward. The crowd cites that active management under performs and buying and holding is the only method. I tend to stay away from crowd mentality but that's just me. I'm rather fond of using timing models and have index exposure, cash flow yields on individual securities and collection of OTM premium on strong names.

[KevinW]

Yes, let's please keep terminology straight. Index fund is an umbrella category that includes not just total market stock funds, but also equity funds that track different indices, bond funds, and some other types of fund.

My take is that index funds will continue to be a reasonable means to the end of investing in a particular market. A total stock market index fund is a good tool for earning stock returns with extremely little outlay of expertise, time, or effort. The same goes for bond index funds. Are they the best tools for those jobs? Admittedly no, but the alternatives take more time and effort, which are scarce resources.

I'd make an analogy to canned diced tomatoes. Are they the best way to get tomatoes? No, fresh-picked homegrown tomatoes taste better, and an experienced gardener can grow them more cheaply. But that takes expertise, time, and effort which might better be spent elsewhere. And cooking from scratch with canned tomatoes is better than not cooking at all. So it's fair to say they're a useful tool, if suboptimal.

The Permanent Portfolio works better for me than does a Boglehead-style portfolio, but IMO conservative Boglehead portfolios are OK too.

[IlliniDave]

A stock market is not a generator of wealth, at least for the average person. Some of the skilled frontrunners and HFT practitioners and the like may be able to systematically exploit the market itself, but that's a fiercely competitive game.

The universe of publicly traded corporations is a generator of wealth, however. Will it always create wealth for its participants in aggregate? Maybe, maybe not. But I think it's likely that it will. Humans are very adept at creating wealth, and very adaptable in doing so even when they hit major bumps along the way. If I didn't believe that public corporations in the aggregate would create wealth I wouldn't invest in them. Nothing is certain, and I'm aware of many of the, "This time it's different" arguments, but to me it seems like as good a bet as any, and realistically my horizon is likely only 30-40 more years and barring the Yellowstone caldera blowing or a big meteor smacking Missouri or something I don't think much will change in my lifetime.

There is no buy and "hope". It's simply participation in the capital markets and collecting a share in the profits. "Buy and hope" is a slogan created by the bitter fleecers who see it becoming more difficult to sit around and collect 1-2% annually from the pockets of the people who are actually putting their capital at risk.

There are certainly other ways to make money, and probably ways to make more money. But it's apparently hard to beat simple indexing for a straightforward and systematic strategy. I'm a majority indexer, but speculate a little on the side. The latter is fun.

[steveo73]

If your asset base is large enough, learning to invest with an improvement of 100 or 200 basis points, will yield great returns compared to the cost (your time). If individual stock picking yields 200 basis points in long run returns and it cost you 200 hours to learn, is your hourly rate worth it? This of course depends on how large a pool you have to invest.

Here is the thing though - you probably can't do this. The returns of professional investors aren't that good. How many Buffets are there out there ?

[steveo73]

There is no buy and "hope". It's simply participation in the capital markets and collecting a share in the profits.

Exactly. You are just taking a share of the profits of companies that exist to make a profit.

"Buy and hope" is a slogan created by the bitter fleecers who see it becoming more difficult to sit around and collect 1-2% annually from the pockets of the people who are actually putting their capital at risk.

Exactly.

There are certainly other ways to make money, and probably ways to make more money. But it's apparently hard to beat simple indexing for a straightforward and systematic strategy. I'm a majority indexer, but speculate a little on the side. The latter is fun.

Indexing works compared to the alternative. I've mentioned this before but I'll state it again. My father in law was a professional trader. He is a multi-millionaire due to making money within the financial markets. He has inconsistent results and he considers trading exactly as per your comments a form of speculation that you cannot rely on. I've seen him with multiple $20 million positions on his own personal account and making a tonne of money. I've also seen the opposite. He managed a big banks trading operations and then managed a billionaires private hedge fund. If he gets inconsistent returns I fail to see how the average person believes they can beat the market by somehow spending some time and learning how to trade.

I should add that I also speculate however it is with a small account and I don't consider it part of my FI assets.

[trfie]

Jacob makes a great book in his book ERE that US stock index funds may be overvalued as a huge amount of money is being poured into them without proper understanding by the investors, which could result in disaster. I think it is important to be diversified, hold international stock index funds and a collection of different US stock index funds.

I think most people are kidding themselves that they can learn how to invest in individual companies. Jacob is probably an exception, as well as the handful of traders we hear about in the news.

[jacob]

@trfie - I'm fairly sure I tried to steer clear of any timely or national advice or comments on specific methods in the investment section of the ERE book. It was written at a Dreyfus level 4 like much of the rest of the book. People who were looking for level 1 specifics were disappointed and missed the point "finding nothing new"---as usual. Whereas the pros I've talked to about and who've read the infamous/controversial investment chapter all thought it was pretty good.

Just goes to say ...

But no ... I'm fairly sure I didn't say anything regarding picking specific strategies and that the message was that "if you're going to make your income from investments you owe it to yourself to be at least semi-professional about it." It's only when you're stinking rich that you can afford not to care at all and just keep everything in a checking account, inflation be damned.

[cmonkey]

I think most people are kidding themselves that they can learn how to invest in individual companies.

That depends on what you are after. Double or triple digit returns based on rising stock price? Certainly kidding themselves. Steady cash flow from solid companies pay dividends? That is much easier to do.

[trfie]

@trfie - I'm fairly sure I tried to steer clear of any timely or national advice or comments on specific methods in the investment section of the ERE book. It was written at a Dreyfus level 4 like much of the rest of the book. People who were looking for level 1 specifics were disappointed and missed the point "finding nothing new"---as usual. Whereas the pros I've talked to about and who've read the infamous/controversial investment chapter all thought it was pretty good.

