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Index Funds, ETFs, and The DIY Investor Herd

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The DIY (Do-It-Yourself) investor crowd has been growing over the years, as average investors saw their portfolios devastated.  They  experienced enormous investment losses from the two most recent crashes in history (credit crisis / housing bust, and the technology / dot-com bust).  The average investors invested mainly in mutual funds, and the average DIY investors mainly purchased individual stocks.  Even traditionally conservative income related funds and financial stocks (which the average person never thought would be hit) nose-dived to unthinkable lows.  As a result individual investors have shunned traditional mutual funds, while DIY investors have given second thoughts to selecting individual stocks.  With an unprecedented number of average investors looking for new advice and solutions/products for investing in their retirement, index funds have been pointed to with feverish frequency.

Such events have set the stage for the next major source of investment revenues for banks and investment firms.  This is realized especially as the growing DIY investor crowd has now been focusing heavily on the passive buy-and-hold strategy/idea using index funds (index mutual funds and Exchange Traded Funds / ETFs) to achieve returns equal to the market averages.  The strategy also includes ideas of diversifying within different index funds, and the couch potato strategy of dollar cost averaging (regular periodic purchases).

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IDEAS & REASONING BEHIND THE MOVEMENT INTO INDEX FUNDS

What are the main ideas & reasoning behind this large movement into index funds by the DIY investor crowd?:

- Efficient Market Theory – The theory states that the financial markets are informationally efficient and rational, because all the information is known and made publicly available to investors. Prices change instantly to reflect the newest information. Therefore it is not possible to outperform the market average with consistency over any period of time.  Some of the most famous and largest proponents of this theory are Burton Malkiel, author of A Random Walk Down Wall Street, and John Bogle, the founder of the Vanguard 500 Index Fund.

- Dislike & distrust in financial/investment institutions – The professionals are there just to make money for the banks and funds (selling the funds, and having high built in fees & expenses).  Wall Street has overcharged for their services and poor performance.  Fund managers did not warn or save clients (average investors) from financial ruin, while the executives received large bonuses & compensation.  Financial institutions and investment firms are the focus of the current financial crisis.

- All someone really needs to know/have is “common sense”, to steer the investor away from risky & unsafe investments.

- From results of recent crashes the average person could have invested just as well as the “expert/professional” and achieve the same (poor) result….. or better, if they stay away from the risky investments.

- The average person will do better by doing things themselves (relates to the two points above).

- Professional investors are unable to “beat the market” over any meaningful time span.

- The average investor can gain the same or better results as the professional investors by investing in the market itself, and staying in for the long term. Since the fund managers can’t beat the market, average investors should not try to.

- The average investor can invest in the market through the purchase of low cost index funds.
- Risk mitigation through diversification into different index funds, and dollar cost averaging through regular periodic purchases (i.e. paycheque/monthly/etc).

- Low cost index fund products are the best investment vehicles, and investing in them (passive investing) will be the way to ensure you have that golden nest egg come retirement, as opposed to active investing where it is likely you will lose money.

- Statistical data shows how mutual funds (stock pickers) cannot beat the market average.

- Examples of even very successful investors (Warren Buffett) who on average beat the market, but does not always beat it every year.

- Some very famous investors (Warren Buffett) succeed because they are geniuses (special), but no one else will be able to do it as they are not.

- Famous & successful investors succeed because they can take large risks, since they have a large sum of money to invest with.  But the average investor has a small sum and therefore can only take small risks, which only amount to small returns.

