CHAPTER EIGHT
THE MATCHING GAME INVESTING IN THE INDEXES

BEATING THE MARKET AT ANY COST

CONVENTIONAL investment managers have an interesting view of risk. They are more concerned with the variation between the actual return on the money they manage and the overall performance of the market than they are with preserving the client’s capital. Most use specific benchmarks, such as a particular stock index, to evaluate their performance. If the benchmark stock index is up 20 percent and the managed funds do better, the manager is deemed to have a successful period. If the market is down 20 percent, the fund is deemed a success if it is down anything less than 20 percent. Success is defined as beating the market, not preserving the capital.

Endless combinations of stocks have been grouped together to form unique indexes. An index is initially based on the total value of a group of stocks. It provides a convenient measure for 130evaluating the stock price movement of the particular group of companies.

Anyone can put together an index. Many firms construct their own distinctive indexes. You may have seen the “Dilbert” index on the Internet, which is composed of actual companies. Every working day we are continuously updated on the behavior of the most widely used indexes—the Dow, the S&P 500, and the NASDAQ.

• Dow Jones Industrial Average (Dow)—Dow Jones & Company has over 3,000 different indexes, but this is the most widely known. The index was put together in the late 1800s and originally consisted of twelve stocks chosen by Charles Dow. Dow invented the average as a benchmark to determine whether the overall market was going up or down. It’s the oldest of the indexes. Today, the index consists of thirty “blue-chip” companies. The larger, more influential companies carry more weight when the average is calculated.
• Standard & Poor’s 500 (S&P 500)—This is one of the most commonly used benchmarks of the overall market. It is a useful benchmark for large companies and accounts for about 70 percent of the U.S. market value. As the name implies, 500 companies make up the index. The index was invented in 1957 when technology only provided for an hourly calculation throughout the trading day. Of course today, changes in the index are calculated instantaneously. Most active mutual fund managers measure their performance against the S&P 500.
• NASDAQ Composite—This index includes over 5,000 companies and is one of the most widely followed and quoted indexes. Many new companies elect to have their stock traded on NASDAQ, which stands for National Association of Securities Dealers Automated Quotation 131System. Many of the new high-tech and dot-com companies trade on NASDAQ, which helps to make this a volatile index. To illustrate, during the four-year period from July 30, 1998, to July 30, 2002, the index went from 1919.58 to 5046.86 and back down to 1344.19. For some investors, it was a wild ride to nowhere. Others got rich quick, and a large number who got in at the top took a hair-raising trip straight down.

BOGLEHEADS—THE ARGUMENT FOR INDEXING

John Bogle, retired chairman and founder of Vanguard Group, was instrumental in creating the first index fund to be marketed to individual investors. The Vanguard 500 Index Fund was launched two years after the birth of Vanguard in 1974. The fund, once known as “Bogle’s Folly,” had total assets of close to $100 billion at the end of 2000. The near-fanatical believers in index funds are proud to be called “Bogleheads” and respectfully refer to John Bogle as Saint Jack.¹

Bogle has been a champion of low-cost investing and indexing for decades, delighting Bogleheads with his sharp criticism of stock-picking brokers and investment managers. He believes—and effectively demonstrates—that stock picking just doesn’t work over the long run. Bogle says, “Beating the stock market is a zero sum game, which means it’s a loser’s game after costs. Indexing eliminates many of the risks associated with investing: the risks of picking individual stocks, portfolio managers and investment styles. Why not eliminate as much risk as you can?”

St. Jack realizes that there’s an entertainment value in investing. He says if you have extra money, you can afford to have a funny money account. “But don’t put one penny more than five percent of your assets into funny money, and track it carefully,” he says.² 132

Although John Bogle retired from active management of Vanguard when he reached age 70 at the end of 1999, he has stayed busy preaching his message of fiscal responsibility and the virtues of indexing. He even wrote a book entitled John Bogle on Investing: The First 50 Years that was published in 2001. Excerpts from his book directly address the supposition that investment professionals can deliver superior returns:

Index fund proponents claim that these funds are superior over actively managed funds for a number of reasons, including:

• The annual expenses and fees of index funds are one-tenth to one-third that of actively managed mutual funds.
• Actively managed funds, when adjusted for risk, do not outperform the appropriate index by enough to cover the cost of their higher trading costs and taxes.
• If a fund claims higher returns than an index, they took more risk, either through stock concentration or style drift (deviating from the agreed-upon parameters).
• Claims of higher returns are the result of inaccurate benchmarking (using the wrong index), which is the measurement of risk. Also, many costs of actively managed funds are overlooked, such as loads and taxes.

In Chapter 1, you saw evidence of how badly individual investors perform relative to the market. For the period 1984 to 2000, a $100,000 investment would have grown to approximately $705,000 in an index fund tied to the S&P 500 index, when adjusted for inflation. That same $100,000 would have shrunk to about $54,500 in one-year treasury bills. The average equity investor would see a value of only $42,000.⁴

When you purchase an index fund you are addressing two issues that drag down investment returns. Since most actively managed mutual funds don’t do as well as the overall market, by using an index fund you know that your fund will perform in line with the overall market. Also, since index funds are not managed, the management fees and expenses for running the 134fund are very low. Put these two factors together, and it makes an index fund look extremely attractive compared to an actively managed fund that is attempting to beat the market.

