TIP743: Should Value Investors Own Index Funds?

25:55Of course, the multiple expansion cannot go forever, but the US has defied gravity to some extent when it comes to the earnings growth side of the equation for quite some time with the continued rise of big tech stocks. I think that many equity investors, myself included, have become a bit complacent with just how good returns have been in the US over the past 15 years. It can be helpful to study history just to put things into perspective and see what types of things are possible, especially after markets have done so well for so long. I'm sure that many investors in Japan felt similar at the end of 1989.

26:31So during the 1980s, the Japanese stock market increased by 19 % per year and proceeded to fall in the 15 years that followed from 1989. From 1990 to 2004, the Japanese market fell by 80 % and would not reach its prior highs until 2024, that's 35 years later. I think that just because US markets have done so well in recent history, it can be good to keep in mind that broader perspective of the realm of possibilities going forward. Valuations, economic conditions, and investor sentiment can all shift dramatically over time, and markets don't move in straight lines forever. History teaches us that periods of extraordinary returns are oftentimes followed by extended stretches of stagnation or even decline.

27:19Investors who ignore that possibility can end up taking on more risk than they realize, and this doesn't mean that we should expect a repeat of Japan's experience, but it does highlight that markets can behave in ways that seem unthinkable during the boom times. Having humility and acknowledging uncertainty can help us build more resilient portfolios. In the end, studying history is not about predicting the future, it's about preparing for a range of outcomes, both good and bad. One of the mental models that Bogle shares in his book is Occam's Razor. Occam's razor suggests that when there are multiple solutions to a problem, you should choose the simplest one.

27:58Of course, he uses this mental model when it comes to investing, as he suggests to simply invest in all of the U.S. businesses in the stock market or its equivalent like the S &P 500. To help make his case, he compares the performance of the S &P against active mutual fund managers. Data from the SPIVA report showed that from 2001 to 2016, 90 % of actively managed mutual funds underperformed their benchmarks, and additionally, the S &P 500 outpaced 97 % of actively managed large-cap funds. Bogle writes here, In 1951, I wrote in my senior thesis at Princeton University that mutual funds can make no claim to superiority over the market averages.

28:4266 years later, that has proven to be a huge understatement." The other drawback of actively managed funds is that they come and go. Of the 355 equity funds that existed in 1970, almost 80 % of them have gone out of business and shut down. If the fund you're investing in does not endure over the long term, how can you invest for the long term? We can safely assume that it was not the best-performing funds that have fallen to demise, it was the laggards that disappeared. Sometimes giant conglomerates acquired their management companies and shut down underperforming funds, or asset shrinkage led to a cutback on the number of funds managed.

29:25There are many reasons as to why these funds disappeared, few of which are good for investors. Two funds that did manage to outperform the market over long time periods were the Fidelity Magellan Fund and the Fidelity Contra Fund, both of which outpaced the S &P 500 by more than 2%. However, these funds did not always outperform despite the track record overall being quite good. For example, the Magellan Fund's best years were early on when the asset base was low. In those early days, it outperformed by more than 10 % per year. Once the AUM hit more than$30 billion in 1993, the funds' returns swiftly decelerated and underperformed the market from 94 to 99.

30:08As Buffett reminds us, a fat wallet is the enemy of superior returns as a similar story played out for the Contra Fund, which was managed by Will Danoff. The returns were the highest in the earlier years when the AUM was low, and as the AUM ballooned, the fund eventually started to underperform. This is something to keep in mind when you consider investing in an active manager that's raising capital. A hot start may have been a byproduct of the flexibility that they had when they had that low starting AUM. History suggests that the odds of outperformance over multiple decades are quite low. Bogle equates trying to select a mutual fund that will outpace the market over the long term to looking for a needle in the haystack.

30:51He proposes that instead of looking for the needle, instead just buy the haystack. Since few mutual fund managers even last over the long term, you have the peace of mind knowing that an index fund with Vanguard is a permanent vehicle should you need it to be. It's built to last at the foundational level. I'm sure that many of our listeners are familiar with the impact that fees can have on your investment returns. But since it's so important to understand, I wanted to be sure to highlight it here as well. As I mentioned earlier, the fees on Vanguard's S &P 500 Index Fund, VOO, is practically zero.

