Index Funds: The
12-Step Program for Active Investors
"Top Ten Reasons to Invest in Index Funds" By
Mark T. Hebner
This website
lays out a thorough and elaborate analysis of how capital
markets work. However, to give you a preview, here is
the short version. Please read it once without clicking
the links, then go back and review the links. Otherwise,
you will be so distracted that it will take several
weeks to get to the tenth point.
1. Market Randomness and Active
Management: Markets are moved by news. News
is unpredictable and random by definition. Therefore,
the markets movements are unpredictable and random.
However, this market randomness does have a positive
average of about 10%/year because capitalism works. Active managers who have claimed to
outperform a market average or index have also implied
that they have the power to predict tomorrow's news. But since it is impossible to
consistently predict the future, the results of active
managers are unpredictable and random. This concept
is known as the Random Walk Theory and it was first
discussed in The Theory of Speculation, a paper written in 1900 by Louis Bachelier.
In 1964, MIT Professor Paul Cootner published a 500
page collection of research papers on the randomness
of the market titled, The Random Character of Stock Market Prices. In 1965,
Nobel Laureate in Economics and MIT Professor Paul Samuelson
wrote his now famous paper, Proof That Properly Anticipated Prices Move Randomly.
Also in 1965, University of Chicago Professor, Eugene
Fama wrote his highly regarded papers, Random Walks in Stock Market Prices, and The Behavior of Stock Market Prices. After carefully reading
this extensive collection of peer-reviewed research,
you will be convinced of the randomness of stock market
prices.
2. Skill
or Luck: The average actively managed investment
must underperform the indexed investment, when all costs
are deducted. [source] Those actively managed investments that beat the
indexed investments fail to consistently beat the index
in the future. The reason for market beating performance
in a random market is simply due to luck and not due to a skill that is repeatable. Research shows that only about 3% of active managers beat
an appropriate index over a 10 year or longer period.
Needless to say, it is nearly impossible to predict
those winners in advance. Lucky investors are well advised
not to expect a continuation of their good fortune.
[see 1, 2, 3, 4, 5, 6, 7, 8]
3. Index
Portfolios Best Capture Risk and Return: Actively
managing your money will create higher risk and lower
returns than a globally diversified, tax-managed, and
small value tilted portfolio of index funds. Due to
commissions, management fees, margin costs, taxes, stock
randomness, and market efficiencies, you will slowly
transfer your money into the pockets of stock brokers, mutual fund managers, hedge fund managers, and the many other individuals profiting from
your numerous transactions and your lack of understanding
of free market principles. Active management is hazardous to your wealth. A recent study by Brad Barber of the University of California,
Davis, showed that 82% of the 925,000 active traders
on one stock exchange lost $8.2 Billion/year from 1995
to 1999. Dalbar Research stated in their 2004 report
on Investor Behavior that the average equity investor earned
a paltry 3.51% annually for the last 20 years, compared
to 3.05% inflation and 12.98% for the S&P 500 over
that same period. The gap between the average active
investor and the market is 9.47%/yr. The global equity
total market value is $25 Trillion as of 12/31/04, so 9.47% of that is $2.4 Trillion!
4. Returns
from the Risk of Capitalism Rank Highest: Capitalism
is a great idea that has worked for centuries. It has
provided an annualized return of about 10%/year since
1926 and has the highest rate of return of all investments
tracked over periods of 50 years or more. That rate
of return is explained by the difference between the
low risk of capital and the high risk of capitalism,
as seen below.It is not the result of speculating in
short term price changes. There is no additional expected
return from speculation above the average return. The
gains from speculation are offset by the losses in any
random situation, leaving the average, or the index,
as the most likely return. This concept is known as
a zero sum game. Investors earn returns from consistant exposure to the
right risk factors, not from gambling on tomorrow's news.
