Today’s guest post, “Indexing is the Best Way to Invest Your Money” comes from Value Indexer. VI writes about enjoying wealth in all its forms at Simply Rich Life, and about index fund ideas and research at Value Indexer.
Indexing wasn’t my first choice when it came to investing. When I was a kid, one of the first books I read about money explained taxes, inflation, and investing (among other topics), all based on simple ideas to which a 10-year old could relate like having a paper route or running a lemonade stand. By the time I was 10 I thought bonds were really cool. Fortunately, by the time I had real money to invest I learned about index investing.
In a conversation with Joe, he asked me about a recent post where I talked about my goal to reach $500 in passive monthly income within the next year. Specifically he asked if my ‘passive income’ goal meant I was into dividend stocks. Dividend stocks were a phase I grew out of, sometime after bonds. Don’t get me wrong: I respect the strategy, it’s just not for me.
My portfolio is focused in a simple collection of index funds. Once we get a newly-opened RESP converted to access TD e-Series funds, that’s also where we’ll put education savings.
Yes, there are many good ways to invest. The best way is to use your money to start an active venture — opening a business, buying a rental property, etc. But eventually you want to slow down — and some people never want to ‘speed up’. The single most efficient passive investment is the use of low-cost index funds (indexing). (Editor Joe’s note: yes, as a reader of TimelessFinance you’ve seen this topic before. Take that as a hint. Also, VI brings some good ideas to the table that are new, at least on this blog.) Indexing can actually help you on the ‘active investment’ front, too — we’ll discuss that later.
Why is indexing so superior?
Adina talked about “financial Gandalfs“ when she wrote her indexing article. (Point taken but, upon review of the trilogy, I think Saruman is a more apt LoTR analogy for mutual fund managers. Saruman is smart, but he’s secretly serving his own interests and working against the protagonists.) These mutual fund managers tempt you to overlook their extraordinary fees and fixate on the possible fruits of their hyperactive investment strategies. ”Why settle for average when we can do better?” But this overlooks the truth that long-run returns from indexing are good if you stick with a solid plan. The passive returns from indexing are, ironically, above-average, because the average fund does worse than the market average after accounting for MERs and commissions. Money managers are paid huge sums to beat each other. It’s obviously impossible for more than half of the managers to beat the average. Investors pay the cost of this game of musical chairs. Canadians tend to be money-stupid about these sorts of things, putting up with fees that investors in other countries laugh at. In short, indexing costs less. OK, you already knew that. I promise I have a lot more ‘advantages’ to discuss and not one of them is the latte factor (so no worries, Adam P!).
But actively-managed mutual funds or financial advisors aren’t the only ways to try and skin the above-average cat. You can do your own fundamental research. You could stick to a dividend growth plan where you pick companies with a good record and let the dividends compound to pay you a tax-efficient income. These approaches sound interesting, can be fun, and may be quite profitable.
Yet in the long run they can’t beat indexing. Not on average. They have a head start against speculative investing or mutual funds — a dividend investor is usually focused on a long-term plan, allowing them to ignore market noise and making them more likely to buy low. Nevertheless, investing in stocks that pay eligible (tax-advantaged) dividends limits Canadians to a very small number of companies (care for BMO with a side of Telus?). That leaves a dividend fiend un-diversified. Remember: even good dividend payers can go bankrupt.
I prefer maximum diversification, which means broad index funds that cover a very high percentage of market capitalization. Index funds are the ultimate diversification tool. There’s hardly a large company in the world that I don’t own, so I don’t mind the occasional BP or Yahoo dragging us down. For each dud in my portfolio, there’s a famous company reaching new highs and, more importantly, many quietly-profitable companies.
Many of those profitable companies re-invest their profits instead of paying dividends. There’s another irony: a true dividend investor couldn’t buy Berkshire Hathaway. If you only buy dividend-payers, you don’t get any of these excellent companies nor any of their profits.
