Index Investing (what is it and considerations in implementation)

Legend:

• As with all pages the ‘✙’ sign is there to warn you/put in a “first do no harm” designation notification. Remember the disclaimer here.

• A ‘do not pet that dog 🐻’ notification means you should stay the hell away or completely distrust whatever that product/security/site/external piece of advice is. It could also mean: “Don’t be dumb” To understand where the ‘do not pet that dog’ reference comes from watch this video here: link

Index investing is something the average person can do, as opposed to value investing. Your returns will be lower than value investing in comparison, but the risk of you making a mistake is also lower. However, just because you can do something doesn’t mean you should.

Index investing “is a passive investment technique that attempts to generate returns similar to a broad market index.” Index funds typically have low expense ratios (something that is critical for your overall return with this style of investing).

Probably the most commonly invested in index in this style of investing is the S&P 500 index. The S&P 500 is an index that tracks the stock performance of the 500 largest companies listed on stock exchanges in the United States.¹

There are other indexes as well such as the Russell 2000 (the smallest 2,000 stocks in the Russell 3000 Index by market cap). There is also the Russell 1000 and Russell 3000 respectively. The Russell 3000 is, “a capitalization-weighted stock market index that seeks to be a benchmark of the entire U.S. stock market.”

There are many others as well. I refer to the S&P 500 index frequently since it is a common benchmark, and one that most people are familiar with (and invested in).

✙ The pros of index investing are:

• You get diversification (in theory anyways, more on that in a minute) this is in contrast to value investing, where all of your money is in 1 or 2 positions only.

• Compared to other funds you could invest in, the fees are lower, and since actively managed funds under perform the broader market, you get to save on fees while outperforming nearly all actively managed funds.

• From investopedia quoted directly: “Complete index investing involves purchasing all of an index's components at their given portfolio weights, while less-intensive strategies involve only owning the largest index weights or a sampling of important components.” ← This is critical to understand. If you hold a non-equally weighted index fund, you have less diversification than you think, and the potential for outsized gains/losses.

On that last point investopedia follows up with this (which is very accurate):

“Despite gaining immense popularity in recent years, there are some limitations to index investing. Many index funds are formed on a market capitalization basis, meaning the top holdings have an outsized weight on broad market movements. So, if, say, giants such as Amazon.com Inc. (AMZN) and Meta Platforms Inc. (META), formerly Facebook Inc., experience a weak quarter it would have a noticeable impact on the entire index.”

The implications are profound. Let’s take an S&P 500 index fund such as Fidelity’s FXAIX, or Vanguard’s VFIAX:

^ Open in a new tab if you have trouble reading this. Here’s the key takeaway: Fidelity’s expense ratio is just so slightly less expensive than Vanguard’s. Over time, if you had invested $10,000 on October 31st, 2013, by October 31st, 2023 (ten years later), you would have either:

FXAIX: $28,821

VFIAX: $28,745

Close to the same performance, but Fidelity’s does better due to a lower expense ratio. Over a longer time frame, the difference grows and becomes enormous. The longer the time frame, the bigger the difference.

But this isn’t the only takeaway here. Most investors probably feel that they get plenty of diversification in an S&P 500 index fund. After all, it is a benchmark that tracks the performance of the 500 largest firms in the US, so following from that they think, they should be invested in hundreds of companies.

However… this is not true. Let’s take a closer look at FXAIX:

^ The top 10 holdings, comprise over 1/3rd of the holdings of the fund. If things were equally weighted, then 500 x .30 = 150. One-fifty, not er… TEN.

Look at the top 7 companies in the index. ALL are currently tech companies as of this writing. All of them have massive exposure to deglobalization and China (an adversary of the United States). Tech companies are also very very sensitive to higher interest rates (which we have now, and will in my view continue to have long term).

The market has not fully priced in these risks yet in terms of company valuations. The move to deglobalize and reshore production has only just begun. It is going to take the rest of the 20’s for that to fully come into force.

Also, notice that in the top 10 is Tesla, a legacy industry company (automotive) that is valued as if it were a high growth company (tech). Telsa also is in a mature market with a ton of competition and the threat of unionization and regulation always around the corner. They are also very exposed to the risks of deglobalization:

^ Conventional cars can easily be produced with materials procured in North America. Electric cars… well… you have to have a powerful army to collect.

So why is Tesla valued so highly? Because of one man who will go unnamed. If that person got hit by a bus or died all of a sudden (or was distracted by a shiny object), then er… Tesla might not do so well. That’s before we even begin to get into higher interest rates either. Now don’t get me wrong, he’s a brilliant guy, but he’s also very… peculiar. So there’s risk there for sure.

An equal weighted ETF that tracks the S&P 500 is Invesco’s S&P 500 EQL WGHT ETF trading under ticker symbol RSP. It comes with more diversification than the index funds above, but the expense ratio is .20%. If the “magnificent 7” do well, then it could under perform over that time frame. So there are some risks either way.

^ So 7 stocks out of 500 are more than doubling your return for the year. Pretty crazy huh? Remember, the reverse can be true, those 7 could more than double your losses.

The S&P in particular is yielding only 1.53% as of this writing. A near all time low:

I’ve written about why lower yields (besides being obscenely unacceptable) increase risks for investors here. Stocks are risky, they are SUPPOSED to pay a risk premium. Not a no premium! Sheesh. Inflation as of this writing is 3.2%, so they’re yielding less than inflation. In theory you’re sacrificing income for appreciation. But the S&P 500 is also still overvalued as of this writing. So appreciation is not guaranteed to say the least. It’s also currently trading around where it was 2 years ago (during a period of higher inflation I might add) so there was no appreciation during that time.

Still however, there is an argument despite all of that for index investing, even if it’s just in an S&P 500 fund.

Let’s say you are in your mid late 20s, with plenty of working years ahead of you. You have a secure highly paid job and no debt. You have saved over $1mm for retirement, and your expenses in retirement you estimate should be no more than $1.2mm in present value dollars. The $1mm you have saved is all in inflation-linked bonds, a cash value whole life policy which can be converted to an annuity in old age, and some shorter term instruments for emergencies such as T bills.

Could you afford to put a portion of your money in an S&P 500 index fund and gradually save an additional 200k in conservative investments for retirement? Sure you could. It might be a great idea over time. might. So yes, you could take the risk in that situation.

Here’s how that might play out:

If you had invested $40,000 in the S&P 500 in 1993, by 2023 your investments would be worth:

^ As you can see, dividends being reinvested significantly boosts the return (one reason why I find the low yields being offered today by the S&P to be so disconcerting).

Still though, amazing. But if you’d had the misfortune to have ALL of your money or even a significant chunk of it in the S&P and retired in say, 2000 or 2008, you might have run out of money in retirement.

So don’t take risks with the money you know you must have for core expenses. I write more on this in other blog posts.

Index investing may be for you, but even if it is, proceed with caution. Have a full understanding of the risks involved, and understand what amount of money you can afford to risk and what amount you cannot afford to risk.

1. https://en.wikipedia.org/wiki/S%26P_500