Mar 27, 2023

My Move Out of Index Funds

I have struggled for years with the logic behind both asset allocation models and indexing, two tenets of modern investing, ideas I’ve used most of my investing life. Unfortunately.          

I recently posted my arguments against asset allocations. My frustration has been that asset allocation eventually got me to invest almost half of my wife’s and my life savings in bonds that historically barely keep up with inflation, and then in 2022 lost over 13% of their value. I’m already moving away from that model.

My next move is away from index funds. The very reasonable argument for index funds is that they may be your best bet for investing in equities rather than trying to “beat the market” by owning individual stocks. I agree that the easiest way to win in the stock market is owning low-cost index funds. A reasonable person can establish an allocation formula for their equities, for example, 70% of stocks in the US and 30% international, balance back to this allocation every year or two, and do little else for decades. It works and I highly recommend it.

But I have a major issue with index funds. By their design, when you buy an index fund, you are overallocating to overpriced stocks, and underallocating to underpriced stocks.  What is overpriced and what is underpriced is subject to great debate, a debate index funds settle by declaring nothing is ever over or underpriced, a tenet of indexing, and that the best estimate of what a stock is worth today is what it is selling for today.

I disagree with this. Stocks often get overvalued and undervalued by almost any valuation measures. Great examples are the Dot-Com Bubble of 2000 and the Great Recession of 2008. But what the intrinsic value of a stock is at any given time is an endless and emotional discussion, a little like religion, and it won’t get settled here.

Let’s just say that I don’t buy this argument that stocks always trade at a price that best represents the value of that company at that time. A live example (and there are endless more) is Tesla. It recently had more market value than the market value of all other automobile manufacturers in the world combined.

Read that last sentence again slowly. No rocket science or deep financial analysis is required to recognize that this is either an overpriced stock in the long term, or all other automobile manufacturers in the world are collectively underpriced.

During 2022, from high to low, Tesla lost over 70% of its value without any significant change in the company. That’s how much variation there can exist in a stock that supposedly is trading at its fair value. And my bet is that at its low, it’s still way overpriced.

The most basic investing maxim that I learned in high school is that you should buy low and sell high. But indexes, by their design, buy high and sell low. It’s not intentional but it is part of their design, a design that is simple and easy, but causes other problems. An index fund mimics the composition and performance of a financial market index, such as the S&P 500 index.

So if in early 2022 you bought an index fund that tracts the S&P 500 index, you are overallocating your money into many overpriced stocks like Tesla, and underallocating your money away from many underpriced stocks, the opposite of what one should do.

There are other advantages to owning individual stocks besides this issue of index funds overbuying overpriced stocks. Although it is easy to find low-cost, low-turn index stock funds, stocks have even lower fees. Many brokerage firms have zero fees for their accounts and zero fees for buying and selling stocks.

So by owning stocks you can reduce any fees to zero sans spreads. If you then hold your stocks for long periods, real fees approach zero. You can have your entire life savings maintained online for years, with full access to the firm’s tools and services, and never pay a fee, directly or indirectly. How these firms make a profit is another discussion.

The arguments against owning individual stocks are many and valid. It takes a lot of time. It requires research and knowledge, although not necessarily any special cognitive skills. The best argument against it comes from Daniel Kahneman, the author of “Thinking, Fast and Slow.” He convincingly suggests that people have too much confidence in human judgment, specifically with forecasting.

His research on stock picking, a form of forecasting, shows overwhelming evidence that professional stock pickers have awful track records doing what they’re purportedly paid to do. It supports his claim that human are terrible forecasters, whether it’s stocks or anything else requiring a long-term view.

Finally, one more strong argument against owning individual stocks is that most money in the stock market is made in very few stocks. Therefore, regardless of one’s skills, the chances of hitting on these few stocks is slim, no matter how good one might be at their trade, and success mostly comes down to luck. And the best way to counter luck is to own all the stocks in a low-cost index fund.

Acknowledging these challenges, people have endless ways to try to make money in the market. I’ve already mentioned buying underpriced stocks and selling them when they return to their intrinsic value or higher. There are strategies for out-smarting other bad investors, such as the ones who bought Tesla in the last several years. These approaches are sometimes known as the “bigger fool,” assuming there will always be people willing to pay yet more for an already overpriced item.

Timing and technical exercises are endless, including the Santa rally and the "sell in May and go away" theory that tries to beat the historical underperformance of stocks from May-October. Apparently, there’s an argument for buying and selling anything based only on the day of the week or even the time of day. And technical analyses are endless, a little like reading tea leaves.

Most have some merit and for sure, someone has always made money doing all of them, which countless articles give undue attention to.

I bought my first stock while in college, Niagara Mohawk Power, a utility that still operates, now owned by a British utility. My next purchase was Manville Corporation, the manufacturer of asbestos-containing building products. That ended badly. I bought some stocks during the Dot-Com Bubble. They ended like most of the market. Ditto the Great Recession.

I mostly learned what’s often stated: It’s hard to beat indexes. I purchased stocks with full confidence they would rise quickly. But it was based on a lot of emotion and little information.

I never quit, probably for the reasons many buy stocks. It’s a little like gambling but with a far better chance of success. I’ve continued to entertain myself, randomly buying stocks based on various valuation theories, and then holding them as long as I can stand it. Since the Great Recession, I’ve usually had about a third of our equities in individual stocks, about as much as I could tolerate. I’ve had some disasters (e.g., Peabody Coal), some close calls and some wins, most notably Ford Motor that I bought during the Great Recession fire sale.

