Tag Archives: indexing

How Behavioural Biases Stopped Me from Becoming an Indexer

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We’re delighted to run the first of what we hope will be many contributions from the popular Boomer & Echo blog.  The topic is something I suspect many investors can relate to if they have an intellectual understanding of the powerful reason for indexing but are unable to fully commit to it because of the behavioural biases Robb Engen so eloquently describes. Robb is the “Echo” part of Boomer & Echo and you can read all about him here.  The piece originally ran in September. Link to the original is below.

robb-engenBy Robb Engen, Boomer & Echo

Special to the Financial Independence Hub

I’ve spent the last five years convincing myself – and many of you – that I’m a sophisticated do-it-yourself investor with a sound strategy that will outperform the market over the long run.

My dividend growth investment approach has indeed performed well, returning over 16% per year since 2009. But the stock market in general has also been red hot over that time. It’ll take another bear market cycle to determine whether my investment returns were skill, luck, or something in between.

In the meantime, since launching our fee-only planning business earlier this year, I’ve been recommending a couch potato investment approach to anyone who’ll listen. I truly believe that 99% of investors would be better off indexing their portfolio with three or four low cost, broadly diversified ETFs.

Related: Why investors should embrace simple solutions

So lately I’ve started to wonder, what makes my situation so special? Why stick with a strategy that I don’t even recommend to my clients?

The answer lies in a whole bunch of hidden behavioural biases that cloud my judgement – framing, recency bias, home country bias, and overconfidence.

Framing

It’s difficult to part ways with a successful investing approach.  Selling a portfolio of winning stocks – my babies that I’ve nurtured through this five-year bull market – just doesn’t feel right. But if I were sitting on $100,000 in cash instead of stocks I’d have no problem starting a couch potato portfolio today.

Recency bias

As the bull market rages on and my investments continue to perform well, it gets harder and harder to recall what a bear market feels like and what I might do if my investment returns start to lag my benchmark.

Related: How are your investments performing?

This year my portfolio has trailed its benchmark by about one per cent – not huge, but enough to make me pause and reconsider my approach.

Home country bias

When I started my DIY portfolio, I bought the 10 highest yielding stocks on the TSX. While I’ve refined my stock-picking approach since then, I’ve stuck with Canadian dividend payers even though Canadian firms make up a tiny slice of the global economy.

Making matters worse, instead of keeping my Canadian dividend stocks in a TFSA or non-registered account, they’re held inside my RRSP. Not an optimal strategy when it comes to tax efficiency.

Overconfidence

It’s hard not to be overconfident when you’ve beaten your benchmark by a full 3% per year over the last five years. But even the best investors will eventually suffer periods of underperformance.

Related: 5 lessons learned about investing

Why wait for that to happen before accepting the inevitable? Indexing gives me the best chance of achieving my investment goals over the very long term.

No shame in becoming an indexer

Norm Rothery had a great piece in the Globe and Mail in mid-September about a DIY investor whose U.S. stock picks had under-performed the market by a good 3% per year since 2007. The investor decided to stop picking U.S. stocks and move to index funds instead – opting for Vanguard’s FTSE All-World ex Canada ETF (VXC) to get his U.S. exposure.

Rothery goes on to write:

Scott’s decision to stop picking U.S. stocks is an uncommon one. Most self-directed investors remain far too confident in their abilities for far too long. Instead, disappointing long-term results are often attributed to misfortune or peculiar circumstances rather than the lack of a competitive edge.

There is no shame in admitting that you’re not the next Warren Buffett. The vast majority of investors aren’t. Those who figure it out are likely to improve their returns dramatically by following simple low-cost mechanical methods such as investing in low-fee index funds.”

Speaking of Buffett, the ‘Oracle of Omaha’ has famously touted the benefits of a low cost, broadly diversified investment approach, saying that most investors would be better off in an index fund rather than trying to beat the market by picking stocks or actively managed mutual funds.

Final thoughts

The more I read about, write about, and teach others about investing, the more I’m convinced that passive investing is the right approach.

It’s not that I stopped believing in a dividend growth strategy – it’s a fine approach that many investors will have success with – but it’s not ideal for my RRSP.  And frankly, the time and effort needed to manage it properly may not be worth it in the long run.

I suspect it’s only a matter of time before I pull the trigger and become a full-fledged indexer.

Robb Engen is a fee-only planner and personal finance blogger at Boomer & Echo. He lives in Lethbridge, Alberta with his wife and two children.

This article  originally ran in September of this year.  Even if you read the Hub’s version above, it’s worth clicking through to the original to read the more than 60 comments appended to it.

Active managers suffer worst year in 30; indexing triumphs

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Joshua Brown; TheReformedBroker.com

As this article at Reformed Broker explained on Friday, Lipper data shows that active security selection is on track for its worst performance in 30 years, with 85% of stock-picking fund managers failing to beat their respective indexes. Brown sums up the gap between promise and the reality of fund managers pithily:

“They cannot do what they profess to do on a consistent enough basis to justify the extra trading costs, management fees or tax ramifications.”

Coupled with all the press over the failings of actively managed mutual funds and the cost and tax-advantages of exchange-traded funds (ETFs), and lately ETF-based “robo-adviser” services, it appears the message is finally getting through to ordinary investors. Consider these sales numbers published by Reuters:

“Through Oct. 31, index stock funds and exchange traded funds have pulled in $206.2 billion in net deposits. Actively managed funds, a much larger universe, took in a much smaller $35.6 billion, sharply down from the $162 billion taken in during 2013, their first year of net inflows since 2007…”

Brown suggests active managers need to cut their fees in half (and he’s talking about the U.S., where fees are already lower than their Canadian equivalents).

