Challenging the Idea of Index Funds

Hi all,

It seems many investors are very much moving toward index style investing for shares which for a long time has made sense to me. I've read Benjamin Grahams 'Intelligent Investor', watched the successes of Warren Buffet and his proclamations for buy and hold index investing and been through some of the Bogglehead web sites.

For those proponents of buy and hold index investing, I've developed some thoughts which may challenge the idea of index investing, or at the very least start some constructive conversation around the idea, so here goes....

I've always liked the idea of Index funds. However, the biggest issue for me is that every 8-10 years or so the market has historically undergone around a 40-50% decline. For those living off dividends it cuts your income in half, not to mention the mental angst.

What's more when we look at the titans of buy and hold investing such as Warren Buffett, it seems that he was terrified when the market was crashing during the GFC, not the calm disposition of a man that new exactly what he was doing. He effectively begged Congress to provide liquidity to the markets and lobbied the government to offer company bailouts to avert financial calamity, essentially using his influence to save his fortune and those of his devout followers. It does not give me the confidence to be a 'buy and hold' investor. Research all you can what Warren Buffett was doing with government at the time of the GFC, you can bet that he was extremely concerned. Only after the bailouts and liquidity did he start to do the whole 'buy when there's blood in the streets' thing.

The GFC was not an unprecedented event it WILL happen again. What happens when someone like WB is not there to support markets? By studying the GFC and other crashes it really concretes the idea for me that financial markets are truly built on sand, confidence is the only thing that holds share prices up. When fear sets in governments will try to counter fear with comments or opinions that aren't tangible but attempt to reverse public fear.

As a buy and hold investor in index funds, can you cope with your wealth halving (or more) and waiting years for it to recover. Also consider that it's easy to look at the positives of index funds when the US market has just had one of it's best stretches on record. Look at history though and you'll see periods where the S&P 500 has remained stagnant i.e. made no net capital gain for up to 10 years or more.

It's easy to say 'I'll hold my index fund forever', but it's important to consider some of these points that challenge the philosophy of index investing. I think I'll prefer to stay more nimble, at the moment the US market is at historical highs, after running through one of its biggest bull runs on record. Right now cash could be a better option.....

 

You seem to be confusing timing the market with the type of investment?

you can focus on index funds and still time the market. Just hold cash (or as property investors undrawn locs) in reserve, and have a plan to buy when markets fall. If youve held index funds over the last decade or more, you have returns higher than the expected average so it would have made sense to pull some cash aside on the way.

also dividends dont necessarily fall when the share price falls. Anyway, us shares pay almost no dividends anyway.

if you dont go for index funds, what is your alternative?

you seem to assume everyone is 100% in index funds with no other asset classes, and no new money to put in. In practice most investors are still working (so have income) and have other assets like property.

 

I am not sure this is the case. When values drop dividends do not necessarily drop as dividends are paid out of profits of the company and not as a % of the value of the shares.
I have seen graphs which show a slight drop in dividends during a GFC but nothing like the drop in values.

If you can hold on for a while values might come back up pretty quickly too. Having a dividend buffer can greatly help ride out any fluctuations.

 

Took the words out of my mouth

 

An alternative view:

Just went 95% cash in Super - Share Market Correction

 

LewisL..
The above would have taken time to think and plan that post out,, and it may even go into the range as former winners of the Keith McDonald Awards for business journalist of the year maybe even in the range of a Quill award..

Quote..
I've always liked the idea of Index funds. However, the biggest issue for me is that every 8-10 years or so the market has historically undergone around a 40-50% decline. For those living off dividends it cuts your income in half, not to mention the mental angst.

i am always interested in what going on in the business world and subsequently the way many of the world's ,biggest decision -makers think and how they play both sides of the field and the animal-lista style they employ..

No one can or will ever manage to emulate Big-Warrens Brilliance ,but with the 40-50 % please re-think that one ,as when the xxxx hits the mach 3 could be this week or next month or years away..

Blue chips can drop over 70% and i can back that up data wise 1000%,but the div's just keep pumping ..

With the 'Intelligent Investor',as i have boxes of the paid monthly advice from ''I-I'' from just prior too 2007 ..

This is one of the quotes from all those year's reading those paid monthly papers,the other is mine learnt from experience

Quote ..
Miss or Mister Market walks past you every morning at about 10 too 10 ,they never say nothing everything is there in front of you you either buy or sell or do nothing ..

This is mine,and mine only..
''You can always learn from people who think the way you don't...

 

And even better is one way @willair - If fifty million people say a foolish thing, it's still a foolish thing, Anatole France.

The task is to determine what is foolish and who is saying it.

 

SatayKing ,that's a classic that quote and as we both know there are very few that have raw superb ability to judge risk in market's ..
I don't ..

 

Well if not buy-and-hold index funds, then what? Actively managed funds? Market timing? You're saying cash could be a better option - how much cash as a % of your portfolio? There's a reason Bogleheads advocate holding bonds, but you need to have a set asset allocation and stick to it (rebalancing yearly if necessary).

But if you focus too much on the possible downturns then you'll miss the ride up - which will more than make up for any potential losses.

 

Always good to challenge ideas, but I'll provide my 2 cents.

Like what others has already mentioned, dividends do not fall as much as share prices during a crash as companies are still earning money and paying them out. If you are in accumulation, this is a good time to top up. If you are retired, hopefully you have read the risks of SORR and have strategies in place.