How have I done with these stocks? It’s hard to say because it’s hard to know what I would have owned if I hadn’t purchased them. And for various reasons, it’s hard to make an apples to apples comparison with comparable index funds I’ve had. For example, my 401(k)s have normally been funded by bimonthly purchases from my salary, commonly known as dollar-cost averaging. My stocks are purchased randomly. Comparing collective returns is difficult.

But as part of my look through the carnage of 2022, I noticed that my individual stocks dropped about half of what the S&P 500 did. Again, comparisons are hard because I own some international stocks and funds.

So I looked a little further and found that over the past many years, my individual stocks have performed nearly twice as well as my index funds have. Further, it held true for most of these calendar years. A look further back has more mixed results but in total, since the peak before the Great Recession to today, my individual stocks have performed significantly better than my index funds.

I considered whether I got lucky. So I looked at returns over several periods excluding the best and worst stocks. The middle ground held about the same as the extremes.

I’ve searched returns for a single year across the entire S&P 500 and contrary to what I’ve read, I don’t find it true that the vast majority of returns come from a very small handful of stocks. These winners make a lot of press, but that’s not the only place money is made. And it’s also where a lot of money is lost.

I did a backtest of what would have happened the past ten years if I had had all of our money in only the same stocks I owned at the time. That is, what would have had happened if I had not owned any stock funds or bonds. Again, it’s a mixed picture – higher volatility but the returns are significantly higher than what I experienced, and in only one year would our total portfolio value have dropped lower than what we actually experienced with our mix of bonds, index funds and stocks.

Another common mistake investors make is focusing on market extremes, the rises or falls from recent highs and lows, rather than long-term returns. For example, the S&P 500 dropped 56% high to low in the Great Recession. But if you limit your analysis to 12-month or other longer term views, the extremes are much less. So when I look through returns, I normally only look by calendar year, or other long periods. This removes so much of the noise that causes such emotion. These short-term variations don’t have nearly the actual impact to your portfolio that your emotions respond to.

Which brings me back to the same place. There is a high price for higher stability, and if one can ignore the noise, there is significantly more money to be made owning individual stocks than there is in either stock index funds or in bonds. As an aside, this is one of the reasons (along with paying their own salaries) that professionals struggle to do well – their clients respond quickly to this noise forcing them to respond accordingly, too, which often includes selling underpriced stocks.

This is where I’ve been stuck for years. I don’t trust indexes and I don’t trust professionals, but I’m never confident that I or anyone can pick stocks well. But there’s little evidence that my stock picking is any worse than index funds. And in fact, I’m reasonably confident that beating the indexes isn’t that hard, which has always been my theory.

To use stocks as long-term investments, I generally rely on three well-known factors: what the stock valuation is using some common metrics; the financial health of the company; and finally, some cautious consideration for what analysts might say about a company. I mostly ignore sentiment, inertia or any technical analysis, other common factors considered in selecting stocks.

Please note that I don’t trust analysts either. They have a Lake Wobegon tendency to rate most stocks above average. But they can highlight some issues. I trust their poor reviews more than their good reviews.

As for valuation, I try not to put much into a stock’s most recent numbers, and instead look closely at its last several years. In addition to profits, I also look at free cash flows and dividends. I also consider their book and enterprise values.

For a company’s financial health, I look at its return on equity, its margins and its liquidity, and very closely at its debt. It’s hard for a debt-free company to go bankrupt.

There’s no secrets to what I’m doing. This information is widely available online. And although it’s time-consuming, it’s not nearly as complicated as it sounds. My usual procedure for buying a stock is to first use various ways to come up with a large number of stocks that I may be interested in, whether something I hear about or see on a list.

However I get there, if I like what I’m seeing, I chase down several pieces of information on the company, and then score it across a half-dozen measures. The scoring is to help contain my emotions, which like most humans are terrible at predicting where a stock price may go. If it all adds up to a good score, then I’m serious about buying it, which I still may or may not do.

Most of my life, whether investing or anything else that requires time and work, I’ve leaned heavily towards the law of parsimony, a principle that recommends searching for explanations constructed with the smallest set of elements. Although my stock analysis can seem a little overwhelming, I suspect one could probably come to the same decisions with half of the information I use. Maybe debt, margins, dividends, and price to cash and earnings, with a look at any warnings from analysts.

I painfully hold to stocks I own whether they’re doing well or poorly. I consider selling when the same analysis doesn’t add up to buying a stock. But even then, I still give it some time. And time is one of many tricks I use to keeping my emotions out of these decisions. My default is to do nothing.

Yes, I miss out on Google and Apple and Netflix. But I also missed out on Tesla last year. Cummins, Emcor, Ryder, Amgen and Teck aren’t nearly as interesting, but I trust them a lot more. Index funds trust overpriced stocks much more than I do.

How far will I stray from index funds? I don’t know. I don’t make fast moves. After combing through scores of stocks over several weeks, I recently made a couple of new stock purchases. As I normally do, they’re a broad mix across sectors, capitalizations, and value and growth.

And that may be all I do for a while as I wait, watching what happens with the recession “everyone” is predicting. If I do beat the market, doing little or nothing will get me closer to where I want to be. If I’m wrong, I’ll find myself making some changes. And confessing my mistakes to you.