31:27And fees that are charged by investment managers can really vary widely. you typically see anywhere from 0.5 % to 2%, which also might vary from year to year based on their performance. And we even shouldn't take for granted the S &P 500 index funds that are out there. The fees within these ETFs can vary widely. Some may have expense ratios of 0.5 % or 1%, and even have sales loads of 1%. As Bogle puts it, your index fund should not be your manager's cash cow. It should be your own cash cow. So let's look at a few examples of how fees impact the end result for someone saving for retirement. Here in the US, individuals can save in a tax advantage account referred to as a Roth IRA, which has a contribution limit in 2025 of$7 ,000.

32:16I myself invest in a Roth IRA account. If someone saves$7 ,000 per year in the S &P 500 from age 30 to age 65, and they managed to get a 10 % annual return, they would end up with$2.2 million at retirement. That return might be a bit high, but it's just for illustrative purposes. Now let's use the same returns, but apply a 1 % fee, bringing our net return down to 9 % per year. This would bring the ending amount down to$1.7 million. So just a 1 % fee compounded over that 35-year time period would cost that investor$500 ,000 or over 20 % of his ending capital. Now, if we were to apply a 2 % fee, the ending amount would be just$1.33 million, costing the investor nearly$900 ,000.

33:09It's no wonder that these financial companies and Wall Street firms have such nice furniture and nice suits to welcome you in. Wall Street makes a killing and taking their share of the market's gains year after year. To put this another way, the investor puts up 100 % of the capital, took 100 % of the investment risk, yet they received around 60 % of the returns. So this is the risk you face when investing with an actively managed fund. You need the manager to not only outperform the market, but also overcome the fees that they're charging to fully justify the service they're offering, assuming that your goal is to achieve at least a market return.

33:50Bogle argues that investors pay far too little attention to the costs of investing, especially for three distinct reasons. First, when the overall stock market returns have been high, it's easy to become complacent and believe that your returns are quote-unquote good enough. Second, when investors tend to focus on short-term returns, they can easily overlook the impact of costs over an investment lifetime. And third, so many of the costs are hidden from plain view, such as portfolio transaction costs, the unrecognized impact of front-end sales charges, and taxes incurred on fund distributions.

34:28I think that there can also be this sense that you aren't really paying for a manager's services when you really are. If someone has a million dollars and they're paying a 1 % fee, that fee might be incurred monthly within your investment account with the manager to where it's almost invisible. If the fees were actually taken out of your bank account, then I'd imagine that many people would think harder about the fees they're paying to their managers. The other deceiving thing about fees is that since they're oftentimes based off a percentage of assets, they compound drastically. What might look like a tiny fee in the first few years ends up being pretty enormous when you look out 20, 30, 40 years down the line.

35:08So the main takeaway with regards to fees is that they matter a lot to investors. There are several parts in the book where Bogle has a don't take my word for it section. He has one where he references Peter Lynch, who himself is an active manager, of course. He managed the Magellan Fund. Lynch is well known for well outperforming the market from 1977 to 1990. And upon his retirement, he noted that the S &P 500 outperformed most of his peers in the industry and that the public would be much better off in an index fund. Now, of course, our show does discuss stock picking and interviews many active managers, which is why we primarily focus on those managers who actually do have a track record of outperforming the market.

35:51A few that we've interviewed over the past year or so include François Verschon, Joseph Sheposhnik, Dev Kontasaria, Guy Spear, Monish Pabrai, Chris Bloomstrand, and Andrew Brinton. It's hard to find some new names that have outperformed the market for more than 10 years, but from time to time, we do find them. Another interesting reality when it comes to mutual funds and active managers is that the returns that the investors actually receive tends to be less than the fund's actual returns since inception. It's not that the managers are being dishonest, but the core issue is that investors tend to put money in with an active manager after they've achieved good performance and take money out once the performance has faltered.

36:34But we'll share some statistics with regards to this. While the S &P 500 delivered returns of 9.1 % over a 25-year time period, the average equity fund earned 7.8 % and the average investor was earning only 6.3 % per year. This isn't necessarily an issue with the active managers, but with how humans are hardwired. I'd imagine that more investors were piling money into the stock market overall in 2006 when the rising tide was lifting all boats. When the market fell, I'm sure many people were either forced to sell because they lost their job during the crisis, or they sold out of fear, believing that it wouldn't recover and they couldn't bear losing any more money.

