Image by Lorenzo Cafaro from Pixabay
In their eternal quest to move your hard-earned dollars into their own pockets, Wall Street has come out with an insane number of index funds.
After all, they're just financial "products."
If you're not careful, you'll lose just as much money as if you threw your money into an actively managed mutual fund.
(Remember Fidelity and T. Rowe Price? You should. The management fees that came out of your fund shares paid for a large number of full-page ads they ran in MONEY MAGAZINE.)
Out of over 2,500 available index funds, which ones should you buy?
The Background
Up until around 1976, almost the entire Wall Street financial services industry believed its own bullshit.
That is, they all thought they could beat the market.
Those other guys couldn't, but THEY could - and had manipulated track records to prove it.
Collectively, they all suffered from the psychological syndrome of overconfidence known as Dunning-Kruger (which I've mentioned before, and will no doubt mention again, as it's a pandemic far more dangerous than Covid - and, of course, made Covid much worse than it had to be.)
It was 1976 when John Bogle of Vanguard came out with the first S&P 500 index fund.
For the first time in history, an average person could buy a "market" rather than one single solitary company.
Single solitary companies come and go, but the S&P 500 lives on.
And, as they're the 500 largest companies in America, owning proportionate shares in them means your portfolio grows with the US economy.
Therefore, this was in great contrast to individual investors choosing to own particular companies based on their research - or managers of actively traded mutual funds choosing a basket of stocks they believed would beat the market.
Even now, brokers, financial advisors, fund managers, financial newsletter gurus and others still claim they can beat the market.
Thanks to the tireless efforts of John Bogle, Burton Malkiel (author of A Random Walk Down Wall Street) and others, the pool of suckers falling for the bullshit has grown a lot smaller.
Cracks in the Beat-the-Market Game
Louis Bachelier was a French mathematician who pioneered a stochastic process for Brownian motion for his 1900 PhD thesis: The Theory of Speculation.
He concluded that, because stock prices were random, in the long run speculators could not profit from them.
But he was ignored for decades in both France and the English-speaking investing world.
In 1932 the economist Alfred Cowles wrote a paper asking: Can Stock Market Forecasters Forecast?
Cowles was a businessperson and investor charged with overseeing his family's fortune. But, despite getting the best available advice, he too was caught by the Great Crash of 1929. He set out to find whether any of the so-called "experts" predicted the crash.
His conclusion: no, stock market forecasters can NOT forecast.
Around 1955, grad student Harry Markowitz discovered the greatest safety - and long-term profit - came from diversifying.
That is, holding from 30 to 50 different companies.
Over the years, study after study has found few to none active fund managers beat the market - in the long run.
There's a measurement system called SPIVA - S&P Indexes Versus Active.
Over the 15 years ending in 2020, 88.4% of fund managers UNDERperformed their benchmarks.
They FAILED to beat the market.
And that can be just as true of hedge fund managers, although they've replaced mutual fund managers as "Masters of the Universe."
Sure, many of them - probably most - beat their markets in particular years.
But not over 15 years.
Most people are investing for 20-30 years or more to reach their retirement goals - and for 20-30 years or more to keep their money while in retirement.
And the pros STILL can't beat the market over those decades.
So, why not just invest in the market itself?
Obviously, that's what S&P index funds - and the exchange traded funds invented in the early 1990's - do.
So, the number of investors putting their retirement savings into index funds has greatly increased - which Wall Street HATES.
Wall Street wants you to believe their fund managers will beat the market so they receive their multi-million dollar bonuses (paid for by you, of course - as management fees) so they can buy houses in the Hamptons, private jets and vacations at the Riviera or wherever the wealthy go to avoid us hoi polloi who make them rich.
In 2010, around 25% of investment money was in index funds.
As of 2019, it was 49%.
Image by Aghyad Najjar from Pixabay
(You’ll be dancing in the streets too when you invest in index funds.)
But Index Funds are No Longer So Simple
Since Bogle and Vanguard launched the index fund revolution, they - and exchange traded funds - have greatly multiplied.
By 2000, you could choose between 380 index funds.
Around 2007 when I was researching my book Income Investing Secrets, there were over 600.
Today, there're over 2,500 index funds.
Compare that to the number of companies traded on United States stock exchanges - 2,400.
How could that happen? Obviously, there aren't 2,500 S&P 500 index funds ("only" 60, according to Morningstar).
There're index funds for every major index, such as the Dow Jones Industrial Average, the NASDAQ, the Wilshire 5000 and so on.
And there're an abundance of index funds covering every slice or sub-sub-subsector of the market.
Municipal bonds, Russian stocks, water industry companies and so on.
That's the thing. Index funds have gone from the easy way to obtain wide diversification and share in the growth of a wide market to the easy way to invest in sectors - without having to research all the companies within a sector.
This isn't necessarily bad. If you're positive water companies are going to have great success, such an index fund will save you the trouble of researching every company in the industry - and probably buying bad ones while missing good ones.
An index fund in a sector provides you with the expertise of the index-maker.
I can't criticize too much. After all, as an income investment guy, I don't advise anyone to buy the broad market indexes.
Instead, I strongly suggest sticking to income index funds, such as for Real Estate Investment Trusts, utility funds, Canadian energy funds and so on.
There're exchange trade funds dedicated to only the best general companies that pay dividends. Some focus on companies paying them for the longest time, for increasing them every year and so on.
With a well-chosen portfolio of index funds, you get the safety of diversification AND income - which, it seems to me, is as good as it gets.
Some People Hate Index Funds
Economist Eric Posner says they're reducing competition and innovation.
As index funds become more popular, ownership of stock market shares becomes concentrated in the hands of just a few fund companies. The three largest are BlackRock, Vanguard and State Street.
