30 reasons to fall in love with index funds

[CaliforniaMan]

The main reason I do not like index investing is that it keeps pumping money into stocks that have risen, while taking money from stocks that have declined. Yes, stock prices usually rise for good fundamental reasons, but buying indiscriminately often drive them to stratospheric levels, causing greater crashes later on.
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I am mostly indexed and have thought about what you mentioned but came to the conclusion that it was of relatively light importance. Certainly index funds have to be invested in stocks of companies with a large enough market cap, and so will periodically have to drop some that fall too low and add some new ones as they rise. The market is after all a dynamic array of companies that come and go with the changing times. However there is no predictability of future returns from a previous price change alone. So as long as the change is done on market cap alone, I don't see much of a problem. They must also keep the market sectors (leather goods and buggy whips vs. airplanes and semiconductors) in line with overall capitalization, which I assume they do reasonably. At any rate, you have to do pretty much the same thing over time with any fund. You might change the company makeup differently, and certainly don't have to worry about keeping a balance, but still must change as the market changes. I just don't see, or have seen presented, a problem with the way the index funds do this overall.

 

[NW-Bound]

I remember that in the year or two leading up to the market meltdown in 2008-2009, no less than Jack Bogle sounded the alarm that financial service and banking companies took up too large a percentage of the market equity for what they did, being basically middle men. I do not remember the exact percentage at that point but perhaps it was more than 20%.

If you put fresh money to the market at that point, a larger percentage of your money goes to buy those frothy financial companies. The same thing happened in 2000, but with tech stocks taking the center stage.

Of course worse than indexing at these moments were MFs who loaded up on the hot stocks, and boasted of beating the index. Only the contrarian investors are not guilty of feeding the frenzy.

 

[mathjak107]

tech went for 18% of the s&p 500 to a whopping 1/3 of of it right when the bubble burst. the whole weighting thing for the s&p 500 is just silly. putting more of your money in the over valued stuff vs the under valued stuff goes opposite wisdom.

in fact had you bought the fourtune 500 instead of the s&p 500 which uses different criteria you would have beaten the s&p 500 by 1-2% average every year.

 

[CaliforniaMan]

I remember that in the year or two leading up to the market meltdown in 2008-2009, no less than Jack Bogle sounded the alarm that financial service and banking companies took up too large a percentage of the market equity for what they did, being basically middle men. I do not remember the exact percentage at that point but perhaps it was more than 20%.

If you put fresh money to the market at that point, a larger percentage of your money goes to buy those frothy financial companies. The same thing happened in 2000, but with tech stocks taking the center stage.

Of course worse than indexing at these moments were MFs who loaded up on the hot stocks, and boasted of beating the index. Only the contrarian investors are not guilty of feeding the frenzy.

tech went for 18% of the s&p 500 to a whopping 1/3 of of it right when the bubble burst. the whole weighting thing for the s&p 500 is just silly. putting more of your money in the over valued stuff vs the under valued stuff goes opposite wisdom.

in fact had you bought the fourtune 500 instead of the s&p 500 which uses different criteria you would have beaten the s&p 500 by 1-2% average every year.

Very good points. So it begs the question, if one were to pick an index fund now, which one(s) to pick? Even Vanguard has 17 of them.

 

[NW-Bound]

As a slicer and dicer, I look at ETFs of different industry and business sectors and try to determine which are undervalued or overvalued. Note that some of the ETFS are along the line of market cap, e.g. large cap valued, midcap growth, etc...., which are not the same thing as the previously mentioned.

But going along the above lines usually requires the investor to be making subjective decisions, and that is against the true indexing philosophy.

 

[photoguy]

I don't think slice & dicing is incompatible with indexing philosophy. Even on bogleheads you see many that slice and dice with index funds targeting different sub-populations of stocks (and this is what I do). It is going against a total market approach -- maybe that is what you meant by "true indexing philosophy"?

I have a big proportion of my portfolio in index funds, but what I appreciate about them is the low costs, low turnover, and no attempt at stock selection (beyond the broad mandate of the fund - e.g. to get small cap stocks, etc.). However, these characteristics can also be found in other funds that use say quantitative screens but are not strictly an index.

 

[NW-Bound]

I thought that the original indexing philosophy (the orthodox one) is that one buys S&P 500 and calls it quit. OK, one is allowed to balance that with bonds, but no more than that.

There seems to be more branches of indexing that I do not know about.

 

[photoguy]

I think the main philosophy behind indexing is that individual stock picking is a fool's errand due to efficient markets.

This is divided into two camps: (1) folks who just get a S&P 500 or total market index and call it a done deal and (2) folks who think that there may be certain sub-populations or classes of stocks that have unique return/risk characteristics. And of course the best way to invest in these asset classes is to buy an index (I can't tell if biotech company A or B is going to be better so I'll just invest in both).

If you look at vanguard that are a lot of different indexes tracking small/large, value/growth and sectors like healthcare/REITs/precious metals. At least on bogleheads, I think the vast majority of posters have funds in indexes outside of the S&P 500 or total market.

I think there's quite a bit of debate as to what subsets of stocks actually have "unique" risk return characteristics. For example, FamaFrench followers might believe that the only other ways to diversify from the total market would be get value and/or small cap stocks. Thus such a person might invest in indexes for total market, small-cap value, and large-cap value. They wouldn't invest in an healthcare index because they think any additional return in healthcare would already be covered in their small and value indexes.