7 important lessons from Index Investing

You can expect a return of 8% on average per year when investing in stocks with a real return, after inflation, of 6% in the very long-term. It’s important to realize this average is taken from about 200 years of recorded returns (from the US). The extremes between movements are not visible by using this average of course so in the shorter term. Up to 20 – 30 years you can see a negative return in worst case!

The book Common Sense on Mutual Funds by John C. “Jack” Bogle has a table showing the historical returns of the past 195 years which gets used in this book:

At an average real return of 7% and an expected inflation rate of 2% we technically get to 9% return for stocks but because not all markets are exactly the same, it’s better to be on the safe side and expect a return of 8% and a real return of 6%.

Risk is an inherint part of investing and it can take 20 to 30 years¹ in the worst possible scenario to get a positive real return on your investment.

^1. Source: E. Dimson, P. Marsh, M. Staunton (2002). Triumph of the Optimists. Princeton: Princeton University Press.

There is no one clear-cut theory why markets cannot be predicted. Three approaches try to give one but can’t give a conclusive theory.

1. Efficient Market Hypothesis
2. Random-Walk Theory
3. Trading is a zero-sum game (Logical reasoning)

Whatever the reason may be if it’s not possible, why trouble yourself with fund managers and paying them hefty fees? These fees also take a big chunk out of your final returns.

Entry fees have an impact since they are only one-time, but the impact is minimal in the long run. As an example, the entry costs of an average index fund is 0.5%, over the course of 25 years this results in a difference of 12%.

It’s more important to pay attention to the (yearly) costs than anything else. At an average Total yearly cost of 2% (which is common for actively managed funds), the total difference is 42% after 25 years.

In the end, all the costs are important and you should do your best to keep the total costs as low as possible but yearly returning costs (obviously) take the biggest bite out of your (yearly) return. you are advised to at least pay attention to these.

If you do wish to time it, at least try and prevent entering at the peak of the market. You can pay attention to the following signs in the market to achieve this. I can’t repeat this enough though, these are just suggestions from the book and by no means solid timing advice.

• Price-earnings ratio
  • < 15: Just enter. While declines are possible the chances are high you will get solid returns.
  • 15 – 20: You can just enter or spread out your purchases depended on your risk appetite and tolerance. There is a chance that the market turns negative.
  • 20 – 25: Consider not entering. If you do want to enter, do so by spreading your investments. The closer to 25 the better it might be to wait longer to deposit the next sum. It might even be only per year.
  • > 25: Wait with investing at all. Place your money in a savings account or short-term government bonds.
• Identifying a hype:
  • Everyone is unbridled enthusiastic
  • All signals are set to green, it doesn’t seem to go wrong
  • Recently prices have risen sharply
  • Everyone is captivated by the chance of fast, easy wealth
  • It is said that this time it is completely different
  • Critics are laughed at and excluded
  • The media report enthusiastically on one record after another on the stock exchange

These are of course not foolproof and it’s very likely you are better off spreading your entries over monthly deposits.

In times of bearish markets, the media cover the negative, strengthening the negative bias. During rallies, they share the success stories of companies that just had an amazing run, which more often than not ends after said stories are publicized².

Just like the positive stories mostly say something about the past performance and nothing about future success, the ‘hit lists’ of funds also tend to mislead investors.
It’s easy to pick the stocks that performed well the previous year or three years. What these lists don’t tell you is that there were thousands of other funds that performed subpar. It was impossible to know three years ago that these funds would come out on top.

If you decided to follow these hit lists and invest in the top stocks you will get caught with your pants down. Just like the success stories earlier, these lists are the start of a decline in performance³. This doesn’t matter to the fund managers. They are more than happy to welcome your money. If they fail to perform the next three years they still get their commision. What you don’t read in the newspapers is what happens afterward. A large portion of funds will get closed-down without the smallest whisper.

When a new fad arises, these fund managers happily start a new fund and aggressively market it as the next big thing.

^2. Source: Arnold, T. J. Earl, D. North. Are Cover Stories Effective Contrarian Indicators? Financial Analysts Journal 63 nr. 2.
^3. Source: D. Allen, T. Brailsford, R. Bird, R. Faff (2002). A review of research on the past performance of managed funds. Funds Management Research Center.

Rebalancing your portfolio once per year makes sure your investment mix stays correct. If your investment is split 60/40 between stocks and bonds it can change over time due to different returns. Over time it’s possible your mix changed to 80/20 which has made your portfolio a lot more aggressive than you want it to be.