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MYTHS & INACCURACIES OF THE INDEX FUND STRATEGY

I agree with many of the points above.  However, many are terribly inaccurate myths and very misleading:

- The Efficient Market Theory is true to a certain degree.  In today’s modern age, information is publicly and widely available.  Markets hear of news related to particular stocks, industries, or the economy within seconds. However, the market is not efficient and rational all the time, because the market is made up of investors.  The investors are human.  Humans are prone to indecisiveness, momentary lack of rational judgment, fear, greed, arrogance, indifference, ambition, impulsiveness, over optimism, over pessimism, unpredictable behavior, and other human factors that make investors as a group inefficient and irrational much of the time.  Hence, the market cannot be rational and efficient all the time, and especially in the short term.  That is how many individual investors can find opportunities, and why there are examples of famous investors who over the long term has beaten the market average (Warren Buffett to name one!).

- It is true that mutual fund managers on average, fail to beat the market. But why is beating the market so important and used as a method of evaluating performance?  So what if you are able to achieve -5% return, when the market return for a given year is -10%, its still negative. By the same token, what does it matter if you got 10% return, when the market returned 20% in a particular year?  Or, if your return is 30% and the market is 20%?  What about absolute returns?  Absolute returns are the most important.  The market return can be used as a benchmark to see if one could have done better by purchasing the market.  However, people have gotten caught up with the comparison, and it is done all the time.  Investors have forgotten about what is important, and that is absolute returns!

- Common sense is a very necessary part.  You also need more. Investing requires skills & knowledge to succeed that the average person does not inherently posses.  The necessary knowledge and skills can be obtained from learning and experience.

- Risk mitigation through diversifying into the same asset class (paper assets, and index funds) does not provide a genuinely different source of investment returns.  Is it really diversifying when 100% of your investments are exposed to the market?  That does not seem like risk mitigation to me, as the entire investment portfolio is susceptible to large and global market downturns (recent dot-com bust, current financial crisis, etc).

- Minimizing your investment expenses is a good idea.  But just because low cost index funds have low investment expenses, it doesn’t mean its the best investment.  The cheapest, is not necessarily always the best. Further evaluation is always warranted.

- Warren Buffett’s mentor Benjamin Graham, also states that passive investing (in a basket of investments) can work with average positive returns, and active investing can work with superior results (if done intelligently).  The basket of passive investments may very well be a basket of index funds (unavailable at the time of his lectures & books).  However, that does not change the fact that there are no guarantees with either passive investing (or active investing).  He discusses that active investing works if one actually takes time to develop the proper knowledge, skills, patience, discipline, and correct mindset (all of which are totally doable) to invest intelligently.

- Index funds give you no more assurance of investment success than other types of investments.  Index funds are also just another investment (tool).  It may not be the best tool at all times, or in all situations. Active investors may employ them at different times as well, as its not restricted for passive investment purposes alone.  It is unlikely, that by only investing passively in index fund products, it will give you enough to retire on and sustain an individual’s current lifestyle.

- Dollar cost averaging can reduce your overall cost by averaging out your purchase prices.  Choosing specific price levels to invest can reduce your costs even more by purchasing at discounts, so you can end up with costs below the average of a particular year.

- You don’t need to have a large sum of money, take large risks, or be a genius.  Buffett attempts to dispel these myths all the time.  Even the greatest investors started with small sums of money.  You don’t need to take large risks to achieve large returns.  Risk comes from not knowing what you are doing, and not being able to evaluate risks properly (as perceived or actual, and their likelihood of occurring). He also reminds people that investing is simple, and a matter of not being overly optimistic (the downfall of most investors).  Calculations and techniques used to perform analysis on investments require simple math, and is just a matter of doing it without emotion and being conservative in your numbers.  Buffett again has reiterated this point many times.  Who has more credentials than Buffett (who built his investments from ground up) to say that he is wrong when he tries to dispel the common myths?  He is well aware of what it takes to be successful, more so than any average person!

