Beat the Index
It’s not that I don’t like the idea of choosing amongst the 37,000 or so globally listed shares of companies to build my investment portfolio. Surely by just discarding the obviously bad ones, it should be “easy” to do better than all of the ones put together in some broad index. And it’s also quite clear which companies are the good ones and even a first-year finance graduate from a reputable university with a spreadsheet could crunch the numbers. So, why are the statistics that which they are? That’s right, there really is no debate and for the last 50 years since we started recording good data, it is evident that nobody beats the market. Go ahead, Google it and then can we please move on and look at the reasons as to why it is so difficult to pick stocks.
Number one, there is timing. You can pick the most beautiful stock in the world, but all that really matters is when you buy and when you sell. The minute we do anything other than buy the index we are at risk, because then we are measured against the performance of all the other stocks. We all think we know when the right time has come and littered are the battlefields with skeletons of all the ones that tried. The point is, buying low and selling high is the easiest concept to understand, but so difficult to put into practice, particularly when you have to do it twice and relative to the index. Needless to say, when it comes to picking the right entry and exit price, it is better to be lucky than smart.
Number two, individual companies can go bankrupt and the share valuations can go to zero. An index can’t, and that is because an index rebalances. The FTSE 100 or MSCI World are very exclusive clubs. Membership requires size and performance and if a stock doesn’t have either, it simply gets kicked out of the index. There is a strong survivor bias that explains much of the success of a perpetual model. Worldcom, Lehman Brothers, Enron or Thomas Cook all can easily go into the annals of history, but the S&P 500 index just made an all time high.
Number three, costs and fees. This one is obvious, but it bears putting into numbers. There are trillions of US Dollars, Euros and Yen that track an index. Whether through ETFs or other mutual funds, the amount of money managed in huge investment vehicles has created an incredible scale. So much so, that some of the large industry giants, such as Vanguard or BlackRock, now offer (some of) their index trackers for free. Why they do that has to do with securities lending and exceeds the subject matter of this post, but from an investment standpoint, I can now get access to thousands of individual companies for zero management fees. And my execution costs will also be lower. Think about your custody, administration, and transaction fees. When BlackRock buys their stocks, they also do it for very low costs, and we, or whoever we pay for picking stocks, simply don’t operate on the same scale. All of these additional inefficiencies add up and therefore, the costs are also much higher over the long term.
And number four, my personal favourite: you are short everything else. That’s right, for every wonderful share we bought, we are now less exposed to all the other amazing companies that are part of the index. The FAANGs, the biotech, value or growth stocks are underweight, the minute we buy anything else. Scary stuff, keeping track of the personal favourites, but also having to monitor all the other thousands of companies? That would require a lot of resources and will most certainly strengthen the argument for point number three.
And there you have it, you are better off buying the market for next to nothing and resting your feet up high, preferably somewhere warm with a cooling beverage in your hand. Whoever said there was anything wrong with that?