The Models Are Broken—But Indexing Still Works

If you’ve researched the theoretical foundations of index investing, you’ve no doubt come across Modern Portfolio Theory and the Efficient Markets Hypothesis. And if you read the commentaries of active money managers and the financial media, you’ve probably seen countless articles that dismiss both as obsolete. Modern Portfolio Theory is declared dead after every market crash, and all stock pickers, almost by definition, believe markets are not really efficient. Many of these critics think passive investing is folly—only the warm embrace of active management can protect you and your portfolio.

In his provocative book, Risk, Financial Markets & You, the Winnipeg-based financial advisor Alan Fustey adds his own criticisms of these two decades-old models. But his conclusion is surprising. When I interviewed him recently, I asked what investors should do if these models were broken. “Well, the first thing you do,” Fustey replied, “is you index.”

The background

Before going further, let’s review these two landmark financial theories, both of which revolutionized investing. Modern portfolio theory was devised in 1952 by Harry Markowitz, who later shared a Nobel Prize for his contribution. Markowitz showed that by combining risky assets that have less than perfect correlation, you can create a portfolio that has lower risk and a higher expected return than its individual components. Index investors understand this as the “free lunch” offered by diversification.

The efficient markets hypothesis was formulated by Eugene Fama in a 1970 paper. It suggests that security prices reflect all public information, and therefore analysis of individual companies does not allow investors to identify “mispriced” stocks. (Occasional mispricings probably exist, but they cannot be reliably exploited.) In an efficient market, buying an index fund is the best way to get market exposure at the lowest possible cost.

‘You’ve got to have a better alternative’

These two ideas are among the pillars of the Couch Potato strategy. But as Fustey explains in Chapter 4 of his book, both have some shortcomings. For example, he says, MPT presumes that asset class correlations remain constant, and that market returns follow a normal distribution (represented by a bell curve). We know neither of these assumptions is valid. He also points out that it is possible for some  participants to have an informational advantage, so capital markets are not truly efficient.

But if you think Fustey is building a case against passive investing, think again: he argues that indexing still offers investors their best chance of success. “It comes down to this,” he told me. “If you’re going to throw out these ideas, then you’ve got to have a better alternative. If you reject the efficient markets hypothesis, you’re saying that you have the ability to get superior information, and that you can make money from that knowledge. But that flies in the face of reality. Someone is always going to have better information than someone else, but are you going to be able to profit from that on an after-fee basis? I don’t think so—and the history of active management proves that.”

Book giveaway

Alan Fustey is a CFA and a portfolio manager at Index Wealth Management, a Winnipeg firm that also has offices in Calgary and Vancouver. I recently added the firm’s three offices to my Find an Advisor directory.

Alan sent along two copies Risk, Financial Markets & You to offer to readers who are interested in learning more. Leave a comment below to be entered in the draw for the books. Contest closes at midnight EST on Wednesday, May 2. I will announce the winners in Thursday’s post.

Speaking of contests, a big thanks to everyone who requested a ticket to PWL Capital’s event featuring Carl Richards, author of The Behaviour Gap. The answer to the skill testing question was Buckingham Asset Management (BAM Advisor Services was also acceptable). Winners will be notified by email.

94 Responses to The Models Are Broken—But Indexing Still Works

  1. Maxwell C. April 30, 2012 at 10:51 pm #

    Dan, please enter me into the draw. I thoroughly enjoyed the last book I won when I finally got around to reading it last month. Very informative.

  2. Canadian Couch Potato April 30, 2012 at 10:53 pm #

    @Russ: rest assured I would not have included them in my advisor directory if they were traders. With most of their clients the firm uses an (optional) strategy of writing puts and calls on ETFs to limit downside and generate income. This is not a strategy I have ever recommended, especially for those in the accumulation stage of their life, but it’s reasonable enough for people who are living off income from their portfolio. I’ll be writing more about this idea next week.

  3. DanH May 1, 2012 at 12:29 am #

    Wednesday, May 2 is my birthday, so I should win the book :D

    Add me to the draw please. And great post by the way.

  4. Paul S May 1, 2012 at 8:27 am #

    I was torn this year as there were a number of reports indicating that the US would perform better than Canada this year. It is a tough choice as there are always reports leaning to one sector over another. Unfortunately hindsight is 20/20 but as long as my investments make a decent return or don’t take too hard of a hit, I try not to look at what could have been. The bulk of my investments are split between Canada and the US with a small portion in other areas.

  5. Raman May 1, 2012 at 9:14 am #

    Dan, I’d love copy of the book. It seems right up my alley — I’ve been getting more and more interested in the technical side of how MPT works.

    Thanks for the interesting article, as always!

  6. Josh L May 1, 2012 at 10:00 am #

    Great post!

    Other than a handful of DRIPs, all my investing is done via indexing. As much as I would love to, I just don’t have the time to dedicate to educating myself about individual companies. Indexing seems like the best way to get diversified, and you can’t beat the fees.

    I would love to read about Fustey’s arguments for and against my strategy. I also haven’t read much about MPT or EMH, so here’s hoping I get the chance to do so in Fustey’s book! :-)

    Thanks for all the great posts.

  7. Danylo May 1, 2012 at 10:54 am #

    Always love reading these posts. Please add me to the draw.

