Kid, You’re Doing Index Funds Wrong

I spend a lot of time reading Reddit, probably too much time in fact. I get hooked into reading and commenting on the personal finance and investment sub-reddit discussions in particular.

When it comes to talking about long-term investing in Index Funds it is the same old common questions and narrative that play out time and time again.

They posts all start out the same way, along the lines of “I’m a first time investor looking to get started in long-term Index Fund investing, which fund should I get?”. Enter a slew of advice touting the ideal portfolio consisting of 10 different funds, delivering the perfect overall strategy to tap into each and every hot growth area.

This advice is just plain wrong.

Kid, you’re doing long-term Index Fund investing wrong.

Refresher: What Is An Index Fund?

Think of an index fund as buying a little slice of almost everything currently available in a particular market. For example instead of researching each of the 200 companies that make up the ASX200, or the 500 companies which make up the S&P 500, and trying to pick a winner, you are buying a small piece of every single one of those 200 or 500 companies. You are betting that on average that package of 200, or 500, companies will grow in value.

Over time the size of the pieces you own in each company will shift around a bit as companies grow and shrink and move in and out of the index, but this process is automatic, it happens in the background, you don’t need to do anything.

There is an index for the S&P 500, there is an index for the ASX 200. In fact, there is an index for hundreds of more specific areas too. Want an index specific to Natural Gas companies, or one which looks at only Highly Volatile companies? Sure.

Your return will be the average of all the companies in the index. If the S&P 500 companies on average go up in value, the value of an index tracking the S&P 500 will also go up. If a single company goes bust you won’t lose your house. But the inverse is also true, that you won’t become rich overnight just because a single company does extremely well. This is diversification at work.

There are a couple of different ways that you can buy into an index. The most common being either through Exchange Traded Funds (ETFs), which follow the same buying process of almost any other share on the market. Or, buy into an index via a Managed Fund through a company such as Vanguard. The end result is pretty much the same though, you are buying a little slice of everything in the index.

Why Does Warren Buffett Recommend Index Fund Investing?

Warren Buffett is a value investor, he is one of the best stock-pickers to ever live. He isn’t known for buying indexes himself, however for most people he suggests that an index fund investing approach may be the best option.

Why is that? Because most people don’t want to spend the time researching companies. And the fact that most people, including paid professionals who manage huge investment funds, fail to beat the overall average of the market over the long term.

Indexes provide the average return of a market, without having to think.

Think about that for a moment. Some people dedicate their lives to researching companies, and still don’t beat the market average returns. The return available from purchasing a broad index with no further thought.

Warren Buffett believes in the continued success of the economy and of the ability for companies, in general, to succeed. He believes that overall the economy of planet earth will continue to grow over the long-term.

He therefore recommends for the average investor to buy into broad indexes. The type which will track the S&P 500, or one which tracks the largest several hundred companies globally. Mega-corporations including Vanguard, iShares and Blackrock have funds available in this space. The funds often come along with low fees, as the purchases are following a mathematical formula, they are automatically buying a certain percentage of everything. There isn’t an expert being paid to pick which individual company is going to be a winner.

You buy a little piece of everything. You continue to consistently buy and hold over decades so that the peaks and troughs are evened out, and on average you will grow too. You choose to reinvest any fund distributions. Then compound interest, the eighth wonder of the world, will help you along nicely too.

Now Back To Reddit

So here we are back in the land of Reddit, joining the discussion with our “long-term index fund investor experts”.

They’re suggesting an all markets index. But then remember to add in a slice of exposure to local markets with another index. You don’t want to miss out on the potential growth from emerging markets, so add in a little slice of that. And everyone knows that environmentally responsible companies are gaining in popularity, so throw in a piece of that. Oh, and we need some tech focus, so let’s add in a chunk of a NASDAQ index too.

This is sure sounding a lot like stock-picking to me, but instead at an index level!

And this approach is terrible for new investors who are looking for a long-term approach for many reasons:

• It adds complexity: Why were those specific indexes selected? What percentage of each should the portfolio contain to begin with? How do they determine what an emerging market even is?
• The strategy needs to change over time: Trends change over time. Should the percentages also change over time? Should we switch out of the NASDAQ if we hit a repeat of the 2000 DotCom bust and move to Gas Futures? It’s not a set-and-forget strategy.
• Changes in strategy result in transactional costs: Sell out of one option and a capital gain tax event is triggered. That’s going to cost you. You’ll then have slightly less to invest into the next thing. Touching things often costs money.
• You think you can beat the overall market: Most people can’t beat the overall market, professional money managers included. So what chance, other than through beginners luck, does a brand new investor have of beating the market over the long-term? The broad indexes are already including small pieces of everything, so why are you choosing to add more weight to specific areas, unless you believe you know more than the overall market? And you know this from how many hours of research?

The Way It Should Work

For that new investor, the one who claims that they are looking for a long-term dollar cost average strategy utilising index funds, keep it as simple as possible.

A wide reaching index for their local economy of choice, likely the country where they live, something following the S&P 500 or ASX 200 maybe. This is the location where they will be spending their money for decades into the future, so it is important to have exposure. Not because we are guessing that this market will out-perform any other.

And then a wide reaching international index, tracking likely the MSCI World Index, to get that little piece of every huge company in the world. You get your little piece of all the big technology players such as Apple, Microsoft and Alphabet. You get your little piece of the health care sector. You get your little piece of the finance sector, the industrial sector, the communications sector, the energy sector. You’re getting them all. And while the majority are based in the United States, there are over 30% based in other countries. If the next big thing happens to be based in Japan, you’re going to get a piece automatically.

That’s it.

Just start. Put in that money the next pay day.

Now keep doing the same thing, 1, 3, 5, 10 years from now.

It should’t take a degree.

It’s boring.

It’s not exciting.

And this is why it is a hard strategy to follow.

The hard part is not touching it.

Now, Move Forward

Broad participation over the long-term is the kind of model Warren Buffett is talking about when he suggests that most people should invest in index funds. Not some precise split of 10 different indexes because you believe that you are Nostradamus after reading a few news articles about emerging markets, green technology and frozen concentrated orange juice futures. He is suggesting a set-and-forget approach, one which won’t require significant adjustment within a couple of years.

Remember the purpose behind the long-term dollar cost averaging broad index fund approach. It isn’t an attempt to beat the market, it is to be a participant in the overall market, for the long-term.

If you want try to beat the market, do your research, go for it. But be honest with yourself about what you are trying to do.

The more simple the strategy, the easier it is to understand, the easier it is to stick to.

I suspect that a lot of commenters providing advice on Reddit haven’t been investing for more than a year. I get unnecessarily worked up over Reddit posts! But that’s a gripe for another day.

The long-term, that’s where the magic of compounding really kicks in.

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