37:15So this probably applies to both the active managers and the index investors, where they're buying high and selling low. The difference with active managers though, is that they will be out promoting their products and their funds when they're getting those high returns. Or some firms might have eight different strategies, shut down six that haven't done well, and go out and market the two that have the performance to show for, thus leading investors on to believe that the superior performance will continue. I once heard Monish Pabrai once joke that you could be an active manager without performance out on a boat in the middle of the ocean, and money would still find a way to get to you.

37:55For example, when we look back at the year 1990, investors put a net total of$18 billion into equity funds. This was a time when stocks were cheap and bargains were plentiful. If we fast forward to 1999 and 2000, we all know that the market was substantially overvalued, yet investor flows were$420 billion. Investors also overwhelmingly tend to choose the new economy funds, technology funds, and the hottest performing growth funds and ignore the more conservative value-oriented funds. One other drawback of mutual funds is that they're incredibly tax inefficient, whereas their index fund counterparts offer excellent protection against the ravages of taxation.

38:40Since we're discussing taxes here, I'll mention that I'm not a CPA and none of this is intended to be tax advice. So the portfolio turnover of the average actively managed equity fund is a whopping 78%. This means that the average holding period of a stock in a mutual fund is less than one and a half years. This constant buying and selling means that investors are typically incurring a taxable event if a stock is being sold at a gain, which adds an additional drag to the mutual fund's performance. Not only do ETFs protect investors from this taxable event from taking place, there's also substantially less turnover.

39:17The turnover on the S &P 500, for example, is between 2 % and 5%. Ironically, it's the active managers themselves who are getting in their own way to delivering superior performance through this frenetic buying and selling that increases the tax bill and transaction costs. Partially, they need to do this to try and justify why they're being paid the fee that they are. Let's take a quick break and hear from today's sponsors. Curious about online trading, but haven't taken the first step yet? You're not alone. And Plus 500 Futures is a great place to start. The futures markets are moving fast, and with Plus 500, you can explore popular assets like oil, gold, S &P 500, Bitcoin, and more.

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43:15When you invest in something like the S &P 500, you're not betting on one CEO, one business model, or one industry. You're betting on the adaptive capacity of the American economy. So whenever there's a severe broader market drawdown, you can be nearly certain that the index will eventually rebound to hit new highs yet again. This can be a more robust bet and one that history has shown pays off over time, even after the devastating shocks like the Great Depression, World War II, the dot-com crash, and COVID-19. However, with a fund manager or with an individual stock, you don't always have that level of certainty.

43:52Once Kodak or Blockbuster fell by 50%, they had another 90-100 % to fall from there. This dynamic can make index funds easier to hold during those severe market drawdowns where many businesses are significantly impaired. An index fund also avoids some of the damage from the catastrophic situations by getting rid of the market's losers. When Kodak was removed from the S &P 500, it was replaced by a better performing company. So as an index investor, you're not only avoiding the risk of a catastrophic loss, you're automatically reallocating capital to the future winners without lifting a finger.

44:30So the know-nothing investor can be watering the flowers and pulling the weeds without even necessarily knowing that they're doing that within a portfolio that holds index funds. The S &P 500 was first established back in 1957, and it included 500 companies from various industries. Of those original 500 companies, only 53 of them remain today, just over 10 % of the original counterparts. So it's constantly turning over a small portion of the portfolio, bringing out the bad, and bringing in the good. Historically, the S &P 500 turns over about 20 % of its constituents each decade. When we look at the top 10 holdings from the year 2000, for example, only one of them remains in the top 10 today, which is Microsoft.

45:15I thought it was interesting that Bogle included a chapter here on what he thinks Benjamin Graham would have thought about indexing. Ben Graham is of course known as the father of value investing as he wrote the book The Intelligent Investor, which was published in 1949, but the first index mutual fund was not formed until 1974, so Graham was pretty limited to selecting individual securities when investing in public markets. Graham categorized two types of investing styles he referred to as the aggressive investor and the defensive investor, and he shared that most investors should be satisfied with the reasonably good return obtainable from a defensive portfolio.

