I encourage you to dive headfirst into the world of index investing with this 3-part series. Index investing is a systematic, low-effort way to create wealth in your sleep. Part 1 defined index investing and outlined key differences between index mutual funds / ETFs. Here, we’ll address the benefits and drawbacks of index investing and how these impact young investors. Part 3 will explain how you can adapt index investing to suit your customized goals.

Time in the market beats timing the market.

In Part 1 of our index investing series, we discussed what it means to invest passively and how we can use mutual funds or ETFs to make these passive investments. Here, let’s talk more directly about why index investing wins versus an active strategy.

This post will explore both the merits of index investing as well as potential drawbacks for young investors. While I firmly believe that well-executed passive investing will outperform active strategies, it’s important for you to get a sense of the full investing landscape. I want you to formulate your own conclusions and feel confident in your personal plan to build lasting wealth.

The Benefits of Index Investing

Diversification

First and foremost, index investing provides an incredible level of diversification at a low cost. Diversification is critical because it allows investors to reduce risk while maintaining an attractive return profile. With broad exposure to many companies, industries, and geographies across the world, diversification enables an investor to capture the upside associated with individual equity investing without undertaking outsize risk.

Let’s explore this further with an example. Consider Mark, a twenty-something who loves Elon Musk and believes that Tesla (TSLA) is the best company to ever exist. Mark has invested his entire $10,000 savings into Tesla stock, and his position has grown to $20,000 two short months later.

He’s crushing it, right? Mark just doubled his money! Call up Ray Dalio, and get this man an interview at Bridgewater.

Here’s the catch. Mark’s risk-level is also sky high. Suppose Elon decides to relocate to Mars tomorrow. Or light his factory on fire with one of his infamous flamethrowers. Mark’s $20,000 could go up in smoke just like that.

Through diversification, Mark can mitigate this idiosyncratic risk. And sure, he could go buy hundreds of different individual stocks to assemble a diversified portfolio that would insulate him from Elon’s whims. Unfortunately, constructing this portfolio would be complex, time-intensive, and costly (if he pays trading commissions).

Alternatively, he could buy an ETF like Vanguard’s VUG with the click of a button. It’s comprised of hundreds of large, fast-growing companies (including Tesla). But Tesla represents only a small percentage of the ETF’s overall holdings. Viola! Mark can enjoy a slice of Tesla’s success without the potential for complete financial ruin whenever Elon decides to light the factory on fire and flee the planet.

Low Stress, Low Maintenance

Another attractive aspect of a passive investing strategy is the convenience and consistency it enables. See, most of us have full-time jobs, romantic relationships, friendships, families and an increasing myriad of responsibilities. Index investing allows an investor to systematize the game, focusing time and energy on these other endeavors. With a sufficiently broad index strategy and long time horizon, an investor can “set it and forget it.”

With an active strategy, an investor essentially creates an additional full-time job. They must cultivate expertise across every stock and business sector held within their portfolio. They must track and analyze company filings, management commentary, industry regulation and much more. And it’s not enough just to perform all of this research before buying a stock. Active investing necessitates constant reevaluation and adaptation to new market conditions and portfolio dynamics.

To crystallize this distinction, let’s put this into terms that everyone can understand. Think about dog ownership.

New puppies are cute as hell. They can be a ton of fun. But they also require a ton of work and responsibility. You’re waking up at midnight to walk them around the block. Tossing out chewed up remotes, shoes, and chargers. It can be exhausting. Picking individual stocks and actively managed funds is a lot like buying the cute new puppy. Thrilling, unpredictable, and potentially rewarding if the stars align.

On the other hand, passive index funds are like the ever-loyal mutt that’s been in your family for a decade. He never breaks the rules, loves you unconditionally, and improves the long-term quality of your life. He also never forces you to sacrifice sleep, relationships or work productivity. While some folks can’t live without a new pup, I’ll take the old faithful mutt every time.

Superior Long-Term Returns

The empirical data overwhelmingly shows that returns generated by passive indexes are superior to those achieved by active managers. While this might seem mind-blowing, it’s true. After adjusting returns for fees, the vast majority of active funds do not outperform. Sure, there are a few glaring outliers, but the odds of you picking one of these outliers, or even gaining access to one of their funds, are exceedingly low.

In fact, 2019 marked the tenth consecutive year that large-cap fund managers lagged the S&P 500’s performance. Let’s put this phenomenon into context. Despite top talent, state-of-the-art analytics / software, close ties to corporate management, and just about every other advantage that you can imagine, most active managers still don’t win.

We could spend an inordinate amount of time debating why this is the case, but the root cause isn’t what matters here. What matters is that you acknowledge this fact of life and invest accordingly.

