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If you’ve read much from the FIRE community you’ve probably heard about the practically guaranteed 7% expected return from index funds (that’s becoming borderline dogmatic).

And if you’ve been following the market you may have noticed that over the last 10 years it’s been more like 10%+ returns.

To give a little background on where I’m coming from, I’ve been through more than one market cycle as an investor, which is something many Millennials can’t claim and been consuming investing knowledge for almost a quarter-century.

I decided to dive a little deeper into index funds and the indexes they’re mimicking to see if they’re as good as everyone is claiming or if there are risks involved that we should be aware of (I have about 15% of my net worth in ’em).

When easy money is being made and net worths are growing at above normal rates because the market is doing fantastically, a simple strategy like index investing is appealing and will easily find more converts.

But with very high market levels (relative to earnings) and lots of people depending on their investments for their incomes in the distant future I wanted to look at index funds more objectively and share my findings so people can gain awareness and make their own educated decisions.

What exactly is an index fund?

The short answer is that an index fund is like a mutual fund, but instead of human brains making the decisions of what to buy/sell, computers are running the fund and programmed to mimic the actual index.

Because technology is being used—and fewer humans, the costs of index funds are very low, which turns into more profits for investors. The big difference in returns compared to an average human-run mutual fund is usually due to the expenses, which would have the average investor constantly lagging the index, especially in down years.

How is an index like the S&P 500 constructed?

The S&P 500 index focuses on the biggest companies in the U.S. that are public and widely traded. A committee selects the ones that meet their criteria, and as companies and industries change some companies are removed, while others are added.

But it’s not like each company can similarly move the index, it’s market-cap weighted, meaning the biggest companies by market capitalization have more sway over index movement.

As of June 27, 2019, the biggest company is Microsoft ($1.027T market cap) and has a weight of 4.2, 2nd is Apple @ a 3.6 weighting.

top-sp500-index-weightings

While the smallest company on the list is Macerich Company with a $4.73B market cap has a 0.0145 weighting (News Corp Class B shares show up last on the list, but it’s not entirely accurate since the index includes both A & B shares and when the totals are summed it’s not actually the smallest).

You might have notices there's 505 companies, that's because some companies have different classes of shares & also varies because of mergers

You might have noticed there are 505 companies and not 500, that’s mainly due to companies with different classes of shares & also mergers

Movement in the price of giant Microsoft has 280+ times the impact on moving the S&P 500 index than movement in relatively small Macerich.

So index funds are overweighting larger companies, which leads to index funds buying way more of them, which leads to even higher premiums paid for those since these massive pools of money are buying up HUGE stakes in the biggest U.S. companies.

This overbuying pushes market prices to inflated market prices. And since they’re holding them indefinitely (which if you have an idea of supply and demand you’ll understand that they’re reducing the available supply) and they’re steadily squeezing prices higher with little care about valuations of these businesses and creating ever-larger discrepancies between price and value.

The above is basically undoing the market mechanism because a massive pool of money is acting unintelligently/irrationally and not caring what something is worth (which is pretty important when you’re talking about buying a piece of a business, which is what stocks are).

This feels very similar to bubble mentality, and I personally wouldn’t be too comfortable having the majority of my net worth invested this way.

In my mind it’s a very similar parallel to the efficient market theory (EMT) folks, that thought ALL the prices in the stock market were ALWAYS fair. You might have heard stories of brokers that follow EMT picking stocks for clients by throwing darts at the stock section of the newspaper since they believed stock prices were ALWAYS correct and no advantage could be had by applying effort to find discrepancies between price and value.

Any value investor would see how silly that is (and we’re slowly growing in numbers), but it’s still a very small subset of the population.

It’s grimmer with index funds, since those efficient market (EM) theorists didn’t control a large portion of the equities market, and weren’t gaining massive additional funds each month to blindly pour into the market and fuel further movement.

Those EM theorists that were too small to move markets were too accepting of a flawed theory and threw their hands up in despair and assumed just because something was challenging and seemingly impossible for them, that it was also impossible for others (and were off the hook). So they didn’t put much effort into their stock selections and used the nearest available solution requiring the least effort to pick investments to buy/sell and hoped for the best.

Index funds are similar, but their “newspaper stock sections” that they’re using on the “dartboards” are skewed, since the 25 largest companies (out of 500), which only make up 5% of the S&P index get a ridiculously disproportionate amount (7x) of the “newspaper page” and take up over 36% of the “newspaper page”.

