Index Funds Are the “Right” Way to Invest…Maybe?? (S3 E3)

Transcript

Proponents of index funds are often steadfast in their belief that investing in low-cost, passively-managed index funds is the, quote, unquote, right way to invest. Now don’t worry, I’m not about to say this statement is totally misguided and ask you to start drinking the active management Kool-Aid. Anyone who knows me knows I love to play devil’s advocate when someone is sure they are right about something. So this episode will provide a couple examples that may help you recognize there are situations where index funds might not be the best option for all of your investment dollars.

Welcome to the third season of Invested Poorly: Sad Tales of FInancial Fails, now part of the Bold Departure Network. Invested Poorly is a short-form podcast designed to help everyday investors make wiser investment decisions by learning what NOT to do with their money. Host Jeff Harrell shares timeless stories from his former life as a financial advisor, about the poor—and irrational—choices he witnessed investors make that disrupted their journey to financial independence, or FI. Your ability to recognize, and avoid, similar mistakes could make all the difference for you along your path to reach FI.

Check out the “Introduction” episode for more background on Jeff, why he created this podcast, and how it can guide you to becoming the hero of your own investing story. Now, on with the show.

Before I begin, I want to make sure all my listeners understand that I do believe index funds are the most appropriate investment vehicle for the majority of investors out there. They have so many benefits from low fees to simplicity to liquidity, they flat out just work. But, given my experience in the financial services industry for more than two decades, I can point to a couple of situations where index funds would have resulted in an inferior outcome.

The first example I’d like to discuss pertains mostly to young investors. When you are just getting started with investing, you usually don’t have a lot of money. Your future savings potential typically dwarfs your current net worth, so in the early stages of investing it almost doesn’t matter what you invest in because the dollar amounts are so small. Whether you make a 10% or 100% return, or even lose 50%, in your early years it is almost meaningless.

Thus, my advice during this period is to consider speculating on some individual stocks, if, and let me emphasize that again, if, you want to. The reason I say this is because when I was a financial advisor, reviewing prospective client portfolios, the only time I ever truly believed someone had materially outperformed a passive index like the S&P 500 over a long period of time was when they had a huge position in a stock like Apple or Microsoft. I’m not saying this happened a lot, but it wasn’t totally uncommon to come across an investor with 25% or more of their portfolio in a single stock. And in nearly every situation, the reason wasn’t because that was their intention from day one, but instead the result of massive appreciation.

Think about it. If you buy 10 individual stocks when you are in your 20s, and 9 of them go bust, but the one that doesn’t turns out to be the next Apple or Microsoft, you won’t even remember the names of those other 9 stocks. This is because the most you can lose on a single stock investment is 100%, but the upside is unlimited. So if you are thinking of speculating with a little bit of your money, especially if you are young, I wouldn’t talk you out of it.

My next example of where an alternative strategy to index funds might be worth considering comes from my own experiences over my portfolio management career. When I started out as a portfolio manager, I was managing a stock portfolio for our clients. I was picking stocks the way most investors do, using all kinds of fundamental analysis to create the portfolio. Over the first year or two we had ups and downs, but I’ll never forget, at some point the portfolio dropped sharply while at the same time the S&P 500 had only experienced a mild decline.

I can’t remember exactly what happened, but I figured out the reason the portfolio took such a huge hit was because I had a disproportionate amount of the investments in a single sector. The revelation I had after this occurred was to recognize that when building a portfolio of individual stocks, the exposure to the sectors is more important than the actual stocks you own.

After this happened, I completely changed the way I was managing the portfolio. I began using what is referred to as a sector neutral strategy. Since my benchmark was the S&P 500, I first identified what the sector allocations of the S&P 500 were by percentage, and I then created a portfolio to match this. I targeted each stock to be around 2-4% of the portfolio. Thus, the number of stocks in each sector was not my decision, but instead resulted from the weightings of the sectors within the S&P 500.

The final step in the process was to look within each sector and identify different sub-industries to make sure I was diversified within each sector. For example, within the healthcare sector, you have drug manufacturers, medical device makers, biotechnology, etc. Within the technology sector, you have software companies, semiconductor manufacturers, electronics companies, etc.

After identifying the main sub-industries within each sector, I would then usually pick just one company within each sub-industry. How you pick the stock within these sub-industries is up to you, but what I can tell you from experience is that this is actually the least important decision in the entire process. The reason is because stocks within the same sub-industries tend to be somewhat correlated to one another. Obviously, you will pick some good ones and some bad ones, but my experience was that using this relatively simple approach to building a portfolio resulted in an overall return that was typically close to that of the S&P 500.

So, that is how I got started, but the other factor I added to my security selection process was to eliminate sectors that were historically poor performers. Some examples include industries like traditional airlines and car manufacturers, grocery stores, mining companies, brick and mortar retailers. While obviously I could have been wrong about those industries, the fact is there are some industries that just don’t have great growth prospects and are stuck with massive competition and low margins. My theory was, I’d rather own the second or third best company in a thriving industry than the best company in a stagnate or declining industry.