45:53The defensive portfolio would comprise of about a 50-50 split of stocks and bonds with the goal of having a balanced portfolio that helped provide psychological comfort during both the bull and the bear markets. For the stock portion of the portfolio, he recommended only investing in large, conservatively financed and established companies. This sounds eerily similar to investing in something like the S &P 500. By the time mutual funds had become popular, Graham became skeptical of their ability to beat the market over long periods after accounting for the fees that they charged. Graham's timeless lessons for the intelligent investor are as valid today as when he prescribed them in the first edition of his book.

46:34He wrote, The real money in investment will have to be made not out of buying and selling, but of owning and holding securities, receiving interest and dividends, and benefiting from their long-term increase in value. end quote. So odds are that Graham would have been a strong proponent of investing in low-cost index funds, just as Warren Buffett is today. In fact, in a 1976 interview, Graham was asked about whether investors should be content with earning the market's return, to which he said yes, and he also expressed his skepticism about an active manager's ability to beat the market after fees.

47:10I love this quote that Bogle shares here from Graham. To achieve satisfactory investment results is easier than most people realize, to achieve superior results is harder than it looks. So if you're someone who's actively managed your own portfolio for more than say 5-10 years, or you've used an active manager and found yourself underperforming the market by more than a percent or two, then perhaps you would be better suited to a more passive strategy that follows the principles that Graham and Bogle outline. Although Bogle's approach to investing in stocks is quite simple, it can still be very difficult to actually execute.

47:46Stocks tend to decline by 50 % a couple of times a century, they experience a 30 % decline about once every 4-5 years, and a 10 % decline at least every other year. This high volatility makes them difficult to hold onto during the turbulent times, and for most people, seeing a decade's worth of growth disappear in less than a year is a gut-wrenching experience. Charlie Munger stated, If you're not willing to react with equanimity to a market price decline of 50%, 2 % 2 or 3 times a century, you're not fit to be a common shareholder, and you deserve the mediocre result you're going to get." So volatility is not a flaw of the system.

48:27It's the price of admission for the superior returns that equities offer over the long run. If you want the reward, you have to accept the ride that comes with it. The most effective way to manage the emotional rollercoaster of the stock market is to keep your focus on the long term. While there are no sure things in investing, history tells us that given enough time, stocks will eventually recover from their occasional downturns. And this is referring to these broader market indexes and not necessarily individual companies. So because of this intense volatility, some investors might opt to invest in other asset classes that are either less volatile or not correlated to the market movements, such as bonds, real estate, REITs, their own business, gold, art, etc.

49:11In addition to volatility being the price paid for good returns, it can also serve as an opportunity to buy when there's blood in the streets. History suggests that even if you find yourself with investable cash during a market correction, it might be one of the best investment opportunities you'll ever get. Because it's during these market crashes that market prices are discounted at their cheapest levels relative to their underlying value. This of course assumes that you're investing in a market that will eventually recover to new highs and not some of these outlier scenarios like we've seen in the past in say Argentina, Russia, Greece, etc.

49:47One reason that market crashes can be an excellent time to buy is that the percentage gain to get back to even is larger than every percentage loss. For example, a 20 % loss requires a 25 % gain to recover and a 50 % loss requires a 100 % gain to recover and so on. During the March 2020 correction, when the market was down 33%, it would have taken a 50 % gain to get back to even. Assuming that you believe that it was reasonable that the market would get back to its prior highs, then it would have been highly advantageous to continue investing during that time period. The tricky thing is that it's during these drawdowns is when it's most emotionally difficult to invest.

50:28Our gut instinct will likely tell us to be conservative or stack cash when we see red across our entire portfolio. But that's usually when the best opportunities are going to present themselves. Historically, some of the strongest forward returns come right after periods of extreme fear and pessimism. That's why having a plan in place before volatility strikes can make all the difference in how we respond. Napoleon once said that, a genius is the man who can do that average thing when everyone else around him is losing his mind. That's not to say that we should try and time when these economic shocks are going to occur, because historically it's been significantly profitable to just dollar cost average into the market rather than trying to wait for these major declines to take place.

51:14Now, some of you might be listening to this and hear just how positively I've spoken about index fund investing, but wonder why I myself do not own any index funds. There are four points that I'd like to share with regards to this. The first point relates to just my love for the game of investing. For me, investing isn't just a means to an end. It's something I genuinely enjoy. I love diving into company filings, understanding business models, and trying to piece together where the market may be mispricing certain opportunities. It's intellectually stimulating and I find the process itself rewarding.