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INDEX FUNDS STRATEGY IS NOT THE MAGIC CURE

There is nothing wrong with low cost index funds themselves, or using them in a particular strategy. Confused?  Low cost index funds and related products can work as part of a particular strategy or plan as well.  What an individual does need to be aware of are its limitations, and that it is not the magic cure-all investment guaranteed to leave you a golden nest egg.  It will not get you from point A to B, simply by investing starting at Time A (continually investing along the way) and then divesting at Time B. One needs to be aware of the inaccuracies & myths, limitations, as well as the other options available to them.  People need to know where each road can lead, and evaluate if they are satisfied with the destinations or not. Financial education & knowledge is still required in order to be able develop an overall plan, and devise strategies on achieving parts of the plan.  The individual investor must have enough knowledge to decide whether or not index funds & related products are tools that would work well for a particular strategy.

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THE HERD MENTALITY

Unfortunately wherever the herd goes, the next milking station will be set up there.  Do you want to be milked?  The media, including analysts on  TV (featured during evening financial news), magazine articles, newspaper, and even radio talk shows, all have been trumpeting index funds as the strategy and solution. Its interesting to note that many of the people and sources, gave very different advice and solutions just prior to the crash.  Should anyone really follow their advice given their track records?

There are also many new index funds that have been setup in recent years trying to cash in on the trend (especially the last two years).  All major investment firms and companies have started index funds, all advertising low costs.  A more recent iShares commercial also mentioned that “investment in iShares ETFs has risen 400% in the last year!”.  Even the banks have their own index funds, and GICs linked to indices. There is no doubt that index related products will provide the next major source of revenues for financial institutions and investment firms, just as normal mutual funds have for the last few decades. For a further discussion on mutual funds read my article: The Unfortunate Baby Boomers (The Mutual Fund Retirement Myth).

The average person will always be targeted, punished, and abused.  The average person will be told and mislead into doing something that is non-beneficial to them.  The above average enjoys fruits of their own success, while the underachievers have government assistance (actually, its the average person’s assistance through taxes).  Its obvious that whatever the average person does, it will lead to mediocre results on average.  If you don’t want average results, you need to choose one of the other two sides. I encourage DIY investors to become investors that are above average!  Progressive & continual learning, and the accumulation of knowledge will help steer the individual investor away from blindly following the herd/masses to the next milking ground!

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UPDATES:

- 2009/08/14 – Index Funds & ETFs Hit Record
- 2010/01/30 – Investors Continue To Pour Money Into ETFs & Index Funds

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Thanks & Happy Investing!
The Investment Blogger © 2009

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Additional Related Info:

- Benjamin Graham, is considered the first proponent of Value Investing (along with David Dodd). Famous books includes “Security Analysis” and “The Intelligent Investor”. The best known disciples of value investing are Warren Buffett, William J. Ruane, Irving Kahn, Walter J. Schloss. Buffett, credits Graham’s teachings as providing with a sound investment framework/mindset.

- Burton Malkiel, most famous for “A Random Walk Down Wall Street”. Malkiel presented academic findings that most mutual funds were not beating the market indexes (indices). He is one of the best known proponents of the efficient market theory.

- John Bogle, the founder of the Vanguard 500 Index Fund. His Princeton University senior thesis “Mutual Funds can make no claims to superiority over the Market Averages”, is also well known for his book “Mutual Funds: New Perspectives For The Intelligent Investor”.

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Books Related To The Topics Discussed:

The Intelligent Investor (Benjamin Graham)
Amazon.com Amazon.ca Chapters.ca
[Amazon.com version includes preface by Warren Buffett]

Securities Analysis: 6th Edition (Benjamin Graham)
Amazon.com Chapters.ca
[Not available at Amazon.ca]

The Snowball: Warren Buffett & The Business of Life (by Alice Schroeder)
Amazon.com Amazon.ca Chapters.ca

A Random Walk Down Wall Street (Burton Malkiel)
Amazon.com Amazon.ca Chapters.ca

Bogle On Mutual Funds: New Perspectives For The Intelligent Investor (John Bogle)
Amazon.com Amazon.ca Chapters.ca

The Warren Buffett Way (Robert G. Hagstrom)
Amazon.com Amazon.ca Chapters.ca