Why I’ve Given Up On Indexing

April 1, 2011

 

[Note: This post was an April Fool's joke!]

This potato is getting off the couch once and for all. That’s right: after several years of studying the art and science of index investing, I have decided that the strategy simply doesn’t work. As a result, I am in the process of liquidating my ETFs and index funds and switching back to an active strategy. I suggest you do the same.

This isn’t a decision I made lightly. But the more I have looked into it, the more I’ve become convinced that indexing is a loser’s game. Here’s why:

Index funds are for only for dumb people. I don’t mean to dismiss index investing out of hand. It’s fine for people who aren’t smart enough to beat the market, such as the fools who manage the UK national pension scheme and the half-wits who run CalPERS, the largest public pension fund in the US. Passively managed investments make sense for institutional investors, since they lack the time and expertise needed to pick stocks and make shrewd economic forecasts. But the strategy is not suited to retail investors, who are much more likely to beat the market thanks to sophisticated research tools such as Yahoo! Finance.

Diversification doesn’t work. The problem with a diversified index portfolio is that some asset classes always lag the winners. Besides, during the crash of 2008–09, everything went down together (except for the things that went up, like government bonds, gold and US dollars). You can earn far higher returns if you simply identify the winning asset classes ahead of time. For example, bond returns will be terrible forever and Canadian equities are clearly superior to the other 96% of the world market. There’s nothing wrong with putting all of your eggs in one basket—as long as you pick the right basket.

The market went nowhere for more than a decade. Today the S&P 500 index is about where it was in 1999. This is proof that index investors earned nothing over the last 12 years, because most of them put 100% of their portfolio in an S&P 500 index fund. Don’t listen to people who point out that this index includes only large-cap US stocks and ignores small and mid-sized companies and international markets, all of which did better than the S&P 500. It also doesn’t matter that the index measures only price increases while ignoring dividends. During the 25-year period ending in 2009, more than 85% of US equity funds underperformed Vanguard’s S&P 500 index fund, but that’s cherry-picking the data over only a quarter of a century.

Indexes contain both good and bad companies. The problem with indexes is that you get both good stocks and bad stocks. That’s like going to a restaurant and telling your server that you don’t care what ingredients go into the meal, as long as its edible. You’re much better off selecting the individual companies that will outperform. This is extremely easy to do: after all, well over 1% of professional fund managers in Canada did it during the last five years, and many of these trounced the index by several hundredths of a percent.

Nortel blew up. Here’s another reason why indexes are bad. In 2000, Nortel Networks made up a third of the S&P/TSX Composite Index. Of course, everyone knew that the company was overpriced — that’s why no professional money managers bought the stock. But sheep-like index investors had no choice but to hold it, and they lost money in 2001 and 2002. It’s true that most actively managed funds did even worse, and that broad-market index funds are now capped so no company can ever make up more than 10%. However, this decade-old example is still convincing proof that indexing doesn’t work.

Only the outcome matters. I know a father of four who didn’t buy life insurance when his children were young. During the next 20 years, he didn’t die, so he saved a bundle by not paying all those premiums. The lesson here is that it’s OK to take enormous risk, as long as you end up being right in the end. The same is true with investing: sure, taking big bets on a small number of companies in one or two sectors could devastate your portfolio. But if things work out, it proves that a more diversified approach would have been wrong.

Warren Buffett beats the market. Don’t let anyone tell you that you can’t beat the market over the long term. How else can you explain Warren Buffett? Anyone can invest like Buffett: all he does is pick value stocks based on a simple formula that you can learn from reading books. Just like you can learn to play hockey like Bobby Orr, it’s realistic to model your investment strategy after the world’s best and expect similar results. After all, the alternative is being average, and who would want to settle for that?

So wake up, you passive chumps. Get your head out of the sand and start listening to what the financial industry has been telling your for decades. Don’t be content with a strategy that will outperform 80% to 90% of professional managers: you can do much better than that.

Now let’s get out there and beat the market together.

{ 29 comments… read them below or add one }

brad April 1, 2011 at 7:07 am

Poisson d’avril!

Michel April 1, 2011 at 7:21 am

Right on, plus I hear that active mutual funds are lowering their MER by 80%! :)

Fox April 1, 2011 at 7:23 am

Dan,

I been following your blog forever and you written some great posts on Index Fund investing. I never got around to investing in some, now that’s neither here or there, but more so for personal reasons.

So now that you’ve officially given up on Index investing, where does the Canadian Couch Potatoe go from here? Where does the focus shift?

Truly, I (and I am sure tons of others who follow your blog) will hope you keep writing some great investing points, strategies and opinions. It’s like a new start, out with the old, in with the new.

Fox

Mike Holman April 1, 2011 at 7:34 am

Glad you finally opened your eyes, Dan!

I think you should rename the site – CanadianSwingTrading.com.

Sustainable PF April 1, 2011 at 8:52 am

While I don’t disagree this advice seems absolutely contrary to the purpose of your website. You will no longer be a couch potato if you become “active”.

Sustainable PF April 1, 2011 at 8:53 am

unless of course we’re waiting for an “April’s Fools” follow up post ;)

Jambo411 April 1, 2011 at 9:15 am

Ha Ha, good one.

DM April 1, 2011 at 9:28 am

I remember last year’s April 1 post and I was wondering if you would do the same this morning. It seems you’ve got a bit of a tradition going here Dan. I love the bit about the half wits at CalPERS.

