There are times when you make a declaration, the whole world might turn against you. When Galileo discovered that Earth is not the center of the universe, when Barry Marshall claimed that bacteria was the cause of stomach ulcers, and when that random Youtube guy claimed that Daniel LaRusso was the real villain in the movie The Karate Kid, it didn’t go well initially. But as time went on, the truth eventually prevailed.
And today, I am going to announce what I believe to be the truth – that index funds are not great for you. And in some cases, it can be downright bad. OK, I already feel the hate coming my way. But I can handle it.
Hello, this is Jia. Welcome to another episode of Love Investor where I talk about how to invest your time and money to get the most returns and fulfillment.
In this video, I will first talk about what index funds are, and what are their perceived benefits that made them so popular. Then, I will talk about why these benefits aren’t that beneficial if you look a little deeper. After that, I will talk about why index funds can actually hinder you from achieving financial freedom. And lastly, I will talk about what is a better way to invest.
When you go around Youtube and search “index funds” you will see clips like this:
So basically, all these “money experts” are telling you that index funds are not only awesome, but also the only smart way to invest your money. If you don’t use index funds, you are stupid and don’t deserve to have children, and you should get a vasectomy.
In a way, index funds are like kale.
It’s OK. I can eat it once in a while, once I get bored. But somehow every hipster would tell you that kale is the best. And when enough people say it, it becomes an echo chamber and everyone just accepts it as the truth. That’s the definition of groupthink. But if you’ve ever tried kale yourself, you know it kinda sucks.
To fully understand index funds, let’s dig a little bit deeper. Index funds were made popular by John Bogle, who founded the Vanguard Group in 1974, based on the idea that instead of trying to beat the market by investing in high-cost mutual funds or picking individual stocks, you should just try to invest in the market by investing in low-cost index funds that track the market returns. So if you buy that fund, you’re basically buying all the companies that the index is tracking. For example, Bogle’s fund – the Vanguard 500 Index Fund, tracks all 500 companies in the S&P 500 index. And the price of the fund goes up and down as the S&P 500 goes up and down.
Since their inception, index funds have become incredibly popular. 7 out of 10 largest mutual funds are actually index funds owned by either Vanguard or Fidelity.
When something becomes this popular, it deserves some praise for its benefits over the alternatives. The benefits can be summarized in three points:
- It is highly diversified. You get to invest in 500 companies instead of one. So if some companies tank, the others might hold up. It’s like the only benefit of having more children. If you only have one kid, he might get addicted to video games and flunk out of school, and eventually become a failed vlogger. But if you have ten kids, even if the first nine flop, you might still have one that turns into a senator. If all ten fail, get a new spouse and improve your family’s gene makeup.
- Low fees. A regular fund might have management fees that are quite high. In fact, a regular mutual fund might have fees that are up to 1-2%, and a hedge fund might be even crazier and take 15-20% of all the profit. That’s why fund managers make a lot of money. A low-cost index fund, on the other hand, only costs around 0.05% in annual fees. Unless you have millions of dollars invested, it’s practically free. And if you do have millions, then you would feel free. The costs of mutual funds are like paying for a filet mignon at a five star restaurant, while index funds are like paying for food at your local Vietnamese noodle house.
- Its attractive returns. This is where the restaurant comparison stopped. The mutual funds might charge like a five-star restaurant, but they serve foods that are trash. I’m looking at you, this fancy restaurant in San Diego. I once spent $500 at your restaurant and came out regretting all kinds of decisions in life.
According to the last S&P SPIVA report, 88.4% of all domestic actively managed funds underperform their respective benchmark indexes. Basically, they suck.
In fact, in 2008, Warren Buffett bet $1M with a group of hedge fund managers that they couldn’t beat the performance of the S&P 500 index fund in a period of ten years. And in 2017, at the conclusion of the bet, the S&P 500 index returned 7.1% annually, while the hedge fund only managed 2.2% per year in annual returns.
Now, after you hear me describing all these benefits, you might have thought I mistitled this video. Don’t index funds sound great? Why are you saying it’s not great?
Well, not quite. Index funds are only great if you compare them to certain selected targets. In this case, these targets are high-cost mutual funds. Because most of them are truly bad.
