Why I’ve Given Up On Indexing - MoneySense

Why I’ve Given Up On Indexing

[Note: This post was an April Fool’s joke!] This potato is getting off the couch once and for all. That’s right: after several years of studying the art and science of index investing, I have decided that the strategy simply doesn’t work. As a result, I am in the process of liquidating my ETFs and […]

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[Note: This post was an April Fool’s joke!]

This potato is getting off the couch once and for all. That’s right: after several years of studying the art and science of index investing, I have decided that the strategy simply doesn’t work. As a result, I am in the process of liquidating my ETFs and index funds and switching back to an active strategy. I suggest you do the same.

This isn’t a decision I made lightly. But the more I have looked into it, the more I’ve become convinced that indexing is a loser’s game. Here’s why:

Index funds are for only for dumb people. I don’t mean to dismiss index investing out of hand. It’s fine for people who aren’t smart enough to beat the market, such as the fools who manage the UK national pension scheme and the half-wits who run CalPERS, the largest public pension fund in the US. Passively managed investments make sense for institutional investors, since they lack the time and expertise needed to pick stocks and make shrewd economic forecasts. But the strategy is not suited to retail investors, who are much more likely to beat the market thanks to sophisticated research tools such as Yahoo! Finance.

Diversification doesn’t work. The problem with a diversified index portfolio is that some asset classes always lag the winners. Besides, during the crash of 2008–09, everything went down together (except for the things that went up, like government bonds, gold and US dollars). You can earn far higher returns if you simply identify the winning asset classes ahead of time. For example, bond returns will be terrible forever and Canadian equities are clearly superior to the other 96% of the world market. There’s nothing wrong with putting all of your eggs in one basket—as long as you pick the right basket.

The market went nowhere for more than a decade. Today the S&P 500 index is about where it was in 1999. This is proof that index investors earned nothing over the last 12 years, because most of them put 100% of their portfolio in an S&P 500 index fund. Don’t listen to people who point out that this index includes only large-cap US stocks and ignores small and mid-sized companies and international markets, all of which did better than the S&P 500. It also doesn’t matter that the index measures only price increases while ignoring dividends. During the 25-year period ending in 2009, more than 85% of US equity funds underperformed Vanguard’s S&P 500 index fund, but that’s cherry-picking the data over only a quarter of a century.

Indexes contain both good and bad companies. The problem with indexes is that you get both good stocks and bad stocks. That’s like going to a restaurant and telling your server that you don’t care what ingredients go into the meal, as long as its edible. You’re much better off selecting the individual companies that will outperform. This is extremely easy to do: after all, well over 1% of professional fund managers in Canada did it during the last five years, and many of these trounced the index by several hundredths of a percent.

Nortel blew up. Here’s another reason why indexes are bad. In 2000, Nortel Networks made up a third of the S&P/TSX Composite Index. Of course, everyone knew that the company was overpriced — that’s why no professional money managers bought the stock. But sheep-like index investors had no choice but to hold it, and they lost money in 2001 and 2002. It’s true that most actively managed funds did even worse, and that broad-market index funds are now capped so no company can ever make up more than 10%. However, this decade-old example is still convincing proof that indexing doesn’t work.

Only the outcome matters. I know a father of four who didn’t buy life insurance when his children were young. During the next 20 years, he didn’t die, so he saved a bundle by not paying all those premiums. The lesson here is that it’s OK to take enormous risk, as long as you end up being right in the end. The same is true with investing: sure, taking big bets on a small number of companies in one or two sectors could devastate your portfolio. But if things work out, it that proves a more diversified approach would have been wrong.

Warren Buffett beats the market. Don’t let anyone tell you that you can’t beat the market over the long term. How else can you explain Warren Buffett? Anyone can invest like Buffett: all he does is pick value stocks based on a simple formula that you can learn from reading books. Just like you can learn to play hockey like Bobby Orr, it’s realistic to model your investment strategy after the world’s best and expect similar results. After all, the alternative is being average, and who would want to settle for that?

So wake up, you passive chumps. Get your head out of the sand and start listening to what the financial industry has been telling your for decades. Don’t be content with a strategy that will outperform 80% to 90% of professional managers: you can do much better than that.

Now let’s get out there and beat the market together.

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