Canadian Couch Potato April 1, 2011 at 10:10 am

@Fox and Sustainable PF: I may reconsider my decision over the weekend. :)

@DM: Glad you remember last year’s post. I got a few people with that one, too
http://canadiancouchpotato.com/2010/04/01/passive-aggressive-solutions-2/

Steve in Oakville April 1, 2011 at 10:12 am

My favourite part:

“You’re much better off selecting the individual companies that will outperform and weeding out the dogs. This is extremely easy to do: after all, well over 1% of professional fund managers in Canada did it during the last five years, and many of these trounced the index by several hundredths of a percent.”

I’m not nearly as creative with my April Fool’s jokes Dan – today I put celery root in my kids lunch bag (last year it was a whole onion).

Paul G. April 1, 2011 at 10:30 am

Nice one, but last years was better…. this year I caught on right from the start, last year it took me a couple of minutes.

Interesting to read, regardless :-)

Squawkfox (Kerry) April 1, 2011 at 10:46 am

Looking forward to your new model portfolios Dan! I hear that the funds with the highest MERs return the bestest results. :|

Canadian Couch Potato April 1, 2011 at 11:03 am

@Kerry: As you know, you get what you pay for. High MER = high quality management. You don’t get Fluevogs at the dollar store, do you?

Squawkfox (Kerry) April 1, 2011 at 11:19 am

I buy my Fluevogs lightly used on eBay. :) But you’re right, I need to up my game and pay full retail. The highest MERs deserve the highest heels. :D

Marie April 1, 2011 at 11:20 am

As one who loves sarcastic humor I thought this post was a great morning ‘gotcha’ laugh and a really jab at the mutual fund industry.

Thanks…and let’s all run out and buy some mutual funds today in hon0r of this post! As one commenter said they’re on sale (today only!)

Canadian Couch Potato April 1, 2011 at 12:29 pm

Come on down to Crazy Dan’s Mutual Funds for our massive blowout sale. We bought waaay too many mutual funds, and now everything must go!

Check out the Surging Emerging Markets Fund: the retail price was 2.7%, but I’ll let you steal it from me for just 1.7%. That’s right, 1.7%.

Looking for gold? Of course you are! Then check out the Crock of Bullion Precious Metals Fund at the unbelievable price of just 1.9% — plus applicable taxes and exorbitant trading expenses.

What are you waiting for?

Brian April 1, 2011 at 12:29 pm

Well put Dan. Glad you’ve finally come to your senses. Looking forward to reading your next series on stock picking strategies.

Canadian Capitalist April 1, 2011 at 12:44 pm

Why settle for average when you can do so much better? Great decision Dan.

Support Spy April 1, 2011 at 12:55 pm

I must admit you had me for about 2.5 seconds. This is a classic.

Michael James April 1, 2011 at 2:32 pm

You forgot the number 1 reason for giving up on indexing: I like Fortis!

Marie April 1, 2011 at 4:29 pm

Thanks for the Friday laughs everyone! Even money doesnt need to be so serious all the time..

Albert April 1, 2011 at 5:27 pm

You DEFINITELY had me…..great one !!!!

The Dividend Ninja April 2, 2011 at 12:26 pm

Great post Dan! Happy April Fools day to you as well :) I must admit you had me for a couple of seconds – brilliant. It just goes to show you can argue a case for anything.

MY biggest concern was having to do a third interview with you, after all the work we put into those first two interviews LOL. I like the sound of “Active Potato” it has a nice ring to it, sort of fitness oriented I think.

I’m sure you could ask Derek for some stock tips. But when you really DO give up indexing investing, you know all of us dividend investors are there to help you out! I’m looking forward to reading your future posts on”stock analysis of CCP.B” and “Dan’s Dividend Income for 2011″ :)

Bill Conner April 3, 2011 at 1:46 am

Actually it was a good one–anyone who accepts investment advice without question is a fool the rest of the year

Canadian Couch Potato April 3, 2011 at 11:55 am

Thanks to everyone for indulging my little joke. Back to business on Monday. :)

Teddi Knight April 3, 2011 at 11:40 pm

Thank goodness someone finally realizes that the couch potato portfolio is basically for those who want to, well be couch potatoes and really do nothing. I’ve tried everything from passive investing, ETF’s with monthly payments into them, full service broker, then financial planners and by and large I ended up with such little growth that I may as well have stayed in GICs. The best was when planners told me that as a woman, I couldn’t be expected to know how to invest. So I looked everywhere and finally found a mentor who taught me how to properly buy stocks and sell options against them. I learned about covered calls and naked puts and after 3 years of mentoring I have never looked back and finally no one is taking care of my money except myself. That was back in 1975! On average I have rarely earned less than 10% a year and many years a lot more. I set my goal at 12% annual and while the market may go nowhere for 10 years I have no concerns. When it crashes, even better as stocks are then on sale. In 2009 I created my own site fullyinformed.com to possibly show other investors (hopefully some women) that you can learn how to invest. I have quite a few of my trades on my website and my strategies. I believe it is worth learning how to handle your own finances and stop paying large commissions and planner fees. Just my two cents Teddi Knight

gibor April 4, 2011 at 12:57 am

Dan, what is your opinion on Horizons AlphaPro Enhanced Income Equity ETF (HEX) ?

Canadian Couch Potato April 4, 2011 at 12:10 pm

@gibor: Sorry, I haven’t looked into this fund and don’t know anything about it.

Open source portfolio April 8, 2011 at 1:41 pm

Ha, I’m reading this a little late so I didn’t realize it was april’s fools joke until later. You almost had me.

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