Why Indexing Works
October 1, 2020
“When dumb money acknowledges its limitations, it ceases to be dumb.” Warren Buffett
2020 has become a textbook example of why index investing works. Most people think that amongst a large collection of stocks like the S&P 500, half will outperform and half will underperform. But that is not how it works. In reality, nearly two-thirds will underperform and the remainder will drive your investment performance. This is because when a stock goes down, all you can lose is 100%. How ever the sky is the limit for the winners. Just look at Elon Musk and Tesla whose stock is up 1,000% over the past 12 months. One winner can pay for many losers.
If we had a basketball team with ten players and the team scored 100 points, we wouldn’t assume half scored more than ten and half less than ten. What happens is a couple of players will score the majority of points and the top players change over time. Star players age and new up and comers will challenge the old. It works the same way with the market and by casting a wide net, we are more likely to catch the next high flyer.
This brings us to 2020 through September 4th, it was not the typical 1/3 of companies delivering the gains, it was six (Facebook, Apple, Amazon, Nvidia, Microsoft and Google). Through the first week of September, they were responsible for more than 100% of the 9.2% gain in the S&P 500. While most of the economy is facing COVID headwinds, the pandemic has been a boom for big tech.
Big tech has been the driving force in the S&P 500’s strong performance over the past decade. We cannot count on these companies to outperform forever, the law of large numbers will eventually have its gravitational pull. Different parts of the economy will have their turn to shine. From the peak of the tech bubble in 2000 into the financial crisis investors bemoaned the lost decade where returns were flat. It took two extraordinary market busts to produce that result however during that same time emerging markets were flying high and garnering investors attention. The reason was because US economic growth was below 3% and overseas it was high single digits and double digits in some countries. There is always a narrative to support the high flyers outperformance, but valuations always get pushed to a point that cannot be sustained and a new segment takes the lead
What will lead the market next year? It’s hard to predict, there are several industries like energy, financials and travel that remain significantly depressed. Perhaps they will lead, maybe tech will continue its run or something else will have its time. The point is index investing almost guarantees you will have the next winner. I say almost because my first example TSLA is not in the S&P 500 and predicting that the auto maker would produce a 1000% run after posting its first profit would have been difficult. Remember indexing does not produce average returns, it produces above average results. The 20 year period ending in 2014 the indexes outperformed active management 71-85% of the time because they rarely missed out on holding the winners.
Thoughts on the Market
As we head into the election, I am expecting an increase in market volatility. Outside of technology and e-commerce, most of the market is down for the year which is appropriate with the pandemic. The impact of COVID on the economy hasn’t been dramatic as I once feared as the government has stepped in with massive stimulus. Consumers have returned to spending near normal levels and have shifted their entertainment budget towards their home and electronics. They have also boosted their savings rate and have been paying down debt. While I still see a speculative fervor in pockets of the market, I would broadly describe company valuations at the high end of what I call the “zone of reasonableness.” Unfortunately with interest rates near zero the bond market has limited appeal making stocks the preferred asset class. I continue to hold 15% of my portfolio in cash but I am looking to bring that percentage down as opportunities arise.
Reminder to stay the course, keep it simple and don't complicate the process.
With investing you don't have to do exceptional things to get exceptional results. I believe the following process is likely to produce satisfactory results over a long period of time by minimizing mistakes.
- Buy great businesses at reasonable prices. Stock valuations relative to interest rates remain the most attractive option
- If you do not know how to identify a great business or a reasonable valuation, buy the VOO (Vanguard S&P 500). Owning a piece of corporate America at low-costs will do well over the long run.
- Do not attempt to time the market
- Avoid active trading - Don’t let emotions drive decisions
- Have a clearly defined plan and stick to it. If you don't have one I can help you.
- Avoid asset classes that diminish returns - i.e. cash and gold
- Keep expenses to a minimum
I have spent a lot of time recently demonstrating peculiarities in the market and pointing out the impact amateur investors can have on the market. I am still finding them everywhere (NKLA), but quite frankly I am tired of writing about them. I use these real-time examples as cautionary tales so that you remain the proverbial tortoise and avoid the temptation to become the hare. But I can not ignore this one. I have had a couple of readers comment about interest in option trading and I issued a stern warning to stay away. This is a zero sum game and the smartest minds on Wall Street have an enormous advantage. The chart below shows option trading has exploded in popularity with amateur investors. I earn my living by looking for mis-priced options in convertible bonds so I can tell you with first hand knowledge it’s not for mom and pop investors. Bloomberg recently reported Chicago billionaire Ken Griffin made $2.4 billion in the first six months of the year and was responsible for 32% of all option trades. How did he do this? He has been behind the “free” trading online brokerage trend. His firm Citadel pays online brokers like Robinhood for their order flow. So if you make an option trade, there is a good chance he is on the other side and will take your lunch money.
This commentary is provided for general information purposes only and should not be construed as investment, tax or legal advice. Past performance of any market result is no assurance of future performance. The information contained herein has been obtained from sources deemed reliable but is not guaranteed.