You could come up with a better portfolio (that’s less arbitrary) and low-effort by:

  • Looking at stocks as businesses
  • Using (mildly) logical buying and selling rules
  • Owning 20 to 40 stocks (purchased in equal weights)

And you’d do great long-term, minimize your market risk (since your portfolio wouldn’t look “index fundy”) and be insulated from bubble stocks (that are likely to pop).

Take a look at the list below of the top 10 companies by market cap to get a sense of how much these big companies fluctuate in value and ranking within an index. Some blossom and rise to the top of the list, while the previous favorites fall in price, wither away and fall out of favor (like fashion).

Start with 2010 and note a few companies towards the top of the list and see how different the list is in 2019.

largest-companies-2010-Q1largest-companies-2019-Q1

Only 4 of the 10 from 2010 are still on the list, so 60% of the companies are new, and even because a company like Exxon is still an on the list with a market cap that didn’t change much, doesn’t mean that the indexes didn’t sell the stock like crazy, since relatively the other companies did better so they sold a bunch of Exxon (helping keep the price low) and bought more of the 6 new companies (inflating those prices).

I’m not saying beating the index is easy.

I mainly want others to be aware of what’s behind the “black box” of index funds they’re buying.

Yes, investing is confusing and emotional. It’s taken me over 2 decades of investing, thinking and study to get to where I’m at (and I’ve still got lots to learn), so I understand if you write this off or are drawing a blank (if there’s anything I can clarify leave a comment below), but awareness of how your investment work is valuable (since we’re talking about your net worth).

We’re going through 10+ years of above-average performance, and if you believe in reversion to the trend/average, to get back to the average return rate after being above it for this long there needs to be a proportional period where the index will deliver below-average returns.

long-term-sp500-trend

If you look at the above chart (sourced here) you’ll notice a pretty common pattern of periods above and below the trendline (red) cutting through the chart. You’ll see above that I circled the current period, where there’s a very long period above the trendline and it’s got lots of area above the line relative to the previous historical periods, and with very little time below the trendline, except for that little sliver of time below during 2009.

I have no idea what’s coming (or when), but it has the potential to be similarly long and drawn out but below the trendline this time.

To bring it back to relative value take a look at the S&P 500 earnings yield below (it’s the inverse of the Price/Earnings ratio), which is a better way to compare relative returns.

Note: The folks marketing overpriced stocks probably helped popularize the P/E ratio to take advantage of the idea of “higher is better”, and confused people and made it a little harder to compare returns to bonds, other investments and frame the stock market for the general public more like a casino than a marketplace of businesses to buy small pieces of (like a businessperson would).

sp500-earnings-yield

Investing rule: you want to buy investments with higher yields (e.g. if you’re shopping for a new bank account you want to get the highest rate of return, a savings account you find paying 2% is better that one that yields 1%).

Looking at the chart above you’ll see buying the S&P 500 index at the current level is returning a very low 4.58%, which means if you’re buying an S&P500 index fund you’re paying too much for the underlying companies earnings if you want to get a 7% return.

Eventually, something needs to change (e.g. prices dropping or the prices going nowhere while earnings catch up) to get back to a 7% return.

An index is a useful tool—within a larger toolbox—to gauge something (like your car’s gauges).

But when an index fund is actively buying and selling the underlying companies in the marketplace unexpected things can happen, since the index fund becomes an active participant in the market and affects the index price. So it’s no longer a passive index that’s relaying information, instead, it’s an active trader that’s influencing prices.

Imagine that your car’s speedometer didn’t just relay the information about how fast you’re going, but actively told you that you should drive faster/slower, instead of relaying information it’s participating in the “driving”.

Now we have some more insight on how arbitrarily created these indexes are, let’s think about what happens when an index fund has to mimic an index.

Let’s think about what happens within an index fund when the price of a stock within the index goes up/down?

If all the companies moved up and down exactly the same percent the index fund could be passive and wouldn’t need to constantly buy and sell. But the reality is different. Even when an index looks to be going nowhere for years on the surface, the individual companies go through all sorts of crazy gyrations and movements.

This goes to show how disconnected an index can be from what’s actually going on with the individual underlying companies.

When something is aggregated (like an index of lots of companies smushed together) you lose lots of valuable and actionable information.

When prices of the individual companies change the index fund needs to buy/sell to copy the index and mimic the new proportions. If one companies price goes up a lot and anothers falls a large amount relative to each other, the index fund has to buy more of the one that went up (doh!) and sell some of the one that went down (which is not a recipe for the old business adage that I won’t repeat… yet).

What about when more people put money into index funds?

Another major instance where buying and selling happens is when investors buy more of the index fund or sell, then the fund needs to buy/sell the stocks it’s holding to balance the weightings.

