I talk a lot about the benefits index funds. Usually, I’m referring to the fact that their low-cost structure and low portfolio turnover give them an advantage over actively-managed funds. What I don’t think I’ve mentioned before are the psychological benefits that can come from owning index funds.
Confidence from knowing what you own
When you own an actively-managed fund, you never know exactly which individual securities the fund owns. This puts you in a situation in which your portfolio is a bit of a mystery to you.
When you own an index fund, you can say with certainty what it is that you own. For example, if you own a fund that tracks the Wilshire 5000, you know that you own (a very small share of) all the publicly-traded corporations in the U.S. economy. Your long-term investment results will reflect the long-term profitability of the U.S. economy. That’s pretty easy to get your head around.
Understanding what you own gives you confidence. And as we’ve seen over the last year, confidence is essential. Without it, there’s no way for an investor to stick with her plan when things get tough.
Maintaining your ideal asset allocation
With actively-managed funds, not only do you not know which individual securities you own, you don’t know what proportion of your portfolio is invested in a given asset class.
For example, most actively-managed funds will explain their asset allocation in terms of a range–something to the effect of “between 50% and 70% of the fund’s assets will be invested in dividend paying equities at all times.”
This makes rebalancing difficult, to say the least. Let’s say that you’ve decided that your ideal asset allocation is 75% stocks and 25% bonds. How exactly do you go about rebalancing your portfolio to maintain that allocation when you don’t even know the exact asset allocation within each of your funds?
With an index fund, you know its precise asset allocation. This allows you to rebalance your portfolio however often you feel appropriate, thereby giving you confidence that you aren’t overexposed (or underexposed) to any given asset class.
Not having to worry about somebody messing up
With an index fund, your results will be tied directly to the performance of the asset class in which the fund is invested. With an actively-managed fund, your results could be significantly better or worse than the overall performance of the asset class(es) in which the fund is invested, depending upon the skill/luck of the fund manager.
That is, actively-managed funds introduce an additional level of unpredictability (i.e., “risk”).
It might sound rather pessimistic to prefer not to have an actual person making investment decisions for me. But my reason is one of optimism: I have unshakable confidence in the long-term creative power of entrepreneurs.
In other words, when I put my money in the stock market, I’m investing in a belief in entrepreneurship, not in a belief in some guy’s ability to beat the market by buying and selling stocks with my money.
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Great summary Mike.
Thanks,
Neal
So when you say “asset class” do you you mean balancing between funds that invest in bonds vs. stocks? Do you mean large-cap vs. small cap? U.S. vs. foreign?
Kevin: Yes, that’s precisely what I mean–making sure your bond vs. stock allocation is appropriate, as well as your large cap vs. small cap, and U.S. vs. foreign.
It’s easy to do with index funds. Rather difficult with actively-managed funds.
Mike,
Have you read this article? Any thoughts?
http://www.fool.com/investing/mutual-funds/2009/03/20/its-time-to-reinvent-the-index-fund.aspx
Kevin, I just did. Thank you for pointing it out.
My thoughts: malarky. (Though if I’m honest, I’ll admit that I’m pretty strongly biased against Motley Fool. More on that later though.)
The quote “Here’s what I propose instead: a low-cost, quality-weighted index fund of large U.S. companies” just kills me.
An index fund with only good companies. Brilliant! Now all we have to do is figure out which companies are the good ones…
Essentially what he proposes is an actively managed fund using quantitative analysis–that is, a system of mathematical rules for determining whether or not to invest in a company.
I have no opinion either way on the validity of his particular system, but I do have some thoughts on quantitative investing strategies in general.
They do have some advantages–namely, it’s possible to fully automate them, so a fund using them could have very low costs. However, I think they’re subject to at least a handful of problems. Probably worth doing an actual post about….
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