The Death Of Index Investing And Other Silly Stats

by Mike Holman

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I recently came across yet another post on investing which goes something along the lines of “If you invested 10 years ago in the Dow then you would have earned exactly nothing in that time”.  I hate to pick on any one blogger since I’ve read these articles all across the blogosphere but this one is the latest and he also had the temerity to tie in poor index performance with the death of index investing.  Of course all the stock pickers out there ALWAYS beat the index so poor market are no concern to them…!  I want to emphasise that Jacob at Extreme Early Retirement does a great job with his blog and I don’t want to sound like I don’t like the blog – just that one post!  :)

What about the dividends?

Usually these posts look at the point value of an index at a previous time, say 10 years ago and compare it to the present index point value.  This is incorrect because they are missing dividends.  Published index returns always included reinvested dividends and any type of analysis on index performance should always include the same.  Admittedly, if you are looking at a 10 year period where the index point value hasn’t changed, the addition of dividends isn’t going to change the argument very much but it should be there.

Selectivity of stats

Why is it that all the articles always pick the worst peak to trough period to illustrate their rather suspect point that maybe equity investing or even index investing is evil?  Have you ever heard of such a person who invests all their money on the same day the markets peak and then doesn’t invest any more?  Doesn’t seem all that likely to me.  Most people invest their money over time because that’s how they earn it, then save it, then invest it.  Picking one particular time period to prove or disprove a theory is like measuring your gas mileage one mile at a time and then using the best or worst mile to prove your point.

Investment performance

And what about active stock pickers – did they all do better than the indexers over that period?  Or did some of them do better, some of them the same, and some of them didn’t do as well?  I’ve asked many bloggers and non-bloggers who claim they can beat the index by picking their own stocks to prove it – measure their performance and let me know if they did better than the market or not.  You know what?  Not one of them has ever shown that they can beat the market – oddly enough, most of them don’t even bother to measure their performance.  How can someone who doesn’t even know how their own investment method measures up criticize someone else’s?

What is average?

One of the criticisms of indexing is that you will only achieve “average” results – again – will I do better by randomly picking stocks or paying someone lots of money to pick them for me?  One thing about indexing is that you will get the index return minus a very small fee – you will never beat the index but more importantly you won’t underperform the index (except for the small fee) either.  Active pickers can certainly outperform the market but they can also underperform as well – sometimes by a huge margin.  I like making money – if I thought it was possible for me to beat the market then you can rest assured that I would give it my best effort.

Dividends, smividends

Ok – one more rant… I like getting dividends just as much as the next investor but I really think there is an over-weighting on the importance of dividends in the blogosphere.  Yes, the idea of living off your dividends is nice but investment performance measures total return which is capital gains plus any reinvested dividends and interest payments.  That’s it.  I don’t care in what form the company pays out in the end – if the total return is higher, then its a better investment.  If that includes dividends, fine – if not, that’s fine too.

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{ 9 comments… read them below or add one }

1 Mr. Cheap

If the dividend addicts show up with pitchforks, don’t answer your door!

2 Four Pillars

Haha – I should have put the word “rant” in the title because that’s what this was… :)

3 Gates VP

(continuing rant)

What about inflation?
People love to draw this line from peak to trough (as you mention) but they also do it with no regard for inflation. Investors and media are constantly talking about “new highs” as if that actually meant something. I’m sorry, but in an inflationary environment, if you’re not constantly achieving new highs, then you’re losing.

I actually like the post you linked to, if only for this quote: If you correct for inflation, you would have done worse. If you correct for the loss of international purchasing power by denominating the S&P 500 in Euro, even worse.

I also like the fact the he outlines the risks.

But yes, he makes the same mistake that pretty much every one makes when discussing long-term investing strategies. They fail to account for the importance of actual cash flow and they just ignore inflation as if dealing with absolute numbers over 2 decades has any relevance.

Of course, we face the inverse problem, how do you make that model understandable to the common man? I chewed out the 10/10/4 model on the Mint.com blog, but even then it’s difficult to understand in text.

So let’s rant away… personally, I’d like to make a video that actually describes this correctly.

4 Four Pillars

Gates – excellent point about inflation. I read that mint article – not so good. They assume you need 70% replacement which is probably more accurate for Yanks than Canucks because of health care. He also excludes inflation from the “4%” rule.

It is a tough calculation and really, it is better to just have a rough plan which you can nail down a bit better as you get older.

5 Dividend Growth Investor

Well buying and holding index funds works out for most people who can stick to the strategy. Of course the most interesting part is that index funds keep outperforming active funds..
I do agree with Jacob that blindly putting $100/month during ups and downs in the markets might not be the best way to go; on the other hand however waiting for the perfect opportunity to invest might result in you missing huge gains and then buying at the top..

If you thought stocks were overvalued in 1996-1997 and you switched to fixed income from stocks you would have done very well and outperformed the markets in terms of total returns. Your emotional ride wouldnt have been as smooth however, as stocks would have doubled in value, then fallen by 50%, then doubled again, then fallen by 50%.. You would have felt as an idiot, smartest person alive, idiot, smartest person alive..

As for dividend investing – the dividend aristocrats are outperforming the S&P 500 in 2008.. They did underperform in 2007 however.. But on average research shows that dividend payers outperform no payers in the S&P 500.. So if we could create an S&P 500 index that only lists the 370 or so stocks that actually payd divs.. and ignore the rest could provide for some interesting long-term investment.. That will yield about 4%..

6 Four Pillars

DGI – great comment.

7 moneygardener

I don’t think dividends are more ‘important’ per se than capital gains. I think of dividends more as a tool or a basis to set up a framework for investing. Dividends can be taken as similar to earnings when evaluating stocks. If they’re growing that is a sign of health. The rate of growth and the percentage of earnings paid out as dividends is key.

What dividends offer that might just trump capital gains is the bird in hand vs. two in the bush scenario. Yes a company can grow its earnings and eventually give you a cap. gain when you sell, but getting the money upfront just makes me feel all warm and fuzzy. Especially when they up that up front money each year, or twice per year. You are being paid their earnings in advance, and that is a good thing especially when you consider that the market might just be valuing a company at the worst level in years when you want to sell. Your capital gain can vanish by no fault of the firm but once you get your dividend nobody can take that away.

8 Four Pillars

MG – there is a LOT to be said for a bird in the hand…especially this year.

9 Dale Rathgeber

FP ; You compained that stock pickers never post their index-beating results. I do.

I lead a group of active-rebalancing momentum / autumn abstinence mutual fund investors who have achieved average returns of 17% per year, since 2001 until this year, during which we are presently down 10%.

I believe that the recent economic forces that led to a star fund’s recent out-performance will typically continue for a reasonable period of time– (three months)– thereby allowing us to use a combination of recent out-performance, and long-term performance as a good (but not perfect) predictor of future performance for three month periods. This is often referred to as momentum investing.

We rebalance every three months because the short-term trading rules for mutual funds allow this; and if we use a discount broker we pay no commissions or fees,– except for the hidden MER which we attempt to keep to the minimum, by choosing low MER funds whenever feasible.

We also get right out of the market in Sept and October,– which works well more often than not, — and which saved our backsides this year.

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