One reason passive investing feels wrong to new investors is because people don’t want to “give all their money to a computer”.
I know, because they’ve told me so.
They typically haven’t analyzed algorithmic trading or weighed up the pros and cons of software versus grey matter.
They don’t know anything about any of that.
It’s just an instinctive thing.
Perhaps some family member picked shares or told them about a star fund manager that did well for them. Maybe they’ve read about Warren Buffett.
But usually it’s just another of those common sense things that trips people up when investing.
It’s common sense that a well-paid human being could avoid the Dotcom bubble or sell bank shares in a financial crisis. A computer can’t even read a newspaper!
A computer can’t appreciate the difference an inspirational leader like Steve Jobs or Elon Musk can make.
A computer doesn’t know about America’s shale gas boom, or the ageing population in China.
All a computer can do is look at the numbers and buy and sell. That’s one reason we have such volatile markets and booms and crashes, and why little investors get screwed over, et cetera.
Those are the sorts of arguments you hear – the latter ones often from more experienced investors, who really should know better.
But these views aren’t based on any evidence.
Most people haven’t read up on the algorithmic trading software used by hedge funds that can pick shares pretty well, on and off, nor have they seen the overwhelming data that neither human beings nor such ‘black box’ software can reliably beat the market for more than a few years, most of the time.
But it’s what they believe.
Chaos theory
These sorts of views are why index investing is a harder sell than those of who’ve seen the evidence expect.
We’ve forgotten what it’s like to be a new investor armed only with common sense.
When we try to explain why cheap passive portfolios will beat the majority of active investors, these fears are lurking in the background, unvoiced by the listener and forgotten by us.
So I had a light bulb moment when one friend of mine, M., put it into words.
After hours of discussion about investing over several days (she’d inherited an estate and asked me about it) she’d had enough:
“Index investing? Okay, I get it! Computers buying what is up and selling whatever is down? It’s random! It’s stupid! I’m not putting my family’s money into that, so can we please stop talking about it?”
To my friend, the stock market is a mass of numbers and an index fund chases them around the park.
Even if it might theoretically work, it doesn’t make sense to her.
Priced to go
Avoiding obscure or opaque things is actually a good guide to avoiding trouble when investing. The problem here was my friend’s knowledge was incomplete.
I must take some blame for that, because I’d clearly not explained well enough what a share price was, or why index funds work.
You see there’s nothing stupid about them.
On the contrary, they work because of all the brilliant human minds – and the clever computer software – that is constantly churning over every opportunity in the stock market.
Tens of thousands of the smartest people of their generation are raking over companies, looking for hidden advantages or drawbacks or other factors not reflected in their valuation.
When these managers think they’ve spotted something, they buy the shares – or sell them if they don’t like what they’ve found.
And who sells – or buys – these shares?
Another smart human being that also spends most of his or her working hours looking for such opportunities. Or a multi-million dollar stock trading robot that never sleeps at all.
When you buy or sell or a share, the other side doesn’t trade for any old price, either. They think they know something you don’t, or have under-appreciated. That’s why you have different views about the price worth paying.
And this is going on every fraction of a second. Millions of times an hour.
Which means the price you see in the market is the current ‘best guess’ according to the world’s greatest investors.
It’s very hard, if not impossible, to guess better.
Smart and cheap fund managers
Do you see why this is fabulous news?
Share prices aren’t pulled out of thin air. They move up and down as the smart money constantly reworks their valuation.
Excellent stock pickers have influenced the share price of every company in the FTSE 100. So when you buy shares via an index fund, you are taking advantage of all this brainpower at a very cheap price.
I explained this to M., and she had a bit of a light bulb moment, too.
She better understood what prices were, and that I wasn’t saying that fund managers were stupid. That offended her idea of humanity on some basic level, I think, as well as seeming unlikely given how well paid they were.
Certainly I am not saying they’re dumb. One reason index investing is the best option is because most fund managers are very smart.
Smart fund managers compete all day against other very smart people in an arm’s race that costs a fortune and that as a group they can’t win – because for every winner there’s a loser.
Hence it’s usually better just to get the average of their results as cheaply as you can via an index fund.
But there’s a but…
Is this index fund evangelism nirvana? Alas there’s a sting in the tail.
And M. still isn’t a committed believer.
Maybe that’s because I felt duty-bound to explain to her the flipside of having all the smartest brains in the room pricing the shares in her index fund.
It is true the best fund managers are doing legwork for you when you buy the whole market.
But unfortunately, you’re also getting input – via prices – from all the worst fund managers, too.
You’re also getting the mediocre managers, and the hundreds of thousands of retail punters making clueless decisions or day-trading away their savings.
Everybody is involved in setting share prices. That’s the catch.
Far more money is smart than stupid these days, which is why you rarely see the obvious bargains that littered the market in the 1950s anymore.
And it doesn’t matter anyway, in practical terms. The evidence is clear – most fund managers do not beat the market and you’re unlikely to pick those who do in advance, so you might as well buy an index fund.
But we knew that already.
It was just that for a moment, we had a way to convert the likes of my friend to the indexing cause by playing the ‘smart fund managers’ card like the best of them.
But investing is far too tricksy for that.
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I like this interpretation. Not yet enough to sell up and use index funds more than where I do, but it shifts the needle on the dial. Thank you 😉
Your friend needs to read your blog more often 😉
@ermine — Cheers! Bit of a riff on last week’s theme but I had hoped sufficiently different. The Accumulator is on his summer hols so I’m seizing the chance to get some things off my chest!
@MoneyObserver — It’s quite funny watching those friends of mine who know I do Monevator waffling to explain why they’ve read it recently. Most people are very uninterested in investing, alas!
