Passive Indexing: The Allure of Easy Money

Let’s get one thing out of the way really quick—I believe in all of the benefits provided by low-cost index funds and Exchange Traded Funds (ETF’s for short).  I would never argue with the likes of Warren Buffett when he hammers home to everyday investors the benefits of keeping fees down and simply purchasing index funds to gain access to stock market investments.  I mean, he doesn’t do it, but then again, he’s Warren Buffett. 

But like many things in life, sometimes the benefits can get overstated.  I believe index funds receive more credit than they deserve, by many investors, simply because the period in which they have gained widespread use has correlated with a period of extremely low risk and high returns.  This is a natural phenomenon in behavioral sciences, ascribing greater significance to people, places, or events simply because they correlate to periods of greater success or failure. 

I’ll give you an example, I am not a great soccer coach.  I do not run particularly disciplined practices, nor to I possess much skill at the sport to be able to impart great wisdom to the kids I coach.  I do, however, love spending time with my sons and stepping up to help out when a team needs someone to coach.  My ability to coach has not improved over the years, however my winning percentage has greatly improved the last couple years. 

Last Sunday we played our first game of the season, in my inaugural season taking over my younger son’s team.  Last season I was the assistant coach for the team, and we went the entire season without winning a game.  The head coach moved on, and I was given the reins.  I did not know what to expect for our first game, but one kid arrived who hadn’t been at any of the practices I had held—his dad had told me he was injured.  Right away I could tell he was good. 

At the end of the game we won 7-3 and the new kid scored 4 goals.  As the parents came over to gather up their kids, I received a lot of smiles and congratulations, particularly from the dads whose sons were on the team last season.  One father shook my hand and said, “A lot better than last season.  Good job.”  I couldn’t help it, I really felt for a moment that I played a vital role in the outcome.  But then I remembered the behavioral tendency to ascribe greater significance to certain things, coaching in particular, when the outcome may just be corollary.  Clearly the new kid had a greater impact on the outcome than my mediocre coaching, but I was receiving the accolades from the dads.

In the same way, index funds have reaped some of the rewards the “Halo Effect.”  Index funds provide investors a great way to invest in the stock market, while being able to diversify out of single stock risk.  But removing one risk, stock selection, doesn’t remove all the risks.  During this period of index funds’ rise to prominence, the US stock market has simultaneously been in the longest running bull market in history.  The bull market feeds complacency.  The further we get away from the bear market of 2001-2003 and 2008-09, the more we forget about the downside risk of stock market investment. 

Stock-index investing doesn’t remove the risks inherent in investing in the stock market--that seems obvious but can be frequently ignored.  The stock index tracked by the most used index funds, the S&P 500, has been around for a lot longer than the funds themselves.  The S&P 500 index has been tracked since 1926.  And while the long-term benefits of investing in this index during this period are undeniable, those returns have been anything but a free lunch.  In the last 90 years there have been numerous drawdowns that would terrify today’s investors.  During the Great Depression, the S&P 500 lost over 80% of its value.  More recently, the S&P 500 Index lost over half its value in 2008-09.  Here is a look at the drawdowns in the index throughout history:         

Courtesy of awealthofcommonsense.com

The only way to protect your money against the cataclysmic impact of those types of losses is by investing a portion of your money out of the stock market.  This seems easy to understand, but hard to implement when the stock market keeps going higher and diversifying out of the stock market means not getting all of the returns of the market, because naturally you can’t get 100% of the good market and 0% of the bad market. 

Retirement, goal-based investing is not the same as stock market investing.  If you cannot stomach, or cannot achieve your goals, if you lose 80% of your account value, then you cannot invest 100% of your retirement portfolio in the stock market.  By diversifying away from the risks seen above means that your returns will not simply follow the returns of the stock market.  It is important to remember this chart, and remember why you are investing, when you consider how you are invested.