The 4 Stops on the Road to Successful Index Investing
Updated: Jan 24, 2020
Investors are born in darkness. At least, according to my favorite tweet from Investment consultant Rick Ferri who states that a successful index investor typically goes through four stages.
My personal experience with the 4 stages of index investing
Much like Bane, I was born in the darkness, molded by it. The darkness I refer to is the belief in stock picking and actively managed mutual funds. When the media covers finance and investing it often promotes the idea of picking stocks and beating the market.
How many times have you read articles pushing “stock tips” or predicting impending doom in the stock market? Humans suffer from an overconfidence bias which makes us primed to receive the message that we can “beat the market” despite the overwhelming evidence that suggests that it is incredibly unlikely.
It’s difficult for financial media companies to tell the truth about investing because the truth about investing is boring. If media companies continually printed a headline that said “the key to successful investing is low-cost, globally diversified equity and bond index funds”, it would not take long for their advertisers to pull the plug.
Stock picking and actively managed mutual funds have a fun story. The gun-slinging stock picker who can beat the market and make you rich. However, it is just that; a story. When you look at the data, this story falls apart.
Standards & Poor’s collects data on how actively managed funds perform against their benchmark index across the globe.
Over the past 5 years
82% of active fund managers in the U.S underperformed the S&P 500 index.
90% of active fund managers in Canada underperformed the TSX index.
80% of active fund managers in Europe underperformed the S&P Europe 350 index.
It was not until I learned about the “efficient market” theory and began reading the research of brilliant economists like Eugene Fama that I entered the second phase of index investing.
This is the period where I had the lightbulb moment that low-cost index investing is the most rational investment decision for a long term investor. At this point, I stopped listening to people like Jim Cramer and started listening to people like Jack Bogle.
There are two other cognitive traits that make humans exceptionally poor investors.
We get bored easily.We want to do better than others.
There is nothing exciting about investing in low-cost index funds. It takes a tremendous amount of discipline to take every dollar you can spare and plow it into the same 2–3 ETFs.
It wasn’t long before I began tinkering with my portfolio again.
“Real estate is a great investment, I better buy some REIT ETFs”.“
Emerging markets are way down right now, better load up on emerging market ETFs”
“Brexit is hammering UK Stocks, where can I find a UK Index fund to buy while prices are low?”
Before long, I ended up with about a dozen ETFs and I found myself actively managing passive index funds. Which of course is it’s own form of active management. Overweighting your portfolio towards a particular sector (like real estate) or a specific region (like U.S stocks) is a form of active management.
I had to step back and realize that i was betting that a particular industry or geographical region will outperform over the long term. I had no evidence to lead me to that conclusion. I had regressed back towards the darkness. Once I realized that I moved towards the final stage of index investing.
Going forward I am investing in two ETF’s
A global market-weighted Equity ETF that tracks the global stock market
A global bond ETF that tracks the global bond market (hedged to my local currency).
If I really wanted to embrace simplicity I would simply invest in the various “one-fund” solutions offered by companies like Vanguard and Blackrock.
Yes, you can actually buy a single passively managed ETF that provides global exposure to stocks and bonds. This is the height of simplicity; A single fund that automatically rebalances. This means the only decisions you need to make are how much to invest and when to start living off your investments (retire).
These “one-fun” solutions come in various stock-bond weighting depending on your circumstances
Ultra aggressive: 100% equity
Growth: 80/20 equity to bonds
Balanced: 60/40 or 50/50 equity to bonds
Conservative: 40/60 or 20/80 equity to bonds
Ultra Conservative: 100% bonds
With the rise of low-cost Robo-Advisors to help you pick a portfolio that fits your circumstances, it has never been easier or cheaper to embrace the simplicity of index investing.
Don't forget to use the free compound interest calculator here.
Do you invest in Index funds? If so, do you diversify globally or mostly in a single country like the U.S?
Do you invest in active funds or pick stocks? Let me know in the comments. Most of all, I am interested to hear what evidence you considered to make your investment decision.
This article is for informational purposes only, it should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any major financial decisions.