Some dividend fans point to the fact that dividends are real cash while earnings are just numbers on a spreadsheet. This is always a concern since there are countless companies that have pushed the earnings “game” too far or squandered real profits on subsequent bad decisions (e.g. Enron, Nortel, etc.). Nevertheless, the fear of immaterial earnings is, largely, immaterial. A recent report from institutional asset manager GMO summarized their research into how much of corporate earnings really go to investors. They built a model that said “if a company’s earnings are $x, the stock price should go up by $x over the next decade so investors can sell their shares and capture the profit”. When they compared this model to actual stock market performance, GMO found that earnings are overstated by a little over 1%. That means that if a company’s earnings are reported as 7.5% of the stock price, you can expect to eventually earn a real profit of approximately 6.5% from owning the shares. Index investors need to acknowledge this risk. Nevertheless, 1% isn’t a bad amount of leakage and leaves room for an awful lot of real profit. Also, dividend companies can be just as good with accounting tricks. If you’re a hardcore “cash is king” advocate, don’t forget: the best cash payouts come from early stage Ponzi schemes!
Speaking of scams, what really bothers me about day trading (or any “investing” strategies that aim to beat the market with hot tips, technical analysis, and capital gains) is that it’s a brutal version of office politics. Every gain you make above the index return must, by definition, come out of someone else’s account. Conversely, one powerful aspect of “settling” for the average is that it’s what anyone can get. The natural profits of corporations aren’t something you have to fight for. Why not? The people buying the products and services that create the profits get more value than what they pay. Because of this, they’re happy to continue paying. You just need to be willing to forgo the use of your money for a bit longer to grab a piece of those profits. On the other hand, making a day trading profit is only possible when you take money from someone else who is fighting to take that money from you. Some people might not be bothered by this — but everybody should be bothered by the fact that they have no advantage in such competitions. It’s just gambling.
Indexing has an air of predictability once you understand it. Not in the same sense as guaranteed-return funds — you don’t know what an index will return from year-to-year — but you can trust that the market will safely store capital. In the long run, it will generate profits for you. If that fails, you’ll need guns and canned goods, not investments. (Editor Joe’s note: sometime we really need to talk about the potential for a “lost decade”, as experienced by the Japanese, to devastate an index’s return; in such situations, heavy international diversification and dividends are the only defenses).
Indexing is also completely scalable. You can do it with as little as one fund (such as a Vanguard lifecycle fund). You can own four funds to diversify (but not overextend) a small- or medium-sized portfolio — this is my current strategy. If you’ve got a large portfolio, you can achieve plenty of diversification with just six to eight funds.
Best of all: once you set an indexing allocation, you can rebalance your portfolio with just a few minutes per year. There is no need to complicate things any further than you want to. Andrew Hallam is happy to manage a portfolio worth over $1M with only four funds, which won’t turn heads but will make lots of money with very little work. The simple fact is that if you take an active approach to stock investing, the work load is huge. It can really become more of a second (or third) job than an investment strategy. Sure, it could be profitable, but it’s not a good income to depend on. The cost/benefit analysis definitely favours indexing over active trading. (Editor Joe’s Note: another benefit of indexing is that it reduces your exposure to market bubbles — if you add money to under-performing funds, you’re usually “buying low” rather than buying into the asset or index that’s currently “hot”).
Now, as promised, let’s talk about how indexing helps you to actively invest. The benefit of passive investing doesn’t just stop at “you’ll save time by indexing!” It extends to what you can do with that time (and the associated peace of mind). Start a business, buy a rental property, or get better at what you already do for money. My business, like most jobs and unlike day trading, is non-zero-sum. People are happy to pay me because they get what they want at the same time. And if I give them extra value, they’re happy to pay even more. Why would I take on a second job as a trader to potentially make an extra $500 a month (assuming I don’t lose my shirt on bad trades) when I could focus on making an extra $30,000 a year in my business? Why would I spend 6 months trying to flip a house when I could earn just as much doing something I’m good at, while working fewer hours? (Editor Joe’s note: VI’s disgust for speculation is welcome on this blog! Capital gains and speculation are synonymous and are the worst kind of investing. Gold = real estate prices = Toronto condos = day trading. Don’t be an idiot.) When you’re considering an investment opportunity, don’t only worry about your capital input. Think about your time.
The way I invest is simple:
- Put in as much capital as possible; and
- Give it as much time as possible to grow.
Index investing makes it easy to execute my investment plan. It provides much better long-term returns than other passive investments like GICs. Unless you have over $1,000,000 in capital, your best way to earn more money is to let your investments manage themselves and to work on earning more from a side business. Then you can shovel more cash into your portfolio to increase your passive income.
What do you think about indexing? How do you invest?