Wednesday, September 3, 2008

To Index or Not to Index

Last week, Frugal Trader over at Million Dollar Journey wrote a provocative article about 4 reasons why index investing may not be for you. This article generated a lot of interesting discussion. Instead of giving my own opinion on the subject, I thought I’d search out views from a recognized expert.

Enter Warren Buffett, or at least a 15-year younger version of him. In his 1993 letter to shareholders, Buffett wrote
“[A] situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.

“On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: ‘Too much of a good thing can be wonderful.’”

You might think that by Buffett’s definition, the investing world is divided into 50% “know-something” investors and 50% “know-nothing” investors, but this isn’t right. Because of the cost of commissions, spreads, increased volatility, increased capital gains taxes, and losses due to market timing attempts, the proportion of investors who beat the index is way below 50%. So, there’s a good chance that you and I are both “know-nothing” investors by Buffett’s definition.

The good news is that even if you can’t evaluate the prospects of individual businesses effectively enough to beat the index, you can still beat most other investors by buying the index.


  1. Thanks for the link Michael! I figured that post would draw some attention to smart indexers like yourself and Canadian Capitalist.

  2. Good find.

    I would add that it is not necessary to fall exclusively in one camp or the other. I know many people who pick stocks in their home markets and index global markets for diversification benefits. Or pick stocks and index fixed income (or vice versa). It's even possible to index your home market and add individual positions to certain companies with which you choose to keep up with.

    Putting in the work to track and study one company can be manageable, but investing in one company is not too prudent. Investing in ten companies is better, but is ten times the work, which may be too much time for many people.

    Indexing is a real boon to most investors.

  3. Preet: Mixing indexing with individual stock selection makes some sense to me, but I suspect that Buffett might disagree. If an investor truly has confidence in his stock picks, why not put all of his money into them? Of course, the answer is that he doesn't have that much confidence in his picks. So why put any money in these picks? I'm not sure how to defend my feeling that a mixed approach is okay against this argument.

  4. Your point about the expense of active investing is well taken. It does not preclude active investing, but it should make investors very, very prudent.

    In a sense, the debate comes down to this: will you do better indexing, or with a buy-and-hold philosophy that really means hold. That is, you (or whoever advises you) have done your homework and are prepared to hang on to your stock for years at a time, even when the market kicks it around a little. It’s always easier to be patient, of course, if the stock is paying you dividends.

    Our experience is that this philosophy will prevail over indexing. But it is equally true that when investors become over-active and start trading in and out of the market, the costs alone (let alone the inevitable losers) will probably drop their returns below the level they could achieve simply by indexing.

    It’s not so much a matter of “smart” vs. “dumb,” as it is one of personality. If you want to go beyond indexing, you need to have the discipline and patience to carry it through.

  5. Investment Reporter: I agree that stock-picking success is more complex than whether you are smart or dumb -- personality is an important factor. But intellect matters a great deal as well. It seems likely that successful stock picking requires both patience and intelligence.

  6. In reply to your point about intelligence, couldn’t agree more. We always assume we are speaking to intelligent people who want some control over their finances.

    The point is that “smart” and “dumb” can’t be used to separate investors into categories, as in active investors are people smart enough to play the market and indexers aren’t. That’s just not true.

    Intelligence implies knowing your own limitations and those of the market as well. In markets like these, an investor may take an apparently “smart” piece of advice — such as buying good stocks at bargain prices — and run the wrong way, indiscriminately grabbing up stocks that may never fully recover.

    In that case, the intelligent thing would have been to do nothing. It’s as much about not making bad decisions as it is about making good ones.

  7. In "The Intelligent Investor", Buffett's mentor, Ben Graham is even more insistent against "active" investing. He says that without lots of additional study, our returns will be much worse than what we could achieve passively. He seemed to say that diligence was of the utmost importance.

    Would like to hear your take on Buffett's inclination to bet big when the odds are in one's favour. I've found this key to my success.

    An additional argument towards picking stocks is that it's just so much more fun! Also, as Buffett has said, investing knowledge is cumulative. What we learn today can be used with everything we learn over the ensuing years. I think there's no better way of learning investing than by actually choosing individual company stocks.

  8. Gene:

    Graham is probably right. Only a minority of investors can beat the index after all costs. To beat the index, you need to take advantage of others who try, but fail to beat the index. So, the majority who think they are taking advantage of others' mistakes are actually making mistakes themselves.

    As for betting big on great opportunities, this will work well for those with Buffett-like skills, but is potentially disastrous for most investors. It comes down to how confident you are that your investing skills are well above average.