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Markets and Indexing: What we can learn from human behaviour

I believe that indexing will turn out to be just another Wall Street fad.

—Seth Klarman, 1991, legendary Hedge Fund Manager

 

It seems Klarman made a misguided prediction. 

Index funds are still here, and here for the long haul. 

 

And we have pioneer Jack Bogle to thank for this longevity. As the founder of Vanguard, Bogle created the first index funds in 1975. At the time they were ridiculed as “un-American” and a “surefire way to mediocrity”. 

 

Fast forward to 2024 and US$11 trillion is now invested in index funds, forming the bedrock of our Navigate Portfolios.

 

It turns out Bogle had the foresight that others didn’t.

 

If a statue is ever erected to honour the person who has done the most for American investors, the hands-down choice should be Jack Bogle.

—Warren Buffet, 2019, world-renowned investor & CEO of Berkshire Hathaway

For investors, the benefits of index funds are multifaceted, including: 

  • lower investment fees 
  • greater tax efficiency
  • lower turnover and trading costs 
  • significantly outperforming the majority of actively managed funds over the long-term 
  • simpler and easier to understand than most investment strategies
  • better transparency around how / where returns are generated  
  • wider diversification means less reliance on specific sectors or managers 

 

Importantly, one clear benefit is that stock market volatility has nothing to do with how index funds perform. 

 

So when a client recently asked—are index funds going to cause a stock market crash?—my immediate answer was “no!” 

 

My “no” was emphatic because there is a far more obvious reason for stock market crashes.

 

Humans.

 

When assets rise too quickly and valuations become detached from reality, it has always been human behaviour that caused markets to be sold rapidly. 

 

Consider the South Sea bubble in the 1700s, The Great Depression (1929), Black Monday (1987), The Great Recession (2008) or the Coronavirus crash (2020). Were index funds responsible for these major crashes? No. In some of these circumstances, they hadn’t even been invented. 

 

Each time, human reactions to global and/or economic events caused market volatility, not investment structures. 

 

If investors are so concerned about index funds, why don't they have similar concerns about active funds causing a crash as well? 

 

Over 10 years ago, while I was still using active funds and index funds were growing and gaining market share, I came across the debate regarding the fragility of the price discovery mechanism.

 

The argument held some attraction. 

 

I then realised it was complete nonsense. There’s more price discovery going on today than ever before. And index funds need all that active trading to “price out” inefficiencies, making them the optimal way to capture value.

 

The argument was settled for me in the 2015 book The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches by Swedroe & Berkin.

 

Swedroe & Berkin argue that in theory, there should be more opportunities for active traders if everyone jumps onto index funds. Yet the evidence they draw on suggests that with technological advancements the turnover of shares increases. 

 

Applying this to an example, fifty years ago, the entire New York Stock Exchange saw a daily trading volume of around 3 million stocks. Yet comparatively, today Apple has an average trading volume of roughly 26 million shares a day! 

 

The authors suggest that active management will always stay in business, despite the evidence they provide that indexing is superior. Stock picking is far too lucrative for those involved, and it's too tempting for type-A alpha personalities to prove themselves smarter than the collective wisdom of billions of investors. 

 

To sell at a profit, someone must make a loss. Because of indexing, anyone can invest without spending hours studying the markets. Those same investors, with fewer resources than a professional trader, are taking themselves out of the active game - meaning there’s even less opportunity for skilful managers to exploit. 

 

By this point, you might be thinking - “In that case, why do I need professional help at all, I’ll just buy an index.” The answer lies in the wealth of insight and expertise we can offer. 

 

While you might consider whether BP is better than Shell, or whether the overall market will be up in 12 months or down, we offer nuanced advice tailored to your individual financial goals. By offering informed recommendations on which index funds to select, in which tax wrappers and with which blend of stocks to bonds we can select indexes specifically for your portfolio.

 

Working with a knowledgeable professional who understands and controls your investor behaviour can tilt the tables in your favour in a way that is far more consistent than price valuations and short-term predictions.

 

Index funds are still only a small portion of the pie.

 

According to Vanguard’s current CEO Bill McNabb, indexing in stocks and bonds globally represents less than 5% of global assets. 

 

So, wake me up when index funds reach 90% of the market. Then it’s a different conversation entirely. 

 

Until then, index funds continue to offer the best value against our mutual investment enemy—inflation.

 

Tom.

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