The Index Revolution & What It Means For You

When it comes to investing, a passive (or index) investment strategy makes sense for the majority of people. Here’s why even Charles D. Ellis thinks so.

As discussed in my March blog post, Index Funds and Passive Fund Management: Understanding the Opportunity:

No one knows with certainty where the market is headed on a daily, monthly, or yearly basis, and while you can always find an example of an active investment manager who beat the market for a year or two, it’s nearly impossible to find evidence of any manager doing so on a consistent basis over the decades of time that most people invest.

I recently read The Index Revolution by Charles D. Ellis, a well-known investor who is widely respected for his success in institutional finance. He has authored 16 books and over 100 articles on investing strategies. The Index Revolution offers numerous reasons why Index investing is the best approach, here are three reasons that stood out to me that I wanted to share:

1.      The Stock Markets of the World Have Changed

In Chapter 2, Ellis walks readers through how the World has changed over the last fifty years, especially the stock market. He cites two important facts that impact investors today. The first is the increase in trading volume and the second is who does the actual trading. 

Ellis observes that, “Trading Volume on the NYSE has gone from 3 million per day to 5 billion, a change in volume over 1500 times.” He also points out that, “Individual investors did over 90 percent of all NYSE trading 50 years ago. Today institutional trading is over 98 percent. The fifty most active of these professionals do 50 percent of all NYSE trading and spend $100,000,000 annually in fees and commission buying information services from the global securities industry.”

What Does This Mean?

Firstly, the increase in trading volume over the last five decades means that the markets are much more efficient, which reduces arbitrage opportunities (the simultaneous purchase and sale of an asset to profit from a difference in the price). This more buyers and sellers of anything, the less chance for a large mispricing.

Secondly, it means that no one has an elite inside track on the market. Remember, no one can see into the future and predict the market. Therefore, if a local investment firm in your town claims to have a superior investment process and an ability to outperform the market by picking individual stocks, know that they are wrong. The data supports that the bigger and better-funded players will continue to dominate the market. 

2.      Indexing Outperforms Active Management

The investment pool has gone global and it’s filled with highly trained sharks. There is no shortage of investor talent, smart individuals who understand the market and know how to play the game. Ellis surmises as much when he claims, “History’s largest, most capable, best informed and most highly competitive professional investors dominate today’s stock market. So almost no one can expect to outperform the others regularly after cost and fees.” 

What does this mean?

For you and other investors, it means that a passive investing approach that tracks the market instead of active management that attempts to beat the market is a smart opportunity. It allows regular people, who aren’t investing experts, to participate in investing strategies created by the experts.

Think about it. Because investing is a global game with an abundance of talent, the firms of today are so skilled that their collective abilities are reducing the possible gains. The average investor doesn’t necessarily have the time or expertise to compete at the elite level, but there is still opportunity to gain the market return with indexing. 

3.      You Have Much Better Things to Do with Your Time

The last point the Ellis mentions in his book that I want to be sure to highlight is the reality that most people have other priorities for their time that don’t include active investing.  Ellis reinforces what we all already know. Chasing performance is not only a waste of your monetary resources, but it’s a giant waste of your time, too.

Indexing, or passive investing, is a way for today’s investor to participate in the market without the high expense of your time and money. To prepare for your future and to save toward retirement doesn’t have to be complicated, expensive, or all-consuming. Ellis, a famous institutional investor, takes an entire book to make the case for indexing. If he sees it as a smart opportunity, you know there has to be something to it.

Ellis admits:

Fifty years ago, I thought it was realistic to expect that an experienced team of portfolio managers would ‘beat the market.’ But over a half-century, it has become virtually impossible for all but a very few investment organizations to outperform the market after fees and costs over the long-term future. […] The past 10 years have accumulated undeniable evidence that almost all investors would do better to rely on indexing for their investment operations and concentrate their time and talent on tailoring investment policies to achieve their own specific objectives.

So, as you consider your own investment strategy, ask yourself these three important questions:

·         Are your investments tailored to your own specific objectives?

·         Is your money focused on your goals and things you can control?

·         Are you paying too much in time and resources to be invested in the market in the first place?

 

If your answer is yes to any one of these important questions, then it may be time to pause and reconsider how you’re investing. Remember, while no one can predict the market, everyone can control how their money is deployed in the stock market. How you invest can make all the difference, no only in your financial future, but your overall quality of life today and in retirement. The choice is yours. What do you decide?