From 1995 to 2015, the proportion of companies that had the same ownership by these fund companies went from 20% to 80%.
Posner says that, since companies are all owned by the same people - index fund investors - they have no incentive to innovate, compete and lower prices.
Obviously, that would hurt the general economy.
However, according to Larry Swedroe, the same index fund would have to own 90% of the entire market before that could happen.
According to Bloomberg, index funds now own only 18% of the entire market.
That means there're still a large number of stock shares owned by individuals, not fund families.
Also, as I think on it, it's only the large market index funds that could cause a problem - not the current trend of people choosing narrow, subsector index funds.
In theory, widespread index investing could eliminate the motivation to invest in new, risky companies. When you take on extra risk, you want extra profit.
Although most of us should be satisfied most of the time to hit singles and doubles with an index fund, maybe sometimes there's a nice easy pitch you should swing to hit out of the park like Babe Ruth.
But let us not forget that even the Babe often missed. He had a high number of strike-outs too.
(By the way, in his book Ruth admitted he'd have a higher batting average if he didn't always go for a home run, but said home runs were what the baseball fans wanted to see, so he obliged them.)
Gurus like to tell you using index funds is only for “average” results.
That’s true - and it’s the point.
Because fund managers and stock market gurus usually are BELOW average.
My Tips for Investing in Index Funds
1. Don't invest in "index funds."
That's like investing in "real estate." It's too general. Houses, apartments or shopping malls? In what city? How big? In what condition?
Index funds (and ETFs, remember) are simply the best way to invest in a particular sector or subsector, such as water companies.
So, you do NOT start by saying you want to invest in index funds.
You start by saying you want to invest in:
* A broad market such as the S&P 500, the NASDAQ or the Dow Jones Industrial Average
* Companies that increase their dividends every year
* Real Estate Investment Trusts
* AAA-rated corporate bonds
* The best companies of India
* Water companies outside the United States
Then you go and look for the best index fund/ETF that meets your goals.
2. Don't invest too narrowly.
Up until last month, you could have made a good case for investing in both Russian stocks and bonds.
The country did default on its bonds in 1998, causing a massive stock market meltdown of 90% - which, coming right after the Asian currency crisis - caused horrific financial problems around the world. (I lost over $2000 in an options trade on Treasury bonds.) (The hedge fund Long Term Capital Management lost so much money, it almost melted down the markets in the United States.)
Because of 1998, Russia became an extraordinarily frugal and fiscally conscientious country. The government budget sometimes ran surpluses - and its debt is quite small compared to Japan, the United States and other European countries. Plus, it makes lots of money by selling oil and natural gas.
Yes, corruption is widespread and oligarchs were massively stealing from the ordinary people and taking their money outside the country - but the Russian government could be relied upon to make its bond payments.
Now we're only a month or so away from another default on Russian bonds. That seems inevitable unless the Russian government, oligarchs or military soon eliminates Putin, one way or another.
The point is: you can't rely on any one country or industry.
That's why Harry Markowitz won the Nobel Prize for discovering diversity is the only way to safeguard your portfolio.
Index funds make that easy - unless you put your money into UNdiversified index funds.
3. When choosing between mutual index funds and exchange traded funds covering the same index, choose the ETF.
As I rant about in my book, mutual funds are terrible from a tax point of view.
4. When you have a choice between funds replicating the same index - look for the lowest expense ratio.
Expenses come out of YOUR profits, so reduce them to as low as you can find.
5. Avoid life-cycle or "target date" funds
These invest in both stocks and bonds, changing the relative amounts of those based on your age.
I believe you should choose the stock/bond ratio based on your current need for income - and the ideal is to avoid bonds altogether, if possible.
And these funds choose stocks for capital gains, not for paying dividend income.
Stocks are the best inflation hedges available, while bonds are the worst.
Bonds do not grow their income.
In the long-run - and I must emphasize this - stocks will carry you, NOT bonds.
And the long-run will probably be much longer than you now realize.
Even you 90-year-olds will likely live longer than you now believe.
If you're relatively young, you should plan on living to 150 - and beyond.
Because of that belief, I now suggest you also . . .
6. Invest a little in the future.
I do NOT mean the standard "growth" companies on the stock market. I DO mean:
* Bitcoin, Ethereum and other cryptocurrencies
* ARK Innovation ETF (ARKK) which looks for the innovation and technologies that will drive the future
Buying a crypto ETF allows you to profit from the rise in cryptocurrencies without having to deal with buying actual Bitcoin.
Cathie Woods of ARK Invest says she's buying for a horizon of five years - not for next quarter.
Basically, she's looking for technologies of the future - innovation and the disruption of current industries.
You have no guarantee either kind of ETF will succeed.
Bitcoin and other cryptocurrencies remain uncertain, but they're gradually being accepted. They will, I believe, keep growing in value in the long run.
The future keeps arriving one day at a time - so we can't count on the successful companies of today to remain the big successes of the future.
Some of us remember when General Motors, IBM, Sears and AT&T dominated their industries.
And some now-small companies will turn out to be the Microsofts, Apples, Googles and Facebooks of the rest of this decade.
Cathie Wood and her team are the best at separating the future titans from the future duds.
7. Don't trade. Hold forever.
Spend the income you receive from funds that pay dividends - if you must.
Or - much better - reinvest that income.
But NEVER sell your initial investment.
Paying capital gains taxes bleeds your portfolio.
My widowed mother's investments enabled her to live a comfortable lifestyle for over 50 years, beating the pants off the Wall Street gurus even though she couldn't have read a balance sheet to save her life.
Find out how.
Check out my Income Investing Secrets book right now
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