Does this sound very passive from the funds perspective to you? Not to me, just very mechanical and unemotional. But these mechanics affect prices in the markets, especially in prolonged bear market stampede selling, which we haven’t experienced yet with index funds at this scale.

What about when a company is added or removed to/from the index?

Another instance when very unusual index fund buying/selling happens is when a stock is added/removed from the S&P 500 by the committee.

Massive buying/selling ensues (traders also profit from this inefficiency, since it’s announced ahead of time and what happens to the prices are quite predictable). Studies have shown company stock prices rising 7% shortly after the announcement that they’ll be added to the index and then in the following weeks the prices drop around 2%, adding a net 5% premium for these companies that are now part of the index.

It’s the same company as before, but now since the S&P 500 committee needs to make some changes, it’s worth $200+ million more or less (depending on if it’s getting added or removed) for no reason associated with the fundamentals or future prospects of the company. This happens just because of a committee’s decisions and then the cascading effects because of computers needing to change things up to mimic the index.

[UPDATE 7/10/2019: Perfect timing. Today the S&P500 announced that T-Mobile ($67 billion market cap) will be added to the index because IBM bought Red Hat ($34 billion market cap). Not sure why the committee picked a company almost twice the size, but because of their silliness we get an extreme example. On the day of the announcement T-Mobile’s stock closed 4.6% higher, magically adding $2,900,000,000 (I wrote it out to get a sense of the magnitute of a billion dollars nearly 3 times over) in market value to the company and adding to the indexes bloat]

T-Mobile inclusion in S&P 500 7/10/19, now worth $2.9 billion more, same company.

Let’s think about the size of passive index funds now vs. when they started (in 1975).

Index funds were previously a niche product that had little impact on the prices of companies stock it owned, but now they’ve grown to a massive scale.

vanguard-aum-1975-2019

Vanguard’s assets under management (AUM) in 15-year intervals & increased $4.2 trillion over the last 14 years to $5.2 trillion!!!

Passively managed funds are conservatively 25% of the current $30 trillion U.S. equity market, and that’s not even counting all the closet index funds (i.e. mutual funds and pensions that are labeled “actively managed”, but behave very similarly to index funds and buy and hold the same few stocks in very high proportions).

It’s not only their size but their growth.

People are leaving actively managed mutual funds (with high expenses) in droves, and quickly pouring tremendous amounts of money upfront into passive index funds when changing strategies, and then adding to their investments monthly, which sustains those high prices paid, like adding fuel to a roaring fire to keep it blazing.

With investing, when an idea gets popular and goes from being niche to something widely followed it typically stops behaving as expected (e.g. technical analysis where traders are chasing each other’s tails or it’s classic Dow Theory variant). This is because the market is a complex adaptive system and the actions/inputs of participants affect prices.

It’s similar to how opportunities appear and disappear with fad products. When something like Beanie Babies becomes hugely popular and lots of people try to profit by trading them while demand is high many people are able to profit, and the party continues for a while. Eventually, demand slows down and so do the easy profits. People start to question if this “previously valuable” thing is worth as much as they thought it was. And then prices start to come down and the party is over (till the next time…).

The stock market is a bit different and works in cycles. Popular strategies are all the rage when they’re working well, but fall out of favor as they stop delivering the previous easy returns and then “investors” move on to something else. Eventually, it’ll be back in a slightly different way, and at a different scale and it’ll work for a while, till it stops working.

Buy low, sell high (or not…)

To profit, you want to buy when prices are low and sell when prices are high.

Index funds do the opposite, which contributes to overvaluations because of the supply/demand situation it’s actions create. This can also lead to volatility, because of inflated equity prices, that when they return to more normal levels have the potential of massive and prolonged loss of confidence and investors leaving the equity market and not coming back for a while.

Gresham's Law

[Gresham’s Law]: “Bad money drives out good money”

—Thomas Gresham

Index funds do have some positive characteristics that help some investors (e.g. reducing the overactive trading of some folks and calming emotional investors and creating distance for them). But when investing is taken to the other side of the spectrum and becomes too passive and too large, it helps push prices dangerously high.

The index fund mainly just buys and holds, and doesn’t make smart decisions to:

  • Take gains when something has appreciated and is dearly priced
  • Sell some losers that have a very low probability of delivering good returns
  • Buy more of a company that has good long term prospects, but is falling on some temporary hard times and their stock just took a beating

This doesn’t mean you should try and time the market (I honestly don’t even know how people are defining that term, but it’s thrown around a lot—with its vagueness—as a reason to buy and hold).

