Index investing has become extremely popular in recent years. A lot of new investors have embraced the strategy in recent years. Unfortunately, many investors are embracing the strategy by believing certain myths that are simply not true. I am going to examine several of their problematic thought points, and discuss why they are myths that could hurt those investors in the future. In reality, there is nothing magical about index investing.
I will refute the five myths below:
1) Indexing is passive investing.
Indexing is not passive, because there is a requirement for the investor to exercise judgment as to which index funds to select. It then also imposes forced market timing through buying and selling of assets at certain time periods. In addition, the indexes themselves comprise portfolios of individual stocks or bonds which constantly add or remove components for a variety of reasons.
At the typical stock-fund office, phalanxes of computer screens glow like the control room of a nuclear reactor. The portfolio manager is an intense young MBA. He can recite earnings estimates by rote for each of the 100 stocks in his billion-dollar fund. He’s a high-pressure guy, the atmosphere is electric with excitement, and the phones are always ringing. All this costs money, but the managers have to justify themselves. What are they for if not to trade in and out of stocks?
Yet all this striving does nothing for most fund investors. Although the industry has its good years, over long periods of time the average U.S. stock fund does worse than a market index. No wonder: Typical annual expenses run to 1.3% of assets.
George Mairs, 66, does things differently. Mairs & Power, Inc., founded by Mairs’ father in 1931, has nine employees and runs a total of $300 millon out of the old First National Bank Building in St. Paul, Minn. Nearly all that money is in separate accounts. Mairs & Power Growth Fund has $41 million in assets; a balanced mutual fund, Mairs & Power Income Fund, runs $13 million.
When it comes to gauging the worthiness of an investment, investors often land way off the mark. Most treat short-term returns as a yardstick, while others have unrealistic expectations. Yet others misinterpret returns completely. However, correct assessment of performance is a must to avoid bad investment decisions.
For most investors, point-to-point return figures serve as the performance yardstick. This can be misleading. The current return profile of equity funds, for instance, is a case in point. The three-year returns of most equity funds comfortably outshine the five-year figures (see chart). Large-cap funds have clocked 13.5% CAGR over the past five years compared to 17.8% over the past three. Mid-cap equity funds have yielded 20.6% CAGR over the past five years against a whopping 34% in three years. To the lay investor, this sharp disparity in returns poses a dilemma—if the return is so much higher for a three-year period, does it make sense to stay invested for five years or more? But the investor is overlooking two critical elements here. First, he is considering a singular point-to-point reference from the past to make an assumption about the future. Second, he is ignoring the difference between annualised returns and simple absolute returns.
Uncertainty remains, but Florida is in the cross hairs.
What to expect today after tornado outbreak.
Why we’re watching Gaston closely now.
These headlines were pulled from a few articles today at weather.com. You could seamlessly replace Florida, tornado, and Gaston with a stock because like the weather, markets are highly complex with countless variables that can’t fully be modeled.
In his highly entertaining book, But What If We’re Wrong, Chuck Klosterman talks about how much money has been spent trying to predict the weather: