Home » Value Investing

Most Investors Should Be in Index Funds, But Not for the Reason Usually Given

Updated on

Valuation-Informed Indexing #172

by Rob Bennett

You cannot beat the market. It’s been proven by the peer-reviewed academic research.

Or has it?

The problem with investing research is that there is a lot of money to be made in this field and being able to cite academic research in support of your marketing slogans helps persuade millions that those marketing slogans communicate important truths.

If it really were so that the academic research had proved that picking stocks never works, there wouldn’t be so many smart people still picking stocks. The claim that investors should only invest in index funds is a claim rooted in a genuine truth that has been taken too far for marketing purposes.

I’ve looked at the research that it is said “proves” that stock picking never works. The usual methodology employed is to check whether a number of mutual fund managers have produced good long-term results for their investors. If the enhanced results are not sufficiently better than what could be obtained by investing in an index fund to more than justify the extra fees paid for funds that engage in stock picking, it is said that the superiority of index funds has been proven.

Please understand that I believe that 80 percent of investors should be in index funds. Most investors do not have the ability or the time or the skill needed to pick stocks effectively or even the ability to identify mutual funds run by people who possess that ability. So it’s not that I don’t like index funds. It’s that I don’t like to hear false claims made for index funds. False claims make all index-fund advocates look bad in the long run. There is enough genuine good stuff to be said about index funds that we should not be making false claims re their superiority.

Fund managers face enormous competitive pressures not to pick the stocks with the best chances of performing well in the long term for their funds. That’s why most fund managers do not pick stocks effectively. Fund managers are not paid to produce results for their investors. They are paid to sell shares in their funds. The actions that generate sales are very different from the actions that produce good long-term results for investors.

Imagine that there are two stocks that a fund manager can add to her fund. Stock A has been doing poorly for five years. It is highly undervalued. The price is likely to rise dramatically as investors come to realize the true value of the underlying company. Stock B has been doing well for five years. It is highly overvalued. The price is likely to fall dramatically as investors come to realize the true value of the underlying company.

Which stock is the fund manager more likely to add to his fund?

If his primary goal is to serve his investors, he is likely to add Stock A.

If his primary goal is to make money in the short term, he is likely to add Stock B.

Investors like to hear that winners are being added to their mutual fund. They hate to hear that losers are being added. The fund manager who adds a stock likely to do well over the next ten years puts himself at risk of losing his high-paying job by doing so. The fund manager who adds a stock likely to do poorly over the next ten years put himself in line for a promotion.

Will the fund manager who adds the overvalued stock to his fund be criticized when the price of the fund drops dramatically? Not really. All fund managers are subject to the same sorts of pressures. So most other funds will be dropping in price at the same time his fund is dropping in price. Investors don’t tend to get too angry with fund managers who do no worse than most other fund managers. They are not happy with losing money. But they blame “the market” or “the economy” rather than the fund manager who picked all those great stocks for all the years of the bull market.

There is no great penalty for picking overvalued stocks and doing harm to one’s investors by doing so. But there IS a penalty for doing the right thing for one’s investors. Pick undervalued stocks that remain undervalued for a few years more and there will be investors looking for your head. All those other fund managers were able to make good picks. Why did this one manager feel a need to break from the herd? It is the fund manager who does what works in the long term who is more likely to hear criticism from her investors.

The fundamental problem with all investing analysis is the human inclination to ignore valuations. Making investing a subject of academic research has made the problem worse. We still all possess the unfortunate inclination to focus on the short term. Now we have research to point to in support of our inclination to ignore what works and go with what temporarily feels good.

Index funds really do make sense for the majority of investors. But not because it has been “proven” that stock picking does not work for those who possess the skill needed to engage in it effectively. We should promote indexing for the genuine benefits it offers and stop with the marketing overreach that makes both the investing experts and the academic researchers who generate support for their overstated marketing claims look shabby.

Rob Bennett has recorded a podcast titled The Only Thing Worse Than Short-Term Investing Is Short-Term Investing That Pretends to Be Long-Term Investing. His bio is here.

Leave a Comment