Imagine this…

There’s a local company, piece of rental real estate, stock (or index fund) that you already own a part of (or were interested in) that’s price dropped substantially and it’s basically “on sale”.

It’s the same productive asset it was before, would it be more or less attractive at the lower price? If you were to buy more I wouldn’t see that so much as “market timing” as being shrewd, logical and opportunistic.

Alternatively, if there’s a stock or index fund that’s risen a lot and no longer priced logically relative to value and future prospects would it make sense to buy more of it? Or sell some and reinvest in something more fairly price to get more for your money?

I might be putting words in your mouth here, I’m guessing you’d logically want to buy low and sell high (which isn’t what index funds are currently doing, they’re buying high today and buying even more next month even higher and also selling low after prices drop).

After you invest the upfront time to learn about the criteria you’re looking for and decide on some buying/selling rules these investment reviews can be made by yourself bi-weekly, monthly or quarterly with a 30 minute session and making a few decisions (or you can outsource this to a mutual fund with a long-term track record of behaving this way).

Is it worth paying a premium for something that’s been “mixed up” with lots of other things? Or that other people are willing to overpay for too?

It seems kind of odd that people are comfortable overpaying for an aggregated, large basket of companies (where they have little awareness of what they actually own) while everyone else is overpaying too.

Let’s talk about a different asset class and see if you’d still feel comfortable:

What if all the duplex investment properties in the neighborhood you’re looking at were worth about $250K, would you prefer paying $200K, $250K or $325K for pretty much the same house?

I like a deal and would like to pay $200K and get the $50K discount (and a higher rate of return and safety margin). Buying index funds at these levels are like saying:

“I’ll buy what I know is worth $250K for $325K because some of my neighbors also paid that much” because “real estate prices only go up”.

7% Expected Return from Index Funds

That 7% number has been thrown around like it’s practically guaranteed, but it’s a “historical average”, each of those words should get you thinking:

  • “Historical”: The past is not guaranteed to repeat itself, so those returns aren’t projections, just what’s happened before and have lots of people hoping will continue in the future. That line of reasoning doesn’t leave me sleeping comfortably, since leaving finances to “hope” is blasphemous.
  • “Average”: This is a way to smooth things out that aren’t actually smooth. Any given years returns can vary widely from the average—like we’re seeing lately above that average with very high returns (over the last 10+ years).

So there’s a high probability that the future will have an abnormally long period where there are returns below 7% to achieve the long term average (maybe).

I hope the people hoping for their 7% return are taking into account a reduction in asset values for an extended period of time and have backups, since the first 10 years of retirement and rate that you draw down money plays a big part in making that money last. This is due to compounding, and either letting it continue uninterrupted so it can do its exponential growth thing (OR robbing it of the building blocks it needs to build future wealth upon).

I feel a little bad and how interesting I find this, I guess I have a sick sense of humor. Human nature is nutty.

I feel a little bad and how interesting I find this trend, I guess I have a sick sense of humor. Human nature is nutty, instructive (and entertaining).

There’s also the possibility of potentially lower returns in the 5-6% range for long periods of time—or as the new long-term average going forward.

When you look at annual returns over any long-term period there’s a lot of variation (an average takes all those widely distributed returns that seem random and creates the false illusion of stability & predictability, which helps people sleep at night).

There are years with declines and others where you’re getting a windfall in your investment returns.

We’ve been enjoying the windfall, I want to make sure you’re prepared to weather the drawdown. You don’t have to take any action or make changes to your investments, but it’s important being mentally prepared to stay the course, while also being flexible to making lifestyle and timing adjustments to avoid withdrawing (and spending) your precious investment principle.

Selecting investments that can deliver good returns that aren’t as susceptible to flawed decision-making is possible with small efforts

Putting in the effort to learn how to invest in stocks or pick a good mutual fund manager with a track record is a great investment of your time when you’re rewarded by discovering a way to get similar or better returns to index funds, while not buying bubble stocks that can cause financial pain.

It can be done with just a portion of your portfolio while having index funds as a foundation.

Another option is rebalancing in a mechanical way between 1-3 other funds and adjusting what you own based on target percentages so you’re regularly taking gains and buying more of the funds that have more upside (less downside) potential.

Achieving—and sustaining—FIRE requires a variety of skills, and for most will require regularly learning new things. Investing more intelligently should be an area high on anyone’s list looking to retire early, since the expectation is that these investments will be providing for you decades to come. So spending some time optimizing the stability and returns of your portfolio is a great investment worth hundreds of thousands (and eventually millions) of dollars when talking about gaining a few additional percent compounded over long periods of time.

