Index funds

by havoc

I meant to toss out a couple thoughts when Robert
blogged about index funds
, reminded by a Wall Street Journal
article yesterday pointing out that the S&P 500 has gone nowhere over
the last 9 years.

Here are said thoughts:

  • Lots of sensible advisers will tell you to buy index funds, but
    importantly, the advice is not simply “buy index funds.”
    There are at least two other critical details: 1) asset allocation
    across multiple well-chosen indexes, maintained through regular
    rebalancing, and 2) dollar cost averaging (or,
    much-more-complex-but-probably-slightly-better, value averaging). The
    advice is not to take your single lump sum and buy and hold a
    cap-weighted index forever. The advice is an investment
    discipline which involves action over time, and an initial
    choice among indexes. An index-fund-based
    strategy is not completely passive, it involves some active risk
    control through rebalancing and averaging.
  • For example, Warren Buffett in a recent
    interview
    adds “don’t put all your money in at once,” when he
    gives the index fund advice:

    “I think everybody should read
    Jack Bogle’s book. … what you really want to do is you want to own
    American industry which is going to do fine over time, but you want to make
    sure you don’t put all your money in at once because you might pick just the
    wrong point. But if you buy in over time into a wonderful business, which is
    American industry, and you make sure you don’t go in at just the wrong
    times, when people get excited, and you get to keep your costs low
    … you’re going to beat 90 percent of the people because they’re going
    to run up unnecessary costs.”

  • The S&P 500 has been nowhere for about a decade, but investing in a
    balanced portfolio with multiple asset classes, averaging over time
    from 1998-2008, and rebalancing regularly, has worked out just
    fine.
  • A great innovation is the “Target Retirement” fund, now the default in
    many retirement plans, which implements the asset allocation and
    rebalancing for you.
  • ETFs can be slightly lower in annual expenses than a normal mutual
    fund, but they also have downsides. Remember the discipline involves
    dollar cost averaging and rebalancing. Thus, you will have commissions
    (at most brokerages), and spreads (at all brokerages), and these are
    not one-time costs. Also, a target retirement fund is the
    right choice for many people, and at least until recently these were
    not available in the ETF structure.
  • Regular mutual funds have some downsides too, but, for me if you’re a
    long-term investor the ETF vs. regular index fund choice seems like a
    bit of a wash. Vanguard Total Stock Market regular share class is
    0.19% a year, or $19 per $10,000; the ETF share class is 0.07% or $7
    per $10,000. The $12 difference is pretty likely to be lost on
    commissions and spread. Contrast either one with an actively-managed
    fund that might be $100 per $10,000. There are some small tax
    differences as well, but those don’t matter in a retirement
    account. Bottom line, maybe ETFs are overhyped if we’re talking about
    a buy-and-hold investor saving for retirement. If you do use ETFs, be
    sure your commissions are darn low.
  • In a bear market, perhaps it helps to think of yourself as investing
    in a discipline, not in a fund. The discipline is to buy an asset
    allocation and to average and rebalance over time. The question is
    whether this discipline is working overall, over a 10-year period, not
    whether each asset class is up or down today. And if you abandon
    the discipline in a bear market, the discipline will not work.

Anyway. I am not religious about index funds, personally I use about a 50/50
mix
of indexing and other strategies. Not to “beat the market” – I
have no idea why discussions center around beating the market, since
doing so has nothing to do with anyone’s goals or their
planning. “Beating the market” in this context has a technical
academic meaning anyway (“alpha”) that doesn’t quite match the
common sense meaning.

Nobody’s retirement hinges on beating the market. Most people’s goals
hinge on whether they make some kind of decent return or not. A major
goal in investment planning should be to increase the probability of
adequate returns, in my opinion. (Where “adequate” is defined
by your personal goals and resources, it’s not an absolute thing. And
where the probability includes human behavior – not just what you
should do but what you will do.)

“You can’t generate alpha so buy index funds” makes no sense to me. I
would say, “dollar cost averaging plus appropriate asset allocation
plus low-cost index funds is one simple, proven discipline to give you
a good shot at decent returns.” Whether decent returns are adequate,
of course, depends on your goals and whether you are saving enough
every month…

(This post was originally found at http://log.ometer.com/2008-03.html#27)

My Twitter account is @havocp.
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