Just goes to say ...

But no ... I'm fairly sure I didn't say anything regarding picking specific strategies and that the message was that "if you're going to make your income from investments you owe it to yourself to be at least semi-professional about it." It's only when you're stinking rich that you can afford not to care at all and just keep everything in a checking account, inflation be damned.

I think you're misunderstanding what I said? I thought the investment chapter in the book was fantastic. I'm not saying there was timely or national advice. You mentioned the risk associated with index funds. What I am saying (my personal opinion) is that most people do not have the capability to invest with the investment ability that I am presuming you have.

[vexed87]

That depends on what you are after. Double or triple digit returns based on rising stock price? Certainly kidding themselves. Steady cash flow from solid companies pay dividends? That is much easier to do.

+1

Not trying to start a tribe war, but the buy and hope (indexing) crowd are the only ones kidding themselves if they think the only way is up . I would be very nervous relying purely on an index fund to provide my future income, as part of a wider stratergy, I'd be less concerned.

...What I am saying (my personal opinion) is that most people do not have the capability to invest with the investment ability that I am presuming you have.

Arguably it's because they don't put the time in to learn or do enough background reading, rather than some mystical property that they lack. With enough motivation and determination, I doubt there's a soul on this forum that couldn't achieve this.

[Ydobon]

Not trying to start a tribe war, but the buy and hope (indexing) crowd are the only ones kidding themselves if they think the only way is up

I'll take your statement at face value (that you're not trying to start an argument), but your condescending generalisations about index investors aren't a particularly helpful way to approach a discussion (particularly in relation to their willingness or ability to read and learn).

I present the counter argument that there are a healthy number of index investors who have read widely, considered the merits of different investing approaches and have actively decided that a 'lose the fewest points' philosophy meets their needs.

There is no 'true faith' when it comes to investing and we should all make decisions in an informed manner, taking responsibility for our own actions.

Talking down to those who do it differently is a pointless distraction.

[IlliniDave]

That depends on what you are after. Double or triple digit returns based on rising stock price? Certainly kidding themselves. Steady cash flow from solid companies pay dividends? That is much easier to do.

+1

Not trying to start a tribe war, but the buy and hope (indexing) crowd are the only ones kidding themselves if they think the only way is up . I would be very nervous relying purely on an index fund to provide my future income, as part of a wider stratergy, I'd be less concerned.

What exactly do we think it going to happen to all those great solid dividend-paying companies in any realistic scenario where someone with even just a simple total stock market index fund is going to suffer some irrecoverable/catastrophic loss?

The caricature of someone buying a single stock index fund and eschewing all other facets of finance and investing is a bit of a straw man.

Some day I'll probably set aside some play money and make up my own little portfolio for fun. But to me, the odds don't seem to suggest that throwing my entire equity stake into such an endeavor is prudent. I've read quite a lot of books and am well into my third decade of investing. The plain truth is that it's unlikely that I can outmaneuver the legions out there who have more brainpower, time, and resources, than I do. It's probably not that hard to stay afloat doing that, but I probably will not match the market unless I concentrate my risk and hope I get lucky. My argument would be that it is both simpler and safer not to play that game for keeps.

As it is I'm content and confident in simply collecting a share of the aggregate profits of the corporate universe that is proportional to the amount of capital I put at risk there. If the worldwide corporate and capital market universe takes a permanent nosedive I'll wish I had invested in guns, bullets, and land with access to natural resources (which I have actually "invested" in). In such a world any investment portfolio is pretty meaningless. For better or worse I am an optimist, and I've bet on life and ongoing human prosperity. Nothing is certain and the future is unknown to all of us. You pay your money and take your chances.

[cmonkey]

What exactly do we think it going to happen to all those great solid dividend-paying companies in any realistic scenario where someone with even just a simple total stock market index fund is going to suffer some irrecoverable/catastrophic loss?

Well if history is any guide (not guarantee) we can expect many companies to continue and increase dividends even as markets decline. 2008 weeded out (and solidified) many large corporations. From my research, it seems that dividends have become pretty entrenched as a metric of corporate health that these companies want to maintain going forward. If they stopped paying them (or reduced) investors tend to move their investments which is not in the Company's best interest.

[IlliniDave]

What exactly do we think it going to happen to all those great solid dividend-paying companies in any realistic scenario where someone with even just a simple total stock market index fund is going to suffer some irrecoverable/catastrophic loss?

Well if history is any guide (not guarantee) we can expect many companies to continue and increase dividends even as markets decline. 2008 weeded out (and solidified) many large corporations. From my research, it seems that dividends have become pretty entrenched as a metric of corporate health that these companies want to maintain going forward. If they stopped paying them (or reduced) investors tend to move their investments which is not in the Company's best interest.

All quite true, but the same history shows the index investor would not have been permanently devastated by any of those same historical events either (provided he did not panic and sell at the bottom but rather stuck with the "hold" strategy and kept his withdrawal strategy reasonable).

My point was more directed at the other poster who seemed to imply there where scenarios where the broad market would be devastated long-term, but somehow a basket of dividend payers that could be gleaned by reading a couple books would march right along.

I actually like dividends just fine, and agree they tend to often show some immunity to the speculative noise that gets superimposed on prices.

Over the long haul the real wealth of the market is generated by the aggregate success of the corporations. If they fail in the aggregate so as to ruin the index investor, there will be no dividends for either the index investor (yes, we're collecting dividends too) or the dividend investor. In other words, it's not reasonable to expect the entire market to permanently collapse sans a few knowable-in-advance dividend payers that will just keep slinging out the cash as if nothing happened. We're all in it together, we just prefer different sides of the same coin.