This was first posted in September 2008. Today the S&P500 trades at 1200 after having gone below 700 in 2009.

If you had bought index funds 10 years ago or 5 years ago, you would have gotten exactly nowhere(*). In October 1998, 10 years ago, the S&P 500 traded around 995. In September 2003, 5 years ago, the S&P 500 also traded around 995. In between those dates, the index generally traded higher. This means that if you have relied on dollar cost averaging over the past five or ten years like a herd of experts recommend, you would have lost money, because the current price is below the average price. Dollar cost averaging only works insofar the the final price is higher than the average price and not surprisingly, most proponents of dollar cost averaging finishes the the example on a high price, not a low price. In reality dollar cost averaging cuts both ways and it only works to average out volatility. So much for that theory.

(*) If you correct for inflation, you would have done worse. If you correct for the loss of international purchasing power by denominating the S&P 500 in Euro, even worse.

Contrary to popular opinion investing is not about picking the right stock or the right timing. Investing is a process. Some processes are rewarded and other processes are punished depending on whether they are compatible with the market. Index investing is essentially a buy and hold strategy of a few dozen large cap growth stocks (the rest of the index is just fluff). This works very well in trending markets because it avoids over-trading. In the long run this works very well. When markets are not trending and find themselves in a trading range, this does not work.

Trading ranges can last for many years. The current trading range era in the US has lasted a decade. In Japan it has lasted 20 years. In both countries cheap credit induced asset bubbles which were followed by government intervention that prolonged the stagnation. Index investors frequently say that they are in it for the long run. It is never quite clear how long that run is? A working career is typically 20 to 40 years long, so if that is a fair and realistic characterization of “the long run”, then 10 or 20 years is a fairly large amount of time to spend on a non-performing investment strategy. In other words, if you rely on the market to magically compound your savings for retirement, a 10 year stagnation corresponds to delaying retirement for 10 years.

The fact that an herd of experts recommend index investing (including Warren Buffet, whom I note does not use index investing for his own portfolio) as a sure-fire method to long term gains is a sure sign that it’s not going to work. There is no free lunch in investing, for who is going to give the money to who, when everyone takes the same side. Stocks, like real-estate, does not always go up and just because it has gone up for a long time does not mean it will continue to do so. Having a herd of people blindly buying at ever increasing prices only works to ensure a spectacular crash when the automatic buying gets out of step with the underlying fundamental reality.

In retrospect it was a good thing that social security was not privatized, at least not in the proposed form. Forcing everybody to hold the same fashionable and limited number of funds(*) would have resulted in another disaster of the kind we are currently seeing, only then there will be nothing to fall back on.

(*) It is the diversification of different strategies that keep the stock market aligned with reality. Herding around one strategy is what causes bubbles to appear.

What we are currently seeing are the indices selling off. Since a market index contains good stocks as well as bad stocks, it means that all stocks are dropping. The smart investors, however, buy up the good stocks and so the good stocks will overperform relative to the bad stocks. This transfers money from the bad companies to the good companies and from the index investors to selective investors.

During general routs, being selective works very well. During the past couple of weeks, my early retirement portfolio has outperformed the S&P500 between 0.5-2 percent per day! My portfolio relies mainly on dividend payments rather than liquidating a total return fund. Hence, my retirement is safe as long as the companies keep paying a dividend regardless of what the market thinks the stock is worth. During this crash, my only loser in my portfolio (which generally holds between 15 and 20 stocks) has been AIG. This has meant a drop in investment income of $88/year. This is certainly livable. On the other hand, with a 30% drop a $100000 S&P500 portfolio from which $4000 could be “safely” withdrawn, would now be worth $70000 and only $2800 could be withdrawn. This comprises a steep decline in “income”. Too steep for me!

The good news about the market rout is that the universe of stocks has now become a target rich environment of opportunities. Compared to last year, there are many more good stocks to choose from to build an income portfolio for an ERE style retirement much cheaper than last year. Furthermore, depressed prices leaves room for further appreciation. I hope to post a “model ERE portfolio” soon.

Originally posted 2008-10-09 07:18:15.