This is the fourth of a multi-part series on how to invest outside of a 401K. In this one, we’ll cover how passive index investing works and why it is effective. The whole idea for this series started when I was asking a group of about 30 co-workers if they invested outside of a 401K, and found out that zero of them did.
I later polled readers as to why they had not started investing outside of a 401k. And now we’re hitting each of the reasons why. The first part in the series dealt with the question of whether you should pay off debt or invest. The second on how to start an online broker account. And the third on how to get over the fear of investing. In this fourth part, we’ll discuss investing theory, particularly why I prefer passive index investing over any other investment strategy.
Now that you have an online broker account, you’ve funded it, and you’re armed with knowledge and motivation to not let your money sit in a hole in the ground, it’s time to get out there and trade like a pro! Not so fast…
The Market is Dominated by Institutional Investors
According to the Harvard Business Review, institutional investors own 80 percent of American corporations, up from 35 percent in 1975. An institutional investor is a person or group that manages a large pool of money – such as a hedge fund, mutual fund, pension, bank, or insurance company. Why should that matter to you?
An institutional investor’s job is to get good returns for the people who are giving them money to manage. As a result, they have resources available to them that an amateur like you or I do not.
- insider knowledge (legal or otherwise)
- ability to negotiate on their trades
- technological trading tool advantages
- researching resources
- time & knowledge: it’s 100% of their focus
- the ability to visit companies first hand, to see what they do and talk to their executives
- the ability to heavily influence the market
We have none of that. Even if we spent 40 hours a week studying every stock we wanted to trade in and out of, we’d still be at a disadvantage to them.
So don’t do it! To buy and quickly sell (trading) stocks, is like saying, “the price of these stocks, mostly determined by institutional investors, is wrong and I know better when to buy and sell than they do”. While that may very occasionally be true, 99.9 times out of 100, it is not.
From personal experience, I have tried an active stock-picking investment strategy and failed massively with it. Occasionally, I made some quick money. But, more often than not, I lost money, and whether I profited or lost, it was very stressful. I was watching that ticker go up and down multiple times every day, and my mood would swing based on whether a stock was in the green or red at that moment. Quite addicting. Kind of like gambling. And not a healthy way to live.
A Better Investment Strategy
So, I’ve basically shot down stock trading. Kind of depressing, isn’t it? Don’t let it be – there is a better way. It’s called passive index investing. And it’s not sexy or thrilling, but that may be just what the doctor ordered when it comes to making money.
To explain what passive index investing is, I’ll first need to explain what an index is. A market index measures the value of a group of investments, pooled together. Much like a mutual fund, it is a way to diversify through investing in a number of different securities (stocks, bonds, etc.).
For example, one of the more popular indexes is the S&P 500, which is a committee selected group of 500 large cap (market value) stocks, mostly domestic, that are meant to resemble the market as a whole. Another example of a market index is the Russell 2000, which includes 2000 small cap stocks.
You’ll also find indexes that measure different sectors of stocks such as international, health care, real estate, REITs, and just about any other way you can group stocks.
Passive indexing is investing in market indexes through one of two vehicles – an ETF or index fund. In their simplest sense they are both meant to diversify, track an index, and be a low cost alternative to actively managed mutual funds.
So how do they perform?
Actively Managed Funds Vs. Indexes
We’ve established the many disadvantages that amateur investors are going to have versus institutional investors. But how does passive index investing perform against institutional actively managed mutual funds? What percent of actively managed funds outperform their index over time?
According to an analysis of active fund performance over the last 5 years,
Not a single one of the initial 2,132 funds managed to achieve top-quartile performance for those five successive years. That hasn’t happened for stock funds since 2011. This time, S&P Dow Jones Indices did the same measurements for fixed-income funds and came up with the same result: zero. Not a single bond fund remained in the top quarter for every 12-month period.
While scoring in the top 25 percent year after year is a fairly high hurdle, it strikes me as a reasonable one. But S&P Dow Jones Indices also used an easier test. How many funds ended up in the top 50 percent year after year over five years? For those 2,132 stock funds, the answer was only 1 percent. That’s still a dismal result.
This has historically almost always been the case. Mutual fund managers are humans, just like you and I. Even though they have more tools and resources available to them, they are still prone to error and making subjective emotional decisions. They are good, but are they as good as the market as a whole? Not often. Despite this under-performance roughly 50% of U.S. fund assets are still actively vs. passively managed.
Index Investing Strategy Takeaways
I’m obviously a fan of index investing. You’re free to make your own conclusions and invest how you see fit and your mileage may vary on how this strategy performs (in other words, invest at your own risk and get the opinions of others). However, index investing has some clear advantages that you should consider:
- it’s passive: it doesn’t take much work or research to buy and let it sit for a while – this may seem boring, but it’s spectacular
- it’s diversified: your risk is much more spread out than a comparable mutual fund and definitely more diversified than a handful of stocks
- it’s low stress: because it’s diversified, you’ll sleep better at night
- it’s cheaper: than managed funds b/c expense ratios are lower
- performance: as evidenced by the stats above, indexes, on average, outperform managed funds
What’s not to like about that?
Passive Index Investing Discussion:
- What do you think of passive index investing? Is it the investment strategy you use?
- Have you traded in and out of stocks? How has that worked for you over the long run?
- Does everything I’ve presented here make sense? We’re moving into the complex world of investing and it’s hard to cover in one post what entire books have been dedicated to.