Over the years I have heard some interesting critiques of index investing. However, the most prevalent one seems to be in response to a particular argument some people use as a defense of passive stock investing. The argument goes, the assumption of the index fund investor is that stocks will always go up in the long term Well that is not true so index investing is flawed. Today, I am going to explore why both this argument and attaching it as a reason for index investing are flawed.
So before we get into the question about index investing itself let’s explore this key point. Does the stock market always go up in the long term? Is this a valid argument for index investing?
Well, the simple answer is yes. In the long term stocks will always go up provided a stable economy. Now before my active posters that have raised this point before
Over a Long Enough Period Stocks Always Go Up
Over a suitable long period of time stock prices in a market are driven by two things. The first is inflation. In the absence of anything else the sheer decline in the intrinsic value of money, through inflation, will raise the price of the underlying assets of a stock market company. As such sooner or later, in a stable economy, a stock market is guaranteed to raise.
In fact, one can argue it is guaranteed to surpass the rate of inflation over a suitably long period. Why? In addition to inflation, the market is also driven by technological advancement. Such advancement leads to efficiencies and over the long term these are guaranteed to increase the value of companies that employ it correctly. Of course, someday technological advancement could stop, but I wouldn’t hold your breath.
The But, What is Long Term?
Now for the major but… Before
So a long time could be 3 years. Most recessions have historically lasted 3 years time. This is the scenario our hapless index investment defender is likely drawing on. But, most
Add to this other country examples. Japan’s stock market has been in decline for nearly 30 years. So what is long term? Is it 3 years, 10 years, 20 years, 30 years, or perhaps even something longer?
What am I blathering on about and does this even matter since it still goes up in the long run?
What is Your Time Horizon?
Well, the market does always go up but does that do you any good. Raise your hand if you don’t expect to need any of the money you have invested in the stock market over the next 3 years. Probably almost all of you have your hands raised. What about 10 years? A few drop out. 20? Staring to thin the herd here. 30? Oh man anyone over the age of 35 is probably defacto out. We could go at this all day since we have no idea where the long term kicks in.
So the point really is that “stocks always go up over the long term” is academically true, but it is not really applicable to an individual human investing. After all, in some form of long run, we’re all dead. That long term can be too long to make this a valid argument for index investing. So why then should we utilize stock index investing?
Why Index Funds?
I have trodden this path before but really it comes down to two factors. First is the reason to invest in stocks in general. This is simply that stocks are one of, if not the, easiest investment to diversify across a large number of investment sources. Very few if any alternatives exist where I can input $100 and instantaneously be exposed to the aggregate outcome of thousands of different companies or investments.
That cheap diversification has value on its own since any single investment option, whether it be a single house, stock, bond, or commodity, can be subject to sudden negative value movement. Diversification reduces the probability and potential scale of that negative movement. As such diversification is the key to long term success for any investment plan. Unless, of course, you have some sort of crystal ball, in which case can I borrow it? Index Funds are inherently diversified. Again I do not condone stocks being your only investment as you also need diversification by asset class. But it’s hard to argue that 1000 stocks are not more diversified than a single rental property.
Indexing or Active Management?
The second thing we need to consider is why index investing instead of active choice. I have probably beaten this one to death but it comes down to performance. It’s been shown time and time again that your average Joe or active fund after expenses cannot beat a diversified index fund investment on a consistent basis. In practice that means both of these methods tend to lag index funds over a significant enough period of time.
There are of course one-off exceptions to every rule. Some people like to point to hedge funds as an example of potentially extraordinary results. However, they forget these companies have tens or even hundreds of analysts researching investments full time, and yet can’t pull off consistent outperformance. Others point to conglomerates like Berkshire Hathaway, but they don’t just buy stock but instead buy seats on the board where they drive decisions. Even with these distinct advantages these companies spend decades lagging the market return. (For example Berkshire, or worse GE, over the last decade). You as the small at home hobby investor don’t have a shot.
What about paying the hedge fund with
We see these examples of one off-market exceeding results every so often trotted out as a counter to index investing. But what we forget is the survivorship bias. That is you only hear about the 1 or 2 investors that have exceeded market returns say the last 3-4 years. You don’t hear about the thousands that failed to do so or the ones that did for a few years and then disappeared. The odds are just not in your favor.
The reality is, the barrier to any type of extraneous success in stock investing is high. A little extra work will gain you nothing because everyone puts in extraordinary amounts of work. So a little work is just throw away. Few if any of us have the resources to put in the extraordinary work, and even if we did it is probably too expensive to justify. In that environment index stock investing should have a high place in your investment toolbox.