Valuation-Informed Indexing #74: Stock Pickers Compete With Other Stock Pickers, Indexers Are All in the Same Boat


by Rob Bennett

Say that you own shares in Netflix and that there are three other companies seeking to become the leader in video downloading. Each uptick in Netflix’s price is good news and each downtick is bad news. The upticks mean that Netflix is closer to becoming the king of the hill and the downticks mean that it is falling behind its competitors.

It doesn’t work that way for indexers. You don’t have a competitor to beat when you invest in the Total Stock Index.

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The investing game played by indexers is a very different game than the investing game played by stock pickers. Many indexers don’t get this. They are trying to carry rules they learned picking individual stocks into the world of index investing and finding themselves rooting for the wrong thing as a result.

Are price upticks good for indexers? They are not. Index funds go up in value by 6.5 percent real per year. If there are years in which the price gain is greater than that, there have to be years when the price gain is less than that. Hoping for a big price gain is hoping that returns will be borrowed from the future and moved into the present.

And that’s bad news for indexers. Borrowing gains from the future and moving them into the present doesn’t change the long-term annualized return — that remains 6.5 percent real. But pushing up prices in the present means requiring investors who invest an equal amount of money in stocks each month to pay higher prices for their shares than they would have paid had there been no borrowing of returns. Indexers should never root for big price gains. Big price gains are a negative for indexers.

Big price losses are a negative too. If prices drop dramatically, indexers can buy more shares with their monthly purchases. That’s a plus. But price losses big enough to drive the price of the index below fair value do harm to the economy. When the index price is below fair value, investors have less money to spend and consumer spending reductions stall the economy. So big losses are not much better for indexers than big gains.

For indexers, the ideal price change is the price change justified by the economic realities, that boring old annual gain of 6.5 percent real. Indexing is a communal approach to investing. The dog-eat-dog competitive spirit that infuses stock pickers does not apply. Since indexers are invested in the entire market, their hope should be that the entire market functions smoothly. The market is functioning best when it prices stocks properly.

I’ve written hundreds of articles about stock investing over the past nine years. I haven’t written any about stock picking. It’s not that I don’t think stock picking is important. It’s that I see lots of smart people covering that territory and don’t feel that I could add much to the discussion. Indexing is different. It’s new (index funds only became available in 1976) and even the experts in the field have not yet figured out the rules that smart investors should be following when investing in this new investment class.

I believe that what we learn from studying how indexing works is going to change the history of stock investing. Most people think that stock investing is great except for the huge losses suffered in price crashes, which always take place during economic crises. If only we could stabilize the free market economy! If it weren’t for economic crises and the stock crashes that go with them, stock investing would be a virtually risk-free endeavor!

What people don’t get is — We’re there!

Stock investing is today a virtually risk-free endeavor for indexers who understand how index investing differs from stock picking. Most of us don’t appreciate this yet. So we are not able to take advantage of the benefits that have been bestowed on us just by us having been lucky enough to have been born at the best time in history to be stock investors. But at least in an intellectual sense, we are already in the place where investors have longed to be going back to the beginning of time.

Once investors get it that they are not in competition with anyone, that the goal is to help the market do a better job setting prices properly rather than to see prices shoot upward, what could ever cause another bull market? Bull markets are markets in which stocks are marked up in dramatic fashion. How could stocks ever again become marked up in dramatic fashion once investors stopped even rooting for price markups? Stocks don’t price themselves. Investors price stocks. Once indexers become indifferent to price changes, there is nothing that can cause a price run-up.

The idea that investors should be indifferent to price changes is a radical one. Investors have always preferred price gains to price drops. But once you become an indexer, there really is no logic to that desire. All price gains increase the size of your portfolio while reducing your future return. All price drops decrease the size of your portfolio while increasing your future return. It always evens out.

The only price changes re which indexers should not be indifferent are dramatic price changes in either direction. Dramatic price increases cause bull markets, which cause bear markets, which cause economic crises, which hurt all investors. Dramatic price drops cause consumer spending cutbacks, which cause recessions which hurt all investors. Smart indexers are Goldilocks investors. We like our porridge not too hot and not too cold but just right.

Why don’t all indexers see it this way today? Why are there indexers who cheer price increases and bemoan price drops?

Stock picking has been around for a long time. All of the conventional investing wisdom was developed at a time when index funds did not exist. Indexing is only now coming into its own. We’re still on the early part of the learning curve.

Rob Bennett acknowledged in an article about learning from mistakes that he never should have bought that Leo Sayer album. His bio is here. 

Rob Bennett’s A Rich Life blog aims to put the “personal” back into “personal finance” - he focuses on the role played by emotion in saving and investing decisions. Rob developed the Passion Saving approach to money management; Passion Savers save not to finance their old-age retirements but to enjoy more freedom and opportunity in their 20s, 30s, 40s, and 50s - because they pursue saving goals over which they feel a more intense personal concern, they are more motivated to save effectively. He also developed the Valuation-Informed Indexing investing strategy, a strategy that combines the most powerful insights of Vanguard Founder John Bogle and Yale Professsor Robert Shiller in a simple approach offering higher returns at greatly diminished risk. Tom Gardner, co-founder of the Motley Fool web site, said of Rob’s work: “The elegant simplicty of his ideas warms the heart and startles the brain.”
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