It comes down to this ..
http://www.forbes.com/sites/phildemuth/2013/08/05/the-one-question-you-must-ask-before-you-invest/
In sum:
1. You can really have an edge.
2. You can believe you have an edge when in fact you don’t.
3. You can admit you have no edge and then make that your edge.
Numbers 1. and 3. do fine. Don’t mess with Mr. In-Between.
Thanks for another excellent post. That is a very good explanation of why index investing works, it’s good that you felt duty-bound to explain it to your friend. I’ve tried and it was a fruitless attempt on my friends.
I’m interested in (i) protecting our wealth, such as it is, from inflations and kleptocratic governments, and (ii) meeting foreseeable liabilities, such as eventually having to pay for ‘care’ for my widow, and unforeseeable liabilities – which takes us back to (i).
So I needn’t give two hoots about whether or not I beat the market.
I’d say the point with your friend is that she needs to run through a financial planning questionnaire regarding what she wants to do with the money, her risk tolerance, etc. Only once you understand what you want to get out, and what you’re willing to risk to do that, can you know where to put the money in.
For example, my parents never really got on with the stock market and did just fine in cash vehicles of various sorts and concentrating on saving. They would, theoretically at least, have perhaps twice the capital and income that they do now if they had used the stock market, but they preferred to be without the inevitable stresses, and they have more than ‘enough’, so cash was a good choice for them.
Jumping into stocks without the necessary level of understanding is like driving an articulated lorry without having any lessons. It’s dangerous, and probably a very bad idea.
“but they preferred to be without the inevitable stresses”: yup, if you don’t need the extra reward don’t take the extra risk.
@John — Good thoughts. And I agree… and I disagree. I think people can allocate a certain amount to equities without truly understanding how the stock market works, if they are convinced by the case for broad asset allocation. This is the joy of the ‘lazy’ passive portfolios.
I 100% agree it would be infinitely better for them to get some knowledge first, so that they are prepared for volatility and so forth. But in reality plenty of people (most?) have and will continue to invest some of their money in equities — particularly through pensions — without any understanding of the asset class. Even my risk-averse dad had a slug via his “with profits” pension in the 1980s and 1990s. (The problem there was a lack of understanding of the appalling nature of much of the financial services industry, although as I understand it he didn’t fare too badly).
I’ve suggested to quite a few friends over the years that they start investing via 50/50 cash and an index tracker, regularly saving every month. I’ve never had anyone come back — even during 2009 — and say they regretted it (quite the opposite). It would be thrown out as trivially simplistic advice, but it is cheap, does the job, the cash provides a massive stability buffer and the equities some growth, with valuable learning lessons along the way. I think it’s fine for the first 5-10 years.
Totally agree that an assessment of risk and aims is a top priority. Ironically I spent a lot of time talking about this with my friend (it’s where the beginners’ investing series I’m occasionally running here comes from) and she was a bit fidgety for the first few lessons, until she finally got why it was important.
For context, she wanted to know on day one “how to read the FT to buy the best shares by P/E and dividend yield” and so on, despite a typically sketchy understanding of investing, with gaping holes in places (e.g. She’d never thought to compare her managed funds to the market). That’s where we were starting. So it was a long way to row back to index funds, let alone a discussion of volatility and so on.
I am getting slightly more sympathetic towards IFAs, in my old age. (The challenge they face, not their previous methods of meeting it!)
TI, your 50/50 stocks/cash portfolio is spot on I think. I always say to people they might want to adjust the stock position until the risk is something they can handle, and to mix it with cash which people like as it has zero volatility.
50/50 gives a max drawdown of about 25% (50% in stocks that has a max drawdown in a typical investment lifetime of about 50%), and most people can psychologically handle 25% ‘losses, especially since the interest and dividends will soon offset that anyway, plus the market rebounds.
My Dad’s approach is like your friends though… effectively going into DIY brain surgery rather than talking to a doctor, buying two or three companies or investing in China (with an admittedly small part of the total portfolio).
Brain surgery is obviously complex, so we don’t do it ourselves, but for some reason stock picking seems so very easy. The widespread poor performance of most investors shows that it’s anything but.
There is nothing like experience in investing. I invested $100.00 in a Vanguard Morgan Stanley growth fund in 1952 my sophomore tear @ U.T. Knoxville. It closed Friday at $ 12,775.00. I started actively trading in 1959 and have experienced the volatility of the market. In 1987 I started watching the market very seriously. I Managed to sell about 90% of my stocks just weeks before the fall and started reinvesting when the market bottomed out. Over the next 18 Months I had doubled the value of my investments.
I started using Zacks Premium service in 1997 and in 2003 I subscribed
to Steve Reitmeister’s trading service adding others over the years. Zack’s has given me good advice except for 1 or 2 that I would not recommend. Steve R. & I starting communicating frequently about 8 months ago and 5 months ago Steve made me a fantastic offer for a lifetime membership to all of Zack’s services. This has been a fabulous investment for me [ I am 81 years old and between keeping up with all of Zack’s recommendations and doing my garden and landscaping I am working harder and enjoying it more than all the years as a Sears manager and an engineering consultant for 10 years after retirement from Sears.
Now my wife and I have built [I was my own contractor] a beautiful retirement home with every thing just like we wanted + We have guest quarters [with separate driveway] with a walk-out basement.
God has really been good to us and we are able to contribute 1/2 of our income to our church, two churches in Kenya who have several 100 aids orphans that they are housing, clothing, feeding and educating. We have a # of other charities that we enjoy giving to. The more we give The more God blesses us.
Best regards,
Warren Beeler