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WSJ’s Jason Zweig

But let’s give the final word to the Wall Street Journal’s eminent personal finance columnist, Jason Zweig. The headline says it all: Stock indexing racks up another triumphant year.

Picking up on the Thanksgiving theme, Zweig begins by nothing “It’s been another turkey of a year for active stock-pickers.” He notes that the decline is even worse than three months earlier, when he wrote this:

” … active fund management is outmoded, and a lot of stock pickers are going to have to find something else to do for a living.”

However, taking a balanced approach to the issue, Zweig notes that these things go in cycles and there will be times when active managers have their time in the sun and indexing lags.  He concludes:

” … most stock pickers are still likely to underperform a comparable index fund over time. But they aren’t going to look quite this bad all the time.”

 

Are there really no “pure” index investors?

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A Reuters article I tweeted this morning bears the intriguing title (and assertion) that “There are no pure index investors.”

The key passage is this one:

The big lie about being an index investor, however, is that it is possible to be one in a pure sense, as opposed to an investor who uses indexing as a tool. There are no pure indexers: everyone, like it or not, is an asset allocator, or asset picker if you prefer.

As I noted here last week in Core & Expore Redux, I certainly agree there are very few “pure” indexing investors, whether they use index mutual funds or ETFs (exchange-traded funds). Even if average retail investors “get” the idea of low-cost passive asset-class investing, most of them still tend to mix it up with both indexing and individual securities. This is a strategy called “Core and Explore.” Preet Banerjee wrote an excellent story on this last year in MoneySense magazine.

There are pure indexing purists and pundits

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Spot the indexer: Dan Solin or Jim Cramer (Huffington Post)

However, as I also said at the Motley Fool — Is it Possible to Successfully Blend Stock-Picking and Indexing? — I think there are many indexing “purists” among some financial advisers who “get it.”  These tend to be authors and/or pundits who are committed to indexing as a consistent philosophy.  Here I’m thinking of authors like Dan Solin or Andrew Hallam, who articulate their philosophies in such books as Solin’s The Smartest Money Book You’ll Ever Read (and others in his “Smartest” series) or Hallam’s Millionaire Teacher. In his book and articles, including one at MoneySense, Hallam memorably describes how he weaned himself off such futile activities as market timing and stock-picking.

Even Jim Cramer says some should index

I find it amusing that even Jim Cramer in his daily Mad Money TV show — he’s the epitome of the belief in stock-picking and the antithesis of Solin — tells viewers who have neither the time nor the energy to pick stocks that they should just stick with an S&P 500 index fund or ETF.

The Reuters piece also touches on a point that has long intrigued me: a global one-stop portfolio, which it describes “only as an idea.” I have long asked the question why the mutual fund industry’s much-ballyhooed “Global Balanced Funds” would not be the only fund you’d need?

Will robo-advisers succeed where global balanced funds did not?

In theory, such one-stop-shopping funds should do what the newer robo-advisers are doing: provide access to all asset classes and securities around the world, with the fund managers (likely co-managers entrusted with equity and fixed income responsibilities) making all the asset allocation decisions and rebalancing.

But show me just one investor anywhere in the world whose only investment is a single global balanced fund. Never mind that their fees are typically going to be high for investors, I’ve seldom seen even the fund companies with big marketing budgets spend even a fraction on advertising the alleged benefits of such one-stop solutions.

Talk about a black swan, finding an individual who puts 100% of their wealth in a single global balanced fund would be a rarer event than locating a pure indexer. If you do know of one, by all means email me at jonathan@findependenceday.com and I will definitely highlight the fact here at the Financial Independence Hub.

It’s still early innings for the robo advisers but I do think we will soon find investors who hand over all their wealth to one of these firms and that these will be the first instances of (the equivalent of) a global balanced fund.

 

 

Core & Explore Redux

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MotleyFoolMotley Fool Canada just posted my latest blog for them, which addresses the question of whether it’s possible to combine indexing (“Core”) and high-conviction stock-picking or the judicious choice of certain sector ETFs. (“Explore.”)

As I note in the piece, this is a followup to Preet Banerjee’s feature story on this topic last year in MoneySense. It also features a nod to MoneySense stock-picking guru Norm Rothery, who also writes for the Globe and Mail, and publishes his own Stingy Investor newsletter.

Strange Bedfellows

I’ve commented before in the editor’s note at MoneySense that Norm is a strange bedfellow to indexing guru Dan Bortolotti, who runs the Canadian Couch Potato blog. It was Dan along with his colleague Justin Bender at PWL Capital who I was thinking of when in the Motley Fool post I referred to “indexing purists” who generally scoff at the notion of poisoning the purity of indexing with such an unsavoury activity as picking stocks. Another indexing purist I had in mind was Mike Bayer at Burgeonvest Bick. You can can find Dan, Justin and Mike all listed at the “Getting Help” section here at the Hub.

And yet when at MoneySense we got reader feedback to Preet’s story, it seemed that more often than not in the real world of actual investing behaviour, fairly sophisticated do-it-yourself investors often engaged in a blend of stock- or sector-ETF picking and traditional “Core” use of low-cost broadly diversified ETFs. (What Vanguard founder John Bogle recommends and no doubt the Bogleheads discussion forums.)

Foolish or foolish?

As I asked at the end of the piece for the Fool, do you think Core & Explore is a foolish practice (that’s with a lower-case f, so a bad thing) or a Foolish thing (that’s with an upper case F in FoolLand and therefore a good thing)?

Please email me at jonathan@findependenceday.com and we’ll do a followup piece on this, either here or for another media outlet, or probably both.