Check out the differences in value when there’s a 1-2% difference in the rate of return when starting with $100,000 that’s left to compound:

compound-interest-differences-100k

If you can find a way to get an extra 1% return a year (i.e. 8% instead of 7%), in:

  • 10 years you’ll have 9.8% more money
  • In 20 years +20%
  • 30 years +32%
  • And in 45 years +51% or $3.2 million instead of $2.1 million (or $1.1 million more compared to 7%)

Are you (actually) diversified with index funds?

It depends on how you’re defining and thinking about diversification.

The idea of diversification can be achieved in different ways (and the effectiveness will vary).

The common advice we’re told is to own a large number of stocks/investments, which will get you average returns. This way is about Quantity.

The benefits with diversifying by Quantity is minimal effort since there is only one decision, and pretty much “buying it all” (where there’s no selectivity).

Another way to think about diversification is to own investments that everyone else does not own (or in different proportions). This way you have diversity from the crowd and a portfolio that moves differently from the average. This is diversification by being a Contrarian.

We don’t achieve Contrarian diversification with the most common index funds.

With diversification by Quantity, there ends up being little actual diversity, and instead homogeneity (since your portfolio will look extremely similar to others because of market-cap weighting). You get the illusion of diversity, the comfort of being part of the crowd and not being able to underperform “the market”, but you don’t enjoy the benefits of a more thoughtful approach to diversification.

Another way to achieve diversification is to own investments that don’t move in a similar way (or are uncorrelated). Index funds solve the individual company risk issue, but doesn’t address market-risk (ie returns/losses following the same pattern as the market), since it’s mimicking the market.

Better to own companies or investments that don’t move the same way, which is where owning value stocks, workouts and other less popular stocks come in. By skewing your portfolio proportions to assets that have already fallen in price (i.e. value stocks) or that are more stable due to mergers (i.e. workouts) you can minimize your downside when the crap hits the fan. This is diversification by focusing on Correlation (which has parallels with the Contrarian variety).

An Uncorrelated portfolio can also be had by owning different amounts of small/mid-sized companies relative to common index funds and large caps (i.e. Size), International (i.e. Location), REITs, Commodities (I don’t practice this though, but gold moves differently) or Bonds (yields have been ridiculously low for too long, currently making them less attractive).

A combination of the diversification factors above will make for a heartier portfolio that might not beat the market every year but will deliver good returns, especially when common index funds are down (remember to get back to even after a 50% decline requires a 100% increase).

Currently, indexing has been taken to the extreme by the masses in the very narrow category of indexing by Quantity to get the average (which seems a tad defeatist).

I get it, simplicity is appealing

I love simplicity, 80/20 rule and being a minimalist, but something too simple can lead to blind, mass adoption, which then changes the character of things and can lead to unexpected consequences.

“Too simple” related to investments comes with pitfalls since most people would love a simple way to put their money to work. And investments have confused most people since it’s already a pretty confusing and emotional subject, probably even more confusing than health, since it involves math, lots of professionals using jargon generously and it’s very serious and means the difference between:

  • A comfy lifestyle in retirement; OR
  • Potentially having to work yourself to death

Basically a cocktail for bad decisions—or indecision.

When making bad decisions here, you lose and the finance people win since they still get their fees.

With indecision, you lose, but so do the finance people since when there are too many options some people do nothing and the finance people don’t get to manage your money and make a fee—or people end up investing a smaller portion of their income as a middle ground.

This is why index funds are so appealing, the decision-making is simplified, it’s minimal effort and the results are average (which is better than below average).

FIRE folks are pretty extraordinary and I think it’s a good challenge to shift some of that extraordinary over to the investing side of things and not be satisfied with extremely average, when a few % difference over 5, 10, 20, 30 years makes a massive difference in the value of your future investments and your long-term security.

Here’s the closing challenge…

Try to learn more about investing or making money by reading some old books on the subject (new stuff that hasn’t stood the test of time can lead to learning tactics and fads and not the lasting principles).

Some great topics to start with are value investing, Warren Buffett, dividend investing, real estate investing for cash flow (not flipping) and small scale entrepreneurship to name a few possibilities.

challenge

The goal here is to find different ways to earn 7% returns (or more) on your money that you might not have thought of and expand your universe so you’re not limited to a type of investment that’s fertile ground for bubble-pricing.

If you’ve got other ideas on investments that aren’t “extremely average” share them in the comments.

I welcome other perspectives that run counter to my small world in the comments (just no personal attacks, since it’s better for our ideas to fight and benefit multiple people).