U.S. Markets closed

Indexing: "the worst way to invest, except for all the others"

Aaron Task
Editor in Chief
Daily Ticker
Indexing: "the worst way to invest, except for all the others"

Investing in index funds vs. individual securities is the best bet for individual investors, according to academic studies and nearly all responsible market pundits. And yet, our recent discussion on the subject touched a nerve with viewers.

"I found 65 actively managed funds that returned better than the 10.8% annual return since inception that have been around longer than Vanguard S&P 500 (VFINX)," writes Louis. "EVERY SINGLE ONE OF THEM is actively managed. There are many thousands of average & below average funds out there - but there are plenty of good choices. BEST BET: a diversified portfolio, with someone else paying attention, to make sure you not only get the best returns (which we're taught is the holy grail) but that we meet the financial goals we've set in the time frame we choose."

Related: Have Index Funds Become Too Popular?

Phil Pearlman, Yahoo Finance's interactive editor and a former hedge fund trader, joined me and Henry Blodget for part two of the discussion.

Paraphrasing Winston Churchill's famous comment about democracy, Pearlman describes indexing as "the worst form of retirement investing except for all the others.”

The big flaw in index investing, he says, is that it does not solve for human nature.

"It doesn't matter how someone’s portfolio is configured, when the market is tanking and when the pain is severe, it is precisely the time people are going to behave irrationally and do the stupidest things possible with their money," Pearlman says. "This is the behavioral manifestation of  loss aversion and it is normal, universal and biologically based. People hate to lose more than they enjoy being right or making money."

For example, the huge flows into bond and gold funds in reaction to the 2008 crisis -- and flows out of equity funds -- demonstrate that retail investors continue to "chase" performance and let emotions drive investing decisions. They also serve as reminders of the benefits of diversification; many investors burned by the 2008 debacle in equities rushed to the perceived "safety" of bonds and gold, only to miss out on the historic rebound in stocks. Many of those investors are now realizing that you can lose with bonds and precious metals -- as with any asset class. 

In addition to preventing us from buying high and selling low, Pearlman notes indexing doesn't address:

Timing: It's very easy for us to give the 'just index' advice AFTER the SPX has risen 175% in the past five years, he writes. But if you were giving that advice five years ago, a good time for it, you'd have been booed out of the stadium. And, if you would had given it in 2000 or 2007, those who listened would've gotten killed.

Expertise: Many people have a bit of alpha in them but they don't take advantage of it. If you are a doctor or engineer or whatever, there are public companies in your field that you know more about than the majority of investors. If you are a nephrologist, for example, chances are you know more about Davita (DVA) than 99% of the managers do; the same is true for dentists and Dentsply (XRAY).

Other tactics that separate successful investors from the rest that aren't solved by indexing include:

  • Be (truly) diversified
  • Rebalance regularly to ensure you stay properly diversified
  • Ride your winners and sell your losers
  • Set stop-losses to prevent declines from mushrooming
  • Don't "marry" positions
  • Don't buy or sell stocks for tax purposes

Mike Santoli adds the following: The ability to ignore how his or her portfolio performs compared to some arbitrary market benchmark is the one great advantage individual investors have over professionals -- and one they too often surrender.

"Individuals consistently evidence regret and anxiety if they sell a stock or reduce equity exposure and the stock or the market goes up 'without them,'” he writes. "But for an investor content with his or her own risk exposure and equity holdings, this 'opportunity cost' is not a real cost, whereas for a professional underperforming an index equals 'career risk' and possible loss of livelihood. Take advantage of your ability to pick your spots and modulate risk levels independent of some idea of being proven 'right' or 'wrong' by subsequent market action."

With more than $3 trillion of assets in index funds, it's clear investors have learned the lesson that indexing is the best long-term solution for individual investors. The point here is that indexing isn't the only thing that matters and there are many lessons investors have yet to learn.

Aaron Task is the host of The Daily Ticker and Editor-in-Chief of Yahoo Finance. You can follow him on Twitter at @aarontask or email him at altask@yahoo.com