As for the results, I’ve kept track of my personal returns for more than a decade and I’ve outperformed the S&P 500 by nearly 2 percentage points annually since I changed to a sector neutral strategy. I like to think the outperformance came not from picking the right stocks, but by avoiding the wrong ones. Maybe it’s just me, but I think avoiding the bad stocks is much easier than picking the good ones. However, it’s not just the performance that has served me well over the years. There are some real benefits of owning individual stocks versus a passively managed index mutual fund or ETF.

One of the biggest advantages of owning individual stocks is that it allows you to strategically donate highly appreciated securities to charities. The benefits of this strategy are multifaceted and if you are unaware of just how powerful donating appreciated stock can be, take my inquisitive little nephew’s advice and “search it up.” You will find plenty of articles on the topic and you will also stumble across information about the use of a donor advised fund, also called a charitable gift account. I don’t have time in this episode to discuss how these work, but if you donate any meaningful amount of money to charity and you have a couple of stocks with significant unrealized capital gains, this is definitely a strategy you need to look into.

Another benefit of owning individual stocks is the ability to perform tax loss, or tax gain, harvesting. These strategies involve reviewing your personal tax situation annually and identifying potential adjustments to your stock portfolio, to optimize unrealized gains or losses. You can search up these strategies to see how they might be incorporated into your situation.

The point I hope I’ve made by now is that owning individual stocks can be more beneficial than owning index funds, but if it comes at the expense of underperformance, it probably isn’t worth it. The sector neutral strategy I discussed earlier, combined with donating highly appreciated stocks and strategically using tax gain and tax loss harvesting has made my personal stock portfolio a flat-out homerun over the years. So, if you are looking for something a little more sophisticated than index funds, but still recognize the power of them, maybe I’ve given you something to consider.

Okay, my final challenge to index funds is my complete lack of desire to use them for my fixed income investments. Again, I will always tell people that if you want to keep things easy by picking a simple stock to bond allocation and adjusting it based on your stage of life and risk tolerance, using 100% index funds is awesome. It keeps everything straightforward, and it works as long as you can prevent yourself from making emotional decisions when fear or greed creeps in.

With that said, personally, I don’t want to touch a bond index with a ten-foot pole. My logic goes like this: index funds just make sense when it comes to stocks. Think about it, as companies get bigger and better, their value goes up. So with respect to stocks, it makes sense to use market cap-weighted index funds because this forces you to have larger positions in the biggest companies in the world.

But, when it comes to bonds, I’m not sure you really want the same thing. Bond index funds essentially work the same way, which is to say they own the entire market based on how much debt issuers have outstanding. Think about that. Do you really want your biggest bond allocations to be the companies with the most debt? It doesn’t make sense the same way it does for stocks. I always had a problem with this idea, which is why throughout my career I never used index funds for our bond investments. Instead, we used a handful of actively managed bond funds and we were very successful over the years.

I can only offer you my personal experience as evidence. The first decade of my career we used actively managed stock funds and rarely would we hold on to them for more than two or three years due to frustrating performance. But, things were different on the bond side. During my career, which to remind you spanned over two decades, I only had to sell out of two bond funds due to performance.

Now, maybe I was just lucky, but my experience suggests that identifying a good bond manager was much easier than a stock manager. The reason, in my opinion, is because bonds are ultimately math, whereas stocks are more about popularity. At the end of the day, there is nothing that forces a stock to go up or down other than supply and demand. This is why no matter what price a stock is trading at, you can find investors on both sides telling you it is over- or undervalued.

Bonds, on the other hand, have a mathematical component to them in terms of a maturity date that forces a price change over time. This episode is already a long one, so if you want to go further down the bond rabbit hole, be sure to check out Episodes 4 and 5 of Season 3. If you think I was fired up in this episode, just wait to hear my conviction get even stronger.

Index funds may be one of the greatest products ever created within the financial services industry. I’m a firm believer in that. Anyone who uses them is doing a great job in my view. But, if you are looking for something that might complement index funds as a portion of your overall investment portfolio, hopefully this episode gave you some food for thought.

I sure hope you enjoyed this episode of Invested Poorly and will be able to take something from it to improve your decision making as you navigate the twists and turns of your personal investing adventure. Be sure to check out my website at AreYouFI.com (that’s A R E Y O U F I dot com) where you can find resources and show notes with the charts and graphs I mention during the episodes. These are like little treasure maps that can help you choose more wisely along your quest to reach FI, or financial independence.

Never forget, in the short-term the stock market is unpredictable, and as my mischievous little nephew likes to say, “things just happen!” So focus on the long-term, by controlling your emotions, simplify your investments, and always… ignore the noise.

I’m your host, Jeff Harrell. Thanks for listening.

Invested Poorly: Sad Tales of FInancial Fails was created for informational purposes only and should not be relied on for specific tax, legal, or investment advice. You should consider consulting a qualified professional to review your situation before engaging in any transactions. Investing involves risk, including loss of principal and past performance is no guarantee of future results.

This podcast was produced by Ted Cragg. Learn more about creating podcast mini-series like this by visiting QuickEditPodcasts.com.