Just curious, but is the your list of outperforming funds net of fees?

The ease of an index fund attracts me. At the same time I’m not in that place yet where I want to go for one. ING’s Streetwise fund is at 3% while their regular saving account is at 3% too. Don’t see the benefit then.

Indexing isn’t necessarily limited to large caps – there are also small cap indexes, and “value” indexes, and various combinations, etc. Not all indexers are drinking the exact same kool-aid either – check out some of the more argumentative posts at boggleheads.org for examples of that.

If literally EVERYONE indexed – we’d be the blind leading the blind, as you have noted. In that situation, some smart guy would notice that and say, “Hey wow, the market prices are really disconnected from what I think the fair value is,” and *boom* we have active investors again. I can’t imagine a situation where we won’t have some active investors keeping the markets more or less efficient, because there is always someone looking to profit from inefficiencies. That’s not to say that the corresponding market moves may not be violent if nobody sees it coming, but…

The reason that I’m generally fond of indexes right now is because of the inequality of information between Fund Company A and the Investor. Its the same relationship as the one between the used car salesman and the consumer, except that in that case, the consumer expects a hefty discount on the car to compensate for the lack of a guarantee that it actually is a good car. In the fund case, not only does the fund company skip the discount for the extra risk, the typically charge you more for it. I also feel ill-equipped to separate the fund wheat from the fund chaff, in order to pick a winner.

Seems like the logical answer there is to pick your own stocks – but that’s definitely not something everyone can do and expect better-than-index results. I’m looking into becoming a more active investor, and in the mean time think indexing is a good idea. Even when I’m taking a more active roll in my investments, there will be segments that I won’t have the experience/economies of scale to manage myself (international, EM, etc), and I think indexes are a good fit there.

I can agree with you that the “cult of the index” (i.e. assuming guaranteed, work-free 10%+ returns for life) is a bad thing, but I don’t think indexes are inherently evil. Do you have any thoughts on that?

I think it would be fair to describe me as the world’s leading expert on the cult aspects of the Buy-and-Hold phenomenon. The Bogleheads.org board, which is probably the most popular investing board on the internet today, was formed to escape me when I posted about the dangers of Buy-and-Hold at Morningstar.com and the “leaders” of that community could not get me banned. “Cult” is not too strong a word to describe SOME who practice Buy-and-Hold Investing.

But I don’t think it is fair to criticize indexing for the weaknesses of the Buy-and-Hold strategy. Indexes provide huge diversification at a tiny cost. What’s not to like?

It’s entirely possible to index without engaging in a Buy-and-Hold approach. That is, you can invest in an index but lower your stock allocation when prices rise to insanely dangerous levels.

I agree with the Charlie Munder comment quoted above. Buy-and-Hold Investing is Get Rich Quick Investing. All rational investing strategies consider value propositions. There is no reason why indexing cannot be done intelligently. People mix indexing and Buy-and-Hold/Get Rich Quick together because Bogle pushes both concepts heavily. He’s right to push indexing. He’s wrong to push Buy-and-Hold/Get Rich Quick.

Rob

@Rob – My main issue is actually with the diversification or lack thereof. Sure there are lots of different indexes, but people tend to pick the same ones. This means that stocks in the index get bought on a belief of safety while what is really happening is that the stocks making up the main component get overvalued.

@retirebyforty – since you have the numbers, try assuming that you retired on the starting date and instead took out $100 each month. What would be the result of that? What you’re really arguing for here is dollar cost averaging; not indexing per se.

I see your point of view now. I’m still working so I’m looking at it from a working person point of view. Yes, once there are no more additional buying then the account value erode quickly.

@Debbie M – Same problem; it’s just one step removed. Asset allocation is a fancy word for diversification across asset classes. Rebalancing is a fancy word for a mechanical trading rule.

The systemic effect of this is that most asset classes are now correlated. Diversifying from 1 to 100 assets isn’t worth much if those 100 assets behave in pretty much the same way as the first one.

@Spork Eye – It’s hardly surprising that an index which by definition is the average of all players minus a small fee beats the players minus a larger fee on average. — Because the funds make up the market, the funds on average can’t beat the market.

What I’m trying to get across here is that an index is just another kind fund. The only difference is that it has a low fee and no brain.

So the real argument is whether brains are worth a fee and if so how much. I definitely believe it’s possible to trade against the index funds. I posted an example in a recent comment.

@Photoguy – The problem is that it’s hard to quantify brains. I remember reading an intro to an investment book saying that students from the school of Graham (so to speak) have all done very well. You could say that randomly some will always do well; however, if they all follow the same methodology, it can’t be that random. However, how do you quantify the methodology? That is very hard. You’d have to make up an algorithm, so you can backtest it. If you want to see if brains are worth it, you essentially have to make an algorithm for the brain, which is practically impossible. You can backtest simple strategies. The French-Fama three factor model for instance shows that you do better if you include low P/B and small caps in the model. So there’s an example of a very simple brain beating the index.

“The French-Fama three factor model for instance shows that you do better if you include low P/B and small caps in the model. So there’s an example of a very simple brain beating the index.”

I definitely believe in the FF three factor model, but actually I think many (most?) of the people following it are indexers. I count myself in that category. But I don’t think Fama would say that you are “beating the index” and outsmarting an efficient market but rather you are investing in riskier stocks.

If you are a value investor, the index you should be comparing yourself to is something like DFA large cap value (DFLVX), DFA small cap value (DFSVX), or the MSCI indexes depending on how small/valuey you go. The S&P 500 is in my mind not an appropriate benchmark.

You can kinda see each possible portfolio as a vector function. If a large group of people decide to go with the same vector function, you wouldn’t say they were diversified, right?

It’s not about what’s in the portfolio. It’s about how many other people behave in exactly the same way. That’s true diversification. People still believe they can diversify by holding different stocks because everybody used to be value investors or trade in single stocks.

This is no longer the case.

So the model breaks down.

Yes?

In that case it would be hard to believe that equity financing should be determined by market cap (bigger companies get cheaper financing because they are bigger) or worse by price (like the DJ) that is companies with a higher stock price get cheaper financing.

I guess my main issue with the index approach is the implied statement that
1) It is impossible take advantage of inefficiencies.
2) There are no inefficiencies because smart people eliminate them.

This can only be resolved by
3) I’ll never be the smart one nor will I ever figure out who is.

Maybe that’s fair enough and why it’s being pushed to the retail/401k investors.

The Dogs of the Dow is simple: “Equal positions of the 10 highest yield Dow components.” Is that an index?

“:The Dogs of the Dow is simple: “Equal positions of the 10 highest yield Dow components.” Is that an index?”

I would consider it an index but as you note there are quite a few shades of gray. Personally, I wouldn’t care for it because I think it doesn’t have a lot of the properties that make indexes good. Namely,

(1) A very small selection of stocks so there is not much diversification against specific company risk. The average stock in the dogs index would be about 10% of holdings — compare to VV with 755 stocks and single largest holding of 2.9%. Why not define a large-cap high yield index with hundreds of stocks?

(2) High turnover.

(3) The origin of the index smacks of excessive data mining (i.e., the discovery is subject to publication bias) to look for excess returns.

[…] a Boglehead myself, I read the ERE article to see what he had to say. I had to sigh when I got to this: “Index investing is basically […]

http://jlcollinsnh.com/2012/01/06/index-funds/

That is all. 🙂

Jacob, that is one long article at the other end of that link! 🙂 Interesting points, but a lot of potential logical flaws in the counter arguments as well.