Thank Goodness For Index Funds
A return of investment precedes a return on investment, and I am thankful to my index fund portfolio for providing both. A simple buy-and-hold index fund strategy has achieved a very respectable return over the past 12 years despite a tough stock market. But perhaps more important, this strategy provided a safe return of my money. A diversified index fund portfolio avoided all the calamities and outright frauds that claimed the savings of so many people.
A simple, low-cost 60 percent stock and 40 percent bond Core-4 index fund portfolio returned 4.5 percent annualized since 1999. A more broadly diversified index fund portfolio that included an extra allocation to small cap and value stocks performed 6.0 percent annualized over the same period. These returns beat a vast majority of comparable active money managers.
As I look back over the last 12 years, what is most impressive about index investing isn’t the rock bottom fees or respectable long-term returns, it’s how index investors avoided thousands of disasters in the marketplace that torpedoed the savings of millions of investors. Index investors were not the victims of dozens of Ponzi scams or hundreds of multi-billion dollar corporate and municipal bankruptcies, nor were they they casualties of poor investment advice from self-proclaimed market experts.
Let’s look back at a few of the calamities that plagued investors who didn’t index. These examples are the tip of the iceberg. There were so many scams, bankruptcies, and outright bad advice that occurred in recent years that it isn’t impossible to list them all.
For 5 years ending in 2010, the Financial Industry Regularly Authority (FINRA) received 23,903 investor complaints against stockbrokers and their firms. The agency filed 5,922 disciplinary actions, barred 1,766 investment professionals from the business, suspended 1,752 others, expelled 84 member firms and suspended 11 more.
The infractions committed by these financial representatives and their firms span a broad range, including misrepresenting investments, omitting facts, overtrading to generate commissions, unauthorized trading in client accounts, unsuitable recommendations, over-concentration in risky investments, breach of ethical duty and lack of management oversight.
The most serious offense includes running fraudulent investment schemes and outright theft. A few of the thieves and scammers that have been caught include:
- Tom Petters – claimed to finance the purchase of electronic goods that would be resold to big-box retailers. $4 billion in investor assets were stolen.
- Allen Stanford – fraudulently sold fake certificates of deposit (CDs) to investors seeking safe income. $8 billion in investor assets were stolen.
- Bernard Madoff – ran a fake investment and securities firm. He holds the record for the biggest Ponzi scheme in history, stealing an astonishing $50 billion.
Investment fraud is running rampant. The Wall Street Journal recently reported in Boomers Wearing Bull’s-Eyes that investment scams aimed at people over age 50 are on the rise. There were 3,475 enforcement actions taken by regulatory agencies during 2010, of which 1,241 were specifically targeted at seniors. This represents a 145 percent increase year-over-year. Most of these scams hooked their prey by promising high income with little or no risk.
It doesn’t take fraudulent activity for investors to lose their life savings. Under-diversification in legitimate investments has also wiped out the life-savings of many investors. This is caused by taking big bets on one or two companies that are often tied to an employer or former employer. Table 1 lists the six largest public bankruptcies since 2001.
Table 1: Largest Public Bankruptcies since 2001
Table 1 is a small sample of a huge bankruptcy number. There were thousands of business bankruptcies since 2001 that sent hundreds of billions of dollars up in smoke. The demise of these firms damaged the savings of millions of investors and devastated the lives and life-savings of countless long-time employees.
Finally, index investors were saved from countless terrible market calls made by so-called experts. Here is a sample of bad advice that torpedoed the savings of many people:
- Who can forget this famous book published in early 2000? Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market, was published by James K. Glassman and Kevin A. Hassett at the very peak of the market bubble. It was a period when people were mortgaging their homes to get into the stock market.
- Bob Brinker couldn’t have been more off the mark with his market prediction in late 2007. “The short-term correction that began in October and continued into November has served as a health-restoring pullback and has paved the way for new record highs in the S&P 500 index.” The S&P 500 collapsed 37 percent in 2008.
- Harry Dent published a book in early 2009 titled The Great Depression Ahead: How to Prosper in the Crash Following the Greatest Boom in History. His timing was terrible. The economy turned positive a couple of months later and stocks gained 100 percent within two years.
- Do you recall Jim Cramer pounding the table to buy Lehman Brothers in 2008? He called the company a "screaming buy” on September 5. Lehman went bankrupt 10 days later.
- Even Federal Reserve Chairman Ben Bernanke has a poor market timing record. On February 15, 2006, the Fed Chairman told Congress that "Housing markets are cooling a bit. Our expectation is that the decline in activity or the slowing in activity will be moderate, that house prices will probably continue to rise." Then, in early 2008, Bernanke told Congress, "The Federal Reserve is not currently forecasting a recession." Ouch!
Index investors do not attempt to beat the market, time market sectors, chase high returns, invest in too-good-to-be-true investments or pick people who say they can do these things. Accordingly, index investors avoided punishing market scams, devastating bankruptcies and terrible advice. A simple buy-and-hold strategy with occasional rebalancing works wonders for serious investors.
Critics say that indexing generates “average” returns and that investors can do better by picking the right investments at the right time. I agree. It is possible to beat the markets; it’s just not probable. Few people have done it consistently over the years, and it’s impossible to know who the winners will be in advance. What’s more likely is that an actively managed portfolio will result in a lower return, or no return, or perhaps a loss on invested capital.
Index investors are grateful because they have had a return of their money and on their money. We have not had to deal with financial fraud, bankruptcies and genuinely bad advice. By diversifying across the global stock and bond markets using index funds and ETFs — thus accepting market returns in all asset classes — we have been successful investors during a difficult period. For this, I am thankful.
I am also thankful for John C. Bogle, the founder of the Vanguard group and widely recognized as the father of index fund investing. He made this strategy possible for all investors. Mr. Bogle is 82 years old this year, and I wish him and his family good health in 2012 and beyond.