INVESTMENT ADVISERS—THE ARGUMENT AGAINST INDEXING

“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor—the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.”⁵

This quotation from Bernstein’s book pretty much sums up why some people insist on continuing to try to beat the market. Active mutual fund managers and most financial advisers argue against indexing investment returns because their jobs are based upon giving people hope that by using a professional to manage money, superior returns will be generated with less risk.

In days gone by if you bought stock from a stockbroker, you paid a fairly hefty commission for the privilege. Today, you can buy a mutual fund directly from the fund company with no commission (no-load) and just about any number of shares of a publicly held corporation for less than ten dollars.

To survive in this environment, the investment sales and advisory business needed to convince investors that they added value to the process. They figured that investors wanted not just execution—the buying and selling of a security—but valuable advice as well. The financial services industry has reinvented itself so that investors have to pay for this advice, usually a fee of one percent to two percent of the total amount being managed. In order to justify this fee, many advisers claim to have a unique or logical system that will provide superior results.

Admitting that an index fund’s performance is superior to actively managed money is analogous to saying, “Our service135 doesn’t add any value.” Most investment managers and advisers are naturally unwilling to make this admission. However, exhaustive studies on the performance of professional investors conclude that it is the investment manager’s fee, not skill, that plays the biggest role in determining performance. The higher the fee, the worse the performance.

In 1992 the television show 20/20 did a news story on investment firms and their value. The story showed clips of the following three investment commercials:

• Shearson Lehman: We’re number one in investment research. Talk with us.
• Prudential: So for peace of mind, investment advice, and your future—Depend on the Rock.
• Merrill Lynch: At Merrill Lynch we know that risk can be dealt with. It can be managed.

These commercials by the brokerage firms sound impressive, don’t they? The conclusion of the 20/20 story was that despite all of the sophisticated research and the rooms filled with people in suits studying numbers, the advice that comes out of brokerage firms is so consistently mediocre that odds are you would do better picking stocks by throwing darts at the stock tables. It’s hard to believe that this would be a better way to pick stocks. But the people who chart the brokerage firms’ recommendations say the numbers don’t lie.⁶

A college textbook, simply titled Investments, eloquently states this warning to students: “Not surprisingly, the efficient market hypothesis does not exactly arouse enthusiasm in the community of professional portfolio managers. It implies that a great deal of the activity of portfolio managers—the search for undervalued securities—is at best wasted effort, and quite probably harmful to clients because it costs money and leads to imperfectly diversified portfolios.”⁷

SAFEGUARDING FINANCIAL ASSETS AGAINST LOSS—THE CRITICAL ISSUE

Index funds are admittedly a great tool for removing the risk of significantly underperforming the market. But this is not the goal of a risk-averse investor. The goal is to preserve capital and to protect principal from the risk of loss.

Rather than trying to beat or match the market, investors would be better served by concentrating on transferring the risk of investing to third parties. Again, attempting to control market risk by diversification and asset allocation will help to reduce market risk but won’t eliminate it. Just one bear market can devastate the value of even a well-diversified portfolio.

If you held a diversified portfolio of index funds between the market high of early 2000 and July 2002, you wouldn’t be very happy with your performance. Consider the performance numbers for these indexes during that period:

See Table

You can see that for this period the smaller companies that compose the Russell 2000 didn’t go down as much as the other indexes. Diversification certainly reduced the risk of investing in just one area, such as the technology laden NASDAQ index or the downtrodden Internet index, but if you were equally invested in each index, your portfolio would still be down by over 50 percent during this period. Each index fund has its unique characteristics with its unique risk and rate of return.

If total financial assets were allocated 60 percent stocks, 30 percent bonds, and 10 percent money market, you would have 137had a 30 percent decrease in financial net worth from the stock portion of your portfolio that is partially offset by the interest earned on bonds and the money market account.

You can see from this example that asset allocation and diversification reduced the amount of loss but didn’t do away with it.

Risk is one of the most avoided, misunderstood, and least quantified subjects in the financial services industry. This is unfortunate, because the primary purpose of an investment professional should be the intelligent management of financial risk. Risk is always present because nobody can predict the future. Protecting financial assets against loss while achieving a reasonable rate of return should be the objective of both investor and adviser. This is the critical issue in investing, and it is being handled by many professionals with smoke and mirrors.

The index fund believers are on the right track in recognizing that it is impossible to beat the overall market except by sheer luck. Backed by volumes of financial research, index fund proponents believe they have found the Holy Grail to investment success, while professional money managers are chastised for what they are—speculators.

Here is an excerpt from “The Parable of Money Managers,” an article by William Sharpe, Nobel laureate in economics:

Isn’t that exactly what is happening when you turn your money over to a professional money manager? The money manager is speculating on stocks or mutual funds without establishing a plan for protection of the principal beyond diversification, asset allocation, and a long-term time horizon. Sharpe’s parody was about active investment managers trying to beat the overall market. You are actually paying someone to gamble with your money!

It’s a pretty wacky way to accumulate wealth, yet it’s still the prevailing wisdom of our times. Index funds are designed to closely match an underlying basket of stocks. Unfortunately, the funds are subject to the same downward market risk that exists with professionally managed funds. There is a better way.