One important point to flag before we move ahead.

It might look like active funds are winning when you let them control the narrative. These funds spend millions of dollars to market effectively and slice data in ways that make their performance look incredible. And frankly, it’s good business for them to do so. Active managers must somehow justify the premium fees that they command. But when you peel back the onion, and dig into the footnotes and disclosures written in microscopic text on the back of that glossy brochure, you’ll often find something closer to the truth.

Index Investing Criticism

Investment Concentration

Critics often point to that fact that index investors aren’t getting as much diversification as they expect. This concern has been exacerbated by the recent dominance of large cap tech stocks in recent years.

For instance, if an investor buys the index fund SPY, hoping for broadly diversified exposure to the S&P 500, they may not realize that ~7% of SPY is composed of Apple (at the time of this writing). To take it a step further, almost 35% of SPY is made up of tech stocks. This is far and away the most overweight sector in its holdings. The second most highly represented sector is healthcare at just under 15%.

While none of this is enough to scare me away from index investing, I do think it’s a valid concern that must be considered. So yes, the incredible run in tech stock valuations over the past few years has created a situation where they make up an outsize portion of many domestic indexes.

As a savvy index investor, you can respond to this in a few different ways:

  • Accept this increased tech exposure and continue investing in the same large cap / S&P 500 indexes
  • Invest in even more broadly diversified indexes (Vanguard funds such as VT or VTI are good examples)
  • Invest in more specialized macro funds (international, small cap value, etc.)
  • Pick a few sector-specific ETFs where you think traditional large cap index funds have left a gap in your portfolio

“Index Bubble”

There’s another more nuanced critique which basically says that given wide enough adoption of index investing, a company’s performance, profitability, and operations will become irrelevant. If all investors blindly pile money into indexes that buy the entire market there will eventually be no scrutiny at the company level, this theory claims. Corporate growth would be prioritized at all costs since index funds, not individual investors, decide where to allocate capital. And these index funds would automatically invest more money into a company the bigger it becomes…even if the underlying company’s fundamentals are terrible. Feeling bubbly yet?

Considered in a vacuum, I understand the argument here. I imagine passive investors laying on resort hammocks across the country, intoxicated with blissful ignorance. Alternatively, corporate management would be left to run amok with wildly distorted incentive structures and performance metrics tied to the unrelenting growth demanded by a totally indexed market. This scenario would likely create a disastrous bubble that would cripple the investing universe as we know it.

But again, this is all in a vacuum. It’s theoretical. I don’t foresee a world where 100% of investors adopt a passive index investing mentality. It goes against human nature. We are innately wired to believe we are better than average. There will always be active managers and individuals who think they can outperform.

And keep in mind, some people do beat the market. Ironically, the more pervasive that passive investing becomes, the more conviction active investors will likely have in their ability to outperform the masses. So while this index bubble might be plausible in theory, it discounts the unpredictable nature of behavioral finance and human emotion.

Performance in a Downturn

Finally, many believe that active investing strategies are superior to passive ones during market downturns. These folks believe that active managers can leverage investing expertise to double-down on companies poised to thrive amidst economic uncertainty. They think active managers will adeptly time market drops by shifting into defensive securities before the worst of a bear market hits. While this sounds compelling, the data does not tend to support this hypothesis.

Even if we pretend that active managers generally outperform during market downturns, this still doesn’t provide a compelling case to invest in active funds. Why?

Put simply, the market goes up a lot more than it goes down. The average bull market is almost five times as long as the average bear market. Therefore, perhaps surprisingly, it’s more important to optimize performance during good times than during bad times over the long term. To build incredible wealth, you need to take full advantage of these bull markets and squeeze them for everything that they’re worth during periods of growth. The way you accomplish this is by minimizing fees and investing in broadly diversified indexes. Alternatively, padding the pockets of some fund manager who’s sold you on the idea of The Big Short 2.0 will generally lead to subpar results.

Concluding Thoughts

There are pros and cons associated with any investing strategy, but I hope this article helps to illustrate why the benefits of index investing outweigh the drawbacks. Index funds provide tremendous diversity, convenience, and risk-adjusted returns at a low cost. While the potential risks outlined above (and the many others that we haven’t mentioned) do warrant caution, they’re not deal-killers. By anticipating these risks in advance, you should feel more adequately prepared to implement a successful index investing strategy while avoiding the most common pitfalls. Capitalize on that confidence. Take action!

In Part 1 of this series, we built your foundational knowledge around index investing the various ways to get involved with it. Here in Part 2, we analyzed the pros and cons of index investing and compared it to active investing strategies. Look out for Part 3 to learn more about how you can implement index investing in a way that suits your precise personal needs.