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Investing for the Long Run: The Power of Index Funds

To truly understand the power of index funds we must first understand how the stock market works.  Any discussion of investing must first start with the fundamentals that modern economics applies to the stock market.  There are two competing theories about how the stock market works or does not work, depending on your perception. Despite their differing views, both of the economists who developed them ended up winning a Nobel prize for their respective work in the same year. After looking at these views more closely, you may find that they easily co-exist rather than compete.  

Efficient Market Theory

The first theory is the efficient market hypothesis. This theory came to prominence in the 1970s by the economist Eugene Fama. This theory portends that the prices of the stock market are efficient, i.e. all known and relevant information is reflected in the price of a stock. The reason, this theory states, is if the market was not efficient then an opportunity for risk free money would exist that would quickly be snatched up. As such it should not be possible to “beat the market”.

Behavioral Economics

Behavioral economics as explained by economist Robert Shiller states that not all man’s actions are rational. Interpreted in some ways this invalidates the possibility of the market being efficient. A common example is a dropped hundred dollar bill on the ground. Under similar arguments to the efficient market, one would never pick up the money on the ground. Why? There would be no chance it would be real because someone would have already picked it up. Behavioral economics became more popular in recent years in light of the dot com bubble.

A Random Walk and Short Term

As stated previously, one can interpret the 2 theories as competing. However, I personally believe that is not necessarily the case, and there is evidence to support this view. Efficient market theory contains another theory entitled random walk. This theory states that stock prices evolve randomly, meaning that beating the market and market timing are not possible. I personally believe this theory is true in the short term. The outcome on any given day of a stock price is completely random. Many studies have observed and found this to be true. Studies that have raised concerns about these theories tend to be based on a longer period of time. For example, some studies at 10 years have shown trends in stocks that appear to invalidate the theory.

Long Versus Short Term

I view this relative inconsistency as largely in line with my views on economics as a whole. The economy and stock market are largely predictable over the long term barring a war or collapse of government, but over the short term the predictability is about on par with flipping a coin.

Implications for Index Funds

What this means is if you define the medium term you can market time and beat the market. So why do almost all studies show that active managers do not “beat the market”? Simply because like other areas of economics the definition of short term and long term cannot be known. You see this in common sense truism around the market: “The market can stay irrational longer then you can stand solvent” (John Maynard Keynes). Even in a world of the Dotcom bubble you could have  missed making a lot of money for years before the bubble burst had you pulled out due to overprice. Predicting when the bubble would burst was impossible. The famous “Irrational Exuberance” speech by Allen Greenspan was long before the bubble implosion, had you pulled out at the time of that speech you would have missed out on 2 -3 more years of ups.

Best bet to Invest in Index funds

In general, the ramifications of the above is that Index funds are a superior investment option for most investors.    If you can’t predict what happens next with any success then why try or expend extra fees on a manager who will try? At best there might be an argument in there that you focus on a specific area of the economy as a long term holding in hopes of hitting that long term. But, remember the long term could be a lifetime.

We are left with one more anecdote. At present, Warren Buffet has a running bet against 5 hedge fund managers that index funds will beat hedge funds over a 10 year period. Warren is winning that bet handily with the index funds up 60 some percent to just below 30 percent for the hedge funds. Perhaps, you should consider his actions as advice. When combined with avoidable investment expense fees, the hedge funds and active investments look even worse. The choice is yours.

How do you invest?

7 Comments

  1. Finance Solver
    Finance Solver September 23, 2016

    I have 2 accounts set up currently. My 401k is automatically added from my paycheck every two weeks. I put 50% of my money into it. It’s 90% invested in the s&p index fund and 10% in a bond index fund. I also have another multi-5 figure trading account that I use to take some additional risk to get some additional returns. I know that if I ever lose a 100% of this account (I hope that doesn’t happen) but if it does, my retirement account with a 50% savings rate will protect me. Hopefully I’m not regretting it in 5 years!

  2. Mustard Seed Money
    Mustard Seed Money September 24, 2016

    I totally agree with you index funding is the way to go. Outside of 10% of my portfolio where I like to play and learn about the stock market. It’s all invested in the low cost index funds from Vanguard.

    • fulltimefinance@fulltimefinance.com
      [email protected] September 24, 2016

      Nothing wrong with a play portion of your portfolio, especially if it keeps you from playing with the rest of your assets. You never know maybe you’ll hit the right stock.

  3. FJ
    FJ September 25, 2016

    Thank you for sharing your thoughts on index fund. I am a buy and hold dividend investor, I select individual stocks that pay growing dividends year-over- year.

    I know in long-run index beats the individual pickers, but I would like to take risk and compete with index (spice up life 😀 ).

    • fulltimefinance@fulltimefinance.com
      [email protected] September 25, 2016

      You might want to consider Mustard Seeds plan. Play with a subset of your account to get out the itch. Thanks for stopping by.

  4. Dividends Down Under
    Dividends Down Under September 25, 2016

    Index funds have been a wonderful investment and should continue to be. Even Warren Buffet says that’s what his wife should invest in after he goes – high praise indeed.

    At the moment we invest in individual stocks in Australia, for tax and better diversification reasons 🙂

    Tristan

  5. Michael
    Michael September 26, 2016

    I am glad that I don’t wake up every morning to check if Bill Ackman shorted any of the stocks in my portfolio. It has happened once – my stock went down by 20% for no good reason other than Bill shorted it. This is just one example. Then it came back up finally and I sold it for a modest profit.

    I have made good money investing in individual under valued stocks. At the end of the day, it all comes down to risk / reward.

    Over the past few years, I have shifted over to index based investing. Don’t wake up every morning and go straight to CNBC headlines.

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