It’s like someone trapped in a horrible relationship for a long time, she finally dumped her deadbeat boyfriend. The next person she meets has a degree, shaves and showers every day, isn’t an alcoholic, and has a regular job. And when he gets paid, he takes her to an Applebee on a date night. In her mind, she thinks this guy is George Washington, Leonardo DiCaprio, and Gandhi all rolled into one.
But let’s dig a little bit deeper and look at these benefits and compare them to a better target to see if they still hold up:
- It is highly diversified. Because you are not picking individual stocks, you are only picking the market, and the market is diversified.
Well, the concept of diversification is rather controversial. It’s the key component of Modern Portfolio Theory. However, many people, like George Soros, Mark Cuban, and Warren Buffett, believe diversification only helps if you can’t find good investments.
Going back to the children’s example, if you are bad at parenting, diversification by having more kids helps. But if you are good at parenting, like you read all kinds of books and go to seminars and spend lots of time with your kids, (or if you have a wife that tells you to do all these things,) the chance of your kids becoming better people can actually increase. So instead of raising ten kids and hoping one turned out okay by chance, you only have one or two kids and raise them right to be better people.
Now I’m not advocating only buying 2 stocks, but you don’t need the hundreds of stocks in the index fund.
- Low costs. This only holds water if you compare them to high-cost mutual funds. I agree, mutual funds charge a high fee and underperform the market. You shouldn’t use them.
But who’s telling you your only choices are high-cost mutual funds and low-cost index funds?
Here at Love Investor, we advocate buying and holding a small group of stocks in the portfolio. If you compare buying index funds with our strategy, the low-cost argument doesn’t work anymore, because individual stock trading is practically free nowadays.
Buying and selling individual stocks used to be expensive. I remember in the mid-2000s, every trade cost $15-$25 in commission, but gas was actually $1.50 back then so everything kind of evened out. However, ever since Robinhood came out with a trading app that offers trades that are $0 in commission, it has forced every other platform to also eliminate commissions.
To be honest, I have a lot of problems with Robinhood. I’ll talk about them later, but they did a good thing here by eliminating commission fees. It’s like I hate diseases like stroke that ruins millions of lives and families, and I hope modern medicine will come up with a cure, but also it did kill Stalin and ended the suffering of the entire country. So kudos to stroke for doing something good despite being evil, just like Robinhood.
So, nowadays, buying or trading stocks costs neither commission fees nor management fees.
So still touting the low-cost part of index funds is a little bit disingenuous here. It’s like Apple in the 2020s came up with a commercial saying “hey, buy our phone! You can make phone calls and listen to music.” We will be like “thank you for letting us know. This was an attractive argument 15 years ago, but nowadays, come up with something else to brag about!”
- Attractive returns. So 88% of actively managed funds underperform the market. Cool. Index funds are better than most traders. I mean it’s something to celebrate. But it doesn’t mean it’s the only way to invest. And there are still 12% that’s better than you.
It’s like an athlete in the Olympics. So, she got the bronze medal out of 24 contestants. It’s good. It’s a lot of hard work. Congratulations! But we are treating her like Michael Phelps or Serena Williams, the greatest of all time. We are saying she is the only athlete that’s worth celebrating, and we are giving her lifetime free meals at Olive Garden. I mean that’s a little overkill. In fact, where I am from, you score in the 90th percentile in school, you have dishonored your family. They chop your hands off.
No, they don’t. No no no, they really don’t. I was just kidding.
OK, on the good return part, I want to dig a little deeper.
One of the biggest reasons that index funds outperform active funds is because index funds, by definition, cannot time the market.
So the stock market goes up and down, and active traders would often try to predict when the market will go next so they can buy low and sell high.
But consistently predicting the future is impossible. In reality, the opposite is often true. When the market goes up, people get greedy and jump in. When it tanks, people get scared and jump off.
It’s basically buying high and selling low. That’s the fundamental trader’s fallacy, and that’s why people say, ‘time in the market is better than timing the market.’ The always-invested beats the market timers over the long term almost every time.
Index funds, on the other hand, always track the market. You can’t try market timing or prediction. So it avoids one of the biggest sins of investing by default, and it beats active traders by default.