Also, you seem to suggest the only reason that the markets came back from the GFC was due to the efforts of WB. I think that's debatable but more to the point, there has been countless crashes/bear markets in history even before the time of WB, and the markets has always recovered without his efforts. What makes you think this time it's different?

If you cannot cope with your money halved then you should not be in the market in the first place. Either diversify or own an IP instead. If you focus too much on the downside, like most people do, you will miss most of the upside, and come out significantly behind the index in the long run. Most people don't get this, and it's OK because you invest for yourself, but it's really not a debatable point with what the research shows.

 

Busting The Myth Of Market Timing

 

Ex equity analyst here. All of active managers struggle to beat the market index and with AI tech the difference between active and AI-driven "passive" funds is declining. Unless you want to pay a premium fee for multi-asset managers or lock capital away for a few years with hedge funds (ie doing listed shares + alternative incvestments + some kind of leverage strategy) - I think index is the way to go.

 

Index funds are going to beat most funds. But the good active funds will still consistently beat the indices. Question is do you have good enough a judgment the right the right fund.

 

All very good points and some excellent insights, thanks for pointing out that dividends are not necessarily cut as a percentage value of the share price. Yes I agree, Warren Buffet was only one in a number of key stakeholders that pushed for bailouts/liquidity etc. Also agree that markets will always rebound eventually, at times the drop could be more pronounced without certain members lobbying government.

My strategy is actually a little unique, I've taught myself technical analysis (chart reading), but this is certainly not day trading. I use charts to buy and hold large-cap US stocks for the long haul, around 2-4 years or so. I play the big (multi-year) trend and when it reverses I'm out, determining when the trend is reversed is based on a number of indicators. It has worked well for me, I don't consider the fundamentals of the company whatsoever, this is entirely irrelevant to my strategy.

I certainly get that this is not for everyone and index funds are certainly the way to go for most people. I've spent years training myself in chart reading and it is not some witch doctor practice but it is extremely difficult to jump some of the initial challenges which is why most struggle to understand it. My advantage is that I'm able to get out when the market starts to turn, this continues to work favorably more often then not (speaking of individual stocks). The biggest issue is having cash on the sideline waiting for the right opportunity, when the index is pumping as it has been lately, then having cash is an opportunity lost. Individual stocks in my portfolio have outperformed the S&P500 (as an average) however the portfolio as a whole has not, due to the cash holding.

By the way, based on my charts I'm expecting this to be an extremely important week for US stocks (aka all stocks). If you're a long term index investor, have your plan in place, remember why you buy and hold, turn the news off, close the newspapers and keep your cash ready to top up once the market finishes its rout. As mentioned above, recoveries will always take place in the stock market, as much as this doesn't seem possible when general fear sets in. Regardless, of whether this weeks 'pull-back' will be the big one or not, probability suggests that 2020 will see a major correction, and this is backed by the fact that US markets have undergone a major bull run and are sitting at extreme high levels. I don't expect property to be affected though nor the Australian markets (as much) as it isn't coming off the same extended bull run. Think of 2020 as something like a repeat of the .com bust in 2000, not GFC level.

Time will tell.

Good luck and be careful this year!

 

Great that you are doing well doing what you are doing. But it seems you are doing it for us stocks.

You dont seem to have enough knowledge of the australian market (eg about dividends) to make an informed judgement.

For most people dollar cost averaging into index funds, maybe add a bit of timing the market, isnt a bad way to do it. Especially if you have geared resi ips for growth. Many resi investors would have undrawn locs waiting for buying opportunities including in shares.

 

Agree, I think dollar cost averaging into Index Funds is an excellent strategy for most people. Being able to hold on through a major bust is something I think very few people are mentally prepared for though. Writing a plan, ignoring the news and researching previous busts so you have a good understanding of what you're going into, are good steps to take to ensure you don't sell out of your long term goals due to panic or fear like 99% of the general public.

With Australian shares though, just because you have healthy dividends which may not change, doesn't mean you won't be mentally impacted by a huge fall in the capital value of your portfolio.

It's good to have a written plan when your head is in the right place, that you can refer back to when markets are panicking.

The old rule of diversification probably helps here too, knowing that your trusty rental property is still giving you the same weekly rent as the stock markets falls.

I would like to see the boggleheads community when things are really testy in the markets, whether people start to question the buy and hold philosophy. The problem comes, just like the GFC, when people say 'that this time is different' markets will never recover. A good read of past busts helps here. There's nothing new under the sun.

 

Another alternative view:

http://csinvesting.org/wp-content/uploads/2016/12/the-coffee-can-portfolio.pdf

I might adopt this approach with some of the direct stocks in my super.

 

This feels like those posts about how buy and hold property investors are overleveraged and dont consider market reversals and will get killed when the markets turn. Then people discuss their risk mitigation and cash buffers and market timing.

What happens when a trade doesnt work out the way you thought? Sure your mentally impacted, but you learn from it and keep going.

Just because a strategy looks passive doesnt mean there is no thought behind it. Just because a strategy is actively trying to avoid risks doesnt mean it will succeed.

The properties arent there for rent. They are there for leveraged capital growth with no margin calls, and are often negatively correlated with shares. Perth isnt the world.

 

So is there anything out of the ordinary that is happening this week?