5. Market
Efficiency Is Why Capitalism Works Better:
The world's stock exchanges facilitate a free market
system that is the cornerstone of capitalism. These
capital markets simultaneously price the cost of capital
and the expected return from the risk of capitalism.
Free markets perform this highly important task in the
most effective and efficient manner because the knowledge
of all investors exceeds the knowledge of any individual.
Due to the millions of intelligent and highly competitive
investors, it is unlikely that any individual investor
will consistently profit at the expense of all other
investors. From this we can conclude that free markets
work and that current prices reflect the knowledge and
expectations of all investors at all times. [more] This concept is known as the Efficient Market Theory. If free markets were not more
efficient than controlled markets, like those in communist
countries such as North Korea or Cuba, then the communists
would be more prosperous than the capitalists. [more]
6. Cost
of Capital and Expected Return for Capitalists:
The expected return for a capitalist, equity buyer,
or investor is equal to the cost of capital of the equity
seller. An intelligent capitalist will estimate the
expected return based on the risk of the equity, which
is tied to the risk of the company. The higher the risk
of the company, the higher their cost of capital, and
the higher the expected return for the capitalist. The
lower the risk of the company, the lower their cost
of capital, and the lower the expected return for the
capitalist. Those investors who carefully match their
risk capacity with their risk exposure have the best
chance of obtaining the long-term historical returns
of the global markets. A buy, hold, and rebalanced risk exposure strategy is the best method to
capture those returns.
7. Small
Value versus Large Growth Companies: Public
companies that are unglamorous, small, and relatively
cheap (small value) are riskier and have higher costs
of capital than those that are glamorous, large and
relatively expensive (large growth.) As a result, a
dollar invested in a Fama/French Index of small value
companies in 1927 grew to $40,095 by the end of 2004
(14.6% annualized return), and a dollar invested in
a Fama/French Index of large growth companies grew to
only $1,154 over the same period (9.6% annualized return.)[more]
8. Diversify,
Diversify, Diversify: Diversification is the
investor's best friend because it reduces the uncertainty
of expected returns, otherwise known as risk, without
changing the expected return. Concentrating investments
only adds risk, and does not increase expected return.
For example, any one stock in the S&P 500 has an
expected return of about 10% per year, plus or minus
about 50% two thirds of the years. However, the S&P
500 Index has the same 10% expected return, but it only
has a risk of plus or minus 20% two thirds of the years.
So 10% plus or minus 20% is far superior to 10% plus
or minus 50%. Highly efficient portfolios of index funds
have had returns of 14.3%/year with risks of 15.6% over
the last 34 years, after fees (see Index Portfolio 100, which includes about 15,000 companies from
35 countries.) This is why buying the whole haystack
(index) is better than looking for the needle (a stock)
in the haystack. What is the risk and expected return
of your portfolio, based on the same investment strategy
over the last 34 years? [compare]
9. Selecting
Index Funds: Dimensional Fund Advisors is the
premier commercial provider of capital markets research,
historical risk, return and correlation data, investment
advisor education, and mutual fund products that reflect
the leading academic research. Their complete product
line of index mutual funds are based on the efficiency
of capital markets. They have constructed unique rules
of ownership for their funds that allow investors to
better capture the right risk factors and engineer portfolios
with greater precision and efficiency. At the heart
of their fund eligibility rules is the Fama and French
three-factor model, which has become the gold standard
among academic researchers for risk-adjusted returns.
The three-factor model on average explains more than
ninety percent of the performance of diversified portfolios
of stocks.
10.
Peace of Mind: Don't let your retirement years
be tainted by the discomfort of poverty. Reliance on
family members or government programs for your financial
well-being will be a source of unhappiness, insecurity,
and low self-esteem. The sooner you start saving and
planning for your retirement, the better. A prudent and intelligently managed investment portfolio
of index funds has the highest probability of providing
security and peace of mind in the years when it will
be needed the most.
To further understand the above 10
points, we have created Index Funds: The 12-Step Program.
You can begin your climb with the overview.