51:49Managing my own portfolio also gives me a sense of control and involvement that a passive investing approach simply doesn't offer. It allows me to align my capital with the businesses and ideas I believe in the most over the long term. During episode 734, I shared my investment philosophy and highlighted how it's been such a privilege to have the opportunity to partner with some of the best business managers in the world. The stock market allows us to really get to know a company and its management's long-term vision, and we don't have to pay a management fee for the privilege of partnering with them.

52:23Of course, an index can also give you access to those same people, but it just isn't the same when you're actually buying directly those shares and controlling the entry price and position sizing. The second point here relates to the inefficiencies of the market, breeding opportunities for value investors. While markets are broadly efficient over the long term, they can be quite irrational in the short and medium term. Investor sentiment, macro uncertainty, and herd behavior often push certain stocks well above or below their intrinsic value. Ben Graham eloquently shared his idea of Mr. Market and how Mr.

53:00Market goes to remote swings based on sentiment, which leads to stock prices moving much more than the underlying business value. Just looking at some of the Magnificent Seven over the past year, from high to low, companies like Alphabet, Amazon, and Meta have all deviated by over 40%. I'm fairly certain that their underlying value did not change by more than 40 % over the past 12 months. The third reason I decided not to index is that the future expectations of returns for the S &P 500 just simply are not as attractive as they once were. As I mentioned earlier, the Shiller PE of the S &P is 38, which is far above the historical norm.

53:38Just to get a ballpark figure of the expected future returns, if we assume no change in the multiple, a 1 % dividend yield, and earnings growth of 6 % to 8 % in nominal terms, we're looking at around a 7 % to 9 % expected return. So while I don't expect the stock market to crash by 70 % or anything like that, I feel that I can just find better opportunities with higher expected returns. As I mentioned in the episode on my investment philosophy, I'm also considering the growth in the US dollar money supply or the currency debasement. And over the past decade, this has averaged around 6 % per year.

54:13If the currency I'm using is being diluted by 6 % and my returns are expected to be 7 % to 9%, then I don't feel I'm being adequately compensated for the risk I'm taking. Ideally, I'm getting a 15 % return or higher at this point in my investment journey, where I'm focused more on capital appreciation rather than capital preservation. And that's not to say that achieving a 15 % return is by any means easy to do, but it is the goal over the long run. Now, the final reason why I've decided not to index is because my returns in recent years have exceeded that of the index. And I hope for that to hopefully continue.

54:50I don't have my exact returns calculated to the nearest decimal point since I don't have all my data from my previous broker. But the other day I was preparing for a presentation I'm doing for our TIP Mastermind community about how value investing has changed my life. And I ran the numbers on how much my net worth has increased since January of 2022, just after I joined TIP, and simply calculated that my net worth has compounded at 30 % over that roughly three and a half year time period, which of course includes investment contributions and doesn't directly translate to the exact returns that I'm getting.

55:23Now, that's not to say that I won't ever own an index funds. I wouldn't be surprised if later in life I start allocating more of my portfolio to index funds to diversify my asset base and provide more peace of mind in the midst of an ever-changing and uncertain world. And doing so could also help make my overall portfolio more anti-fragile, as the chance of having a significant capital impairment is very low when you have a long-time horizon holding an index fund. Broad market exposure through index funds can also act as a stabilizing force, especially when paired with more concentrated or higher risk positions.

56:01Morgan Housel wrote in his book, The Psychology of Money, if I had to summarize money success in a single word, it would be survival. With that said, if I ever had a friend or family member ask me where they should park their long-term savings, I think almost always I would answer an index fund if I had to give an answer. For most people, especially those who don't want to spend their weekends reading 10Ks or dissecting earnings calls, is the smartest, most reliable way to build wealth over time. It removes the pressure of picking individual stocks, it keeps costs low, and it ensures broad market exposure to the growth of the economy.

56:36And most importantly, to a large extent, it ensures survival. So while I've taken a different route personally, I still have a deep respect for indexing and believe it's the right choice for the vast majority of investors for those reasons. In Nick Majuli's book, Just Keep buying, he also makes some great points with regards to stock picking. Even if one does beat the market over say five years, it's just so difficult to know whether you're truly good at it, meaning that you actually have the skills to beat the market over long periods of time rather than just getting lucky. In most domains, the amount of time it takes to judge whether someone has skill in that domain is relatively short.