However, index fund investors are not index funds. Let’s make the distinction here. Index fund investors use index funds to invest, but they have the freedom to buy and sell the funds at any time, just like individual stocks. So they fall into the same greed and fear problems that other traders fall into. And they exhibit the same market timing behavior with the index funds as they would do with individual stocks.
OK, now I’ve talked about index funds’ benefits are not that beneficial if you look a little bit deeper. Next, I’ll talk about cases where index funds can be downright bad. It’s like your current average boyfriend looks great compared to your terrible ex. But he’s not perfect by any means. If you look closely, he might’ve got some major issues on his own. Maybe he has a secret body piercing addiction. Maybe his mom is a lifelong Creed fan. You just have to look. The signs are there.
- Return is not great.
One of my favorite books of all time is called Good to Great. One quote stood out: “The Good is the Enemy of the Great.”
The S&P 500 index has returned 10.6% per year in its history. It’s good, but not great.
If you look at the richest people in the world, they all became rich because they held tons of stocks of the companies they owned or founded, not because of index funds. Their portfolios look like this:
But when it comes to everyday people like us, the only acceptable way to invest is through index funds. That doesn’t seem fair, does it?
Now you might say, none of us is shooting to become Elon Musk or Warren Buffett. We just want to have enough money to retire. But having higher returns would also make a major impact on personal finance for everyday people like us.
In my last video, I talked about how if you invest $1,000 per month in an index fund at around 10% per year return, if you do this for 35 years, it will give you $3.8M. It’s good, but not great. But do you know what’s great? A 15% return. At a 15% return every year, if you invest the same amount and frequency for 35 years, it will give you $15M. Now that’s rich.
In this channel called Love Investor, I’ll teach you an intuitive way to invest so you have a chance to beat the market over the long term. To learn about the basic concepts of love investing, check out my recent video called Beating the Market the Fun Way.
- You have to pick anyway.
Another reason I don’t buy the idea that index funds are better than individual stocks is that index funds are in fact also stock-picking. You are actually picking hundreds of stocks selected by a group of old guys in a committee. They have their own agenda and criteria, and they are not thinking about your returns, and you are not part of the selection process.
Moreover, there is no such thing as “the market” or “the index fund.”
There are in fact so many index funds to choose from. From the S&P 500 that tracks the overall US market, to Russell 2000 that tracks small-cap companies, to MSCI that tracks the world markets, to bond index to commodity index to real estate index. There are in fact 1,732 index funds in the world. Which one do you buy? And whichever ones you are picking, you are actually picking, just like individual stocks.
- You won’t understand it.
One of my favorite investors, Peter Lynch, famously said, “you should only buy things you know.”
Index funds, by definition, are diversified and contain hundreds of companies. But their way of diversification is like making sausages. It sounds good and tastes ok, but you don’t know what’s in there. There could be pork shoulders, or cow intestines, or jellyfish ovaries. You just don’t know.
Let’s look at the S&P 500 list. I used a random generator to randomly pick some companies off this list. KLA Corporation. Telefax Incorporated. W.R. Berkley Corporation.
Ok, I’m sure these are fine companies but why should I invest in them? I don’t know what they are, I don’t know where they’re from, I don’t know what they build. For all I know, they all build coffins for hyenas. I want to invest in something that I know and I use and I love. I want to feel like I own part of something awesome.
And when you don’t know what you are owning, you are at the mercy of market psychology. When the market goes up and everything’s going up, you don’t care. When the market goes down, you will panic.
When you own Apple, Google or Costco, when the market goes down, you’re still OK, because you still use them, you spend money there, you know millions of people like you still love them and they will continue to be okay and when you own these hyena coffin makers, you don’t know. They might go up or down or out of business. If you don’t know what you are buying, you will panic at the first sign of trouble.
Now, these were the reasons I don’t buy index funds. I only use them when I have to. In case of 401K plans that don’t allow any individual stock purchases, I use index funds there. But in my personal brokerage accounts and IRAs, I do Love Investing, where I use my love for the products and services of companies to decide which stocks I’ll buy and own for a long term. If I do that, I have confidence and have fun and I’ll never panic.
By the way, I love Vietnamese food. I can eat it every day. I love it as much as I love Love Investing. It is so good. I love it. I love it. I love it!