57:15For example, any competent basketball coach could tell whether someone was skilled at shooting a ball within just 10 minutes. Similarly, a professional chef can often judge from one meal whether a cook knows how to get the seasoning and the balance of flavors right. Now for stock picking, it takes multiple years just to get a good idea of whether one is skilled or not. The reason is that the feedback loop can take years. And even if an investment makes money in absolute terms, it can still lose money in relative terms if you're comparing it to an index. More importantly though, the result that you get from that decision may have nothing to do with why you made it in the first place.

57:54So maybe, you know, a stock you own jumped because a competitor stumbled or interest rates fell and not because the business performed how you expected it to. Conversely, a rock-solid thesis can look like a loser for years if sentiment or market liquidity flows are a big driver of the share price movements. When outcomes are decoupled from your original reasoning, you risk drawing the wrong lessons, confusing luck for skill and reinforcing behaviors that won't work over the long run. Another point shared by Majuli is that even if you're a skilled stock picker, you're almost certain to go through some periods of underperformance.

58:31There are periods of up to three years where certain investment styles are just simply out a favor. And it's up to these great investors to stick to a process that works and not deviate from it. It's often said that the great investors are going to underperform the market about one third of the time. So if you're picking stocks, it's really key to not let the market's short-term movements change your process. Letting the market's movements sway your decision-making might help you in the short-term by chasing trends or whatnot, but be detrimental to your returns over the long term. Sticking to a process can be challenging because the world is constantly changing.

59:08Technologies change, consumer preferences change, and economic regimes cycle in and out. What worked yesterday might be outdated tomorrow, making it tempting to abandon a proven process for whatever seems to be working now. But the irony is that those who stay disciplined amidst this uncertainty are often the ones who achieve lasting success. And just to add to my point earlier about survival, capitalism is brutal, and just maintaining one's business over a decade can be even a tough task, nonetheless trying to deliver value in excess of the broader market. Over half of stocks end up underperforming the market, and around 40 % of public companies end up losing all their value.

59:50Getting money and growing money are two entirely different skill sets, and as Morgan Housel puts it, getting money requires taking risk, being optimistic, and putting yourself out there. But keeping money requires the opposite of taking risk. It requires humility and fear that what you've made can be taken away from you just as fast. It requires frugality and an acceptance that at least some of what you've made is attributable to luck so past success cannot be relied upon to repeat indefinitely. End quote. So to ensure survival, sometimes you might need to do things that just don't make sense when you plug it into a spreadsheet.

1:00:29Perhaps for some that means holding most, if not all of your portfolio and index funds. Perhaps for others, it might mean holding one to two years worth of cash because it gives you the peace of mind to not worry about the day-to-day market movements. Or maybe it means avoiding individual stocks that aggressively use debt since excessive leverage can make a company vulnerable to creditors in financial distress. Having some sort of financial plan in place is essential, but recognize that it's oftentimes the norm for things to not go according to plan. A good plan leaves some root for error and for things you can never foresee happening, such as the housing crisis or COVID, or God forbid, losing your job or having trouble paying your bills.

1:01:13I'll close out the episode the way John Bogle closes out his book. I quote, the simple ideas in this book really work. I believe the classic index fund must be the core of such a winning strategy. But even I would not have had the temerity to say what the late Dr. Paul Samuelson of MIT said in a speech in the autumn of 2005. The creation of the first index fund by John Bogle was the equivalent of the invention of the wheel, the alphabet, and wine and cheese. Those essentials of our existence that we have come to take for granted have stood the test of time and so will the traditional index fund, end quote.

1:01:54With that, I think we'll close out the episode there. Thank you for your time and attention today. And I hope to see you again next week. Thank you for listening to TIP. Make sure to follow We Study Billionaires on your favorite podcast app and never miss out on episodes. To access our show notes, transcripts or courses, go to theinvestorspodcast.com. This show is for entertainment purposes only. Before making any decision, consult a professional. This show is copyrighted by the Investors Podcast Network. Written permission must be granted before syndication or rebroadcasting.