  8. SterlingF May 1, 2012 at 11:02 am #

    I’d like to enter the draw as well. Thanks.

  9. Amir May 1, 2012 at 12:12 pm #

    Great Webiste. Please enter me in the draw.

  10. Chantal May 1, 2012 at 12:34 pm #

    I’d love to learn more on this topic. Enter me in the draw please!

  11. Martin May 1, 2012 at 12:37 pm #

    Please add me to the draw!

    And thanks for your website. I’m in the process of dumping my advisor and going couch potato, thanks mostly to your website.

  12. John Buchanan May 1, 2012 at 1:18 pm #

    Please enter me in draw. Most advisors still adhere to the modern portfolio theory and efficient markets and while I intuitively felt they were wrong never had the background to argue against. This will provide me with the information I need.

  13. Gary May 1, 2012 at 1:40 pm #

    I’m getting ready to make the switch to indexing. Please enter me in the draw.

  14. JO May 1, 2012 at 2:54 pm #

    Please add me to the draw and keep up the great work.

  15. J A H May 1, 2012 at 2:56 pm #

    Sign me up for the book draw. Thanks for more good writing.

  16. Andrew May 1, 2012 at 3:25 pm #

    Fantastic post. Please enter me in the draw.
    I have been researching an alternative portfolio that is related to the work of Nassim Taleb. It is a barbell approach where 80-90% of the portfolio is in very low risk assets such as cash, CDs and short term bonds and the rest is in highly risky but high reward assets. It is a counter to modern portfolio theory. ETFs can be used as well as options strategies using stocks or ETFs.
    A variation on this is the Escalating Life Annuity by Zvi Bodie: 80-90% real return bonds or TIPs depending on currency and 10-20% call options on broad market indexes. Options in the money are used to buy more real returns.

  17. Michel May 1, 2012 at 3:58 pm #

    Great topic! Please enter me in the draw.

  18. Chris May 1, 2012 at 4:46 pm #

    I am starting to put indexing into practice more with my own finances. I’d very much like to know the drawbacks in greater detail. Please enter me in the draw.

  19. David May 1, 2012 at 5:38 pm #

    Sign me up.

  20. Andrew May 1, 2012 at 6:14 pm #

    Dan,

    I’m the fellow who paid you the complement about your blog, with my misdirected email on April 12th. I was embarrassed by my error, but am glad you got to read how positive I am about your blog and the insights it contains. IMO, all an index investor needs is do is follow your insights and those of Jeremy Grantham of GMO. Should you select me to receive the Risk, Financial Markets & You book, it would be put to good use. Thank you.

  21. Pacific May 1, 2012 at 6:44 pm #

    Sign me up for the book, it is for my friend, she is a beginner.
    And I always need help!

  22. Allison May 1, 2012 at 7:01 pm #

    Thanks for the great post, and please enter me in the draw!

  23. Be'en May 1, 2012 at 9:02 pm #

    Thanks to your blogs, I am on my way to indexing! Just a few more mutual funds to dump and buy ETFs as replacement. Have quite a few shares of the company I was working for and will be looking to sell them as well to buy an ETF – instant diversification! Just need to overcome emotional attachment to them!

    Would love to read the book, Dan. Please consider me for the draw. Thanks.

  24. GeoEng51 May 1, 2012 at 9:06 pm #

    I never bought into the Couch Potato idea because of MPT or EMH (although the latter makes a lot of sense, generally speaking, for the average not that well informed investor). What convinced me were the statistics about how poorly all the expert financial advisors do. As your guest says, what better alternative do you have?

  25. Chris B May 1, 2012 at 10:55 pm #

    Another interesting post. Please enter me in the draw.

  26. Patrick S May 2, 2012 at 4:09 am #

    My comment for a free book… Since indexing has been brought up 36 years ago, the money invested in these funds swelled up from a couple of hundred of millions to 5 trillion of dollars. With the indexing becoming ever so popular and the vast amount of the money being poured into it, would it not overvalue the companies held in these funds?

    Let’s put it in perspective, the amount of money pouring in these funds and the simplicity of the investment strategy, one has to wonder, would this strategy be self-defeating like any popular strategy on wallstreet?

    Passive investing is a very cost effective way of investing and a great way to hold a basket of securities, but if everyone is doing it and great sums of money are pouring into these index…

    /imo

  27. Mark Telewiak May 2, 2012 at 1:00 pm #

    I’d enjoy another great read on this subject. I enjoy index investing!

  28. maureenC May 2, 2012 at 1:03 pm #

    Great post! Please enter me for the draw. Thanks

  29. Jesse May 2, 2012 at 4:19 pm #

    I’m a young investor and reading this blog has really given me a lot of help in setting up my own index investing portfolio. I still have so many questions and try to read all that I can, this book sounds quite interesting and I would love a copy.

  30. Aravind Sithamparapillai May 2, 2012 at 4:28 pm #

    From everything I have read and even from first hand experience, index funds do seem to be the way to go but then my next question though is do you diversify your index funds? I.e. you have things like the S&P 500 and the nasdaq but should you be looking at global index funds as well? The fall back answer would be yes, but where do you draw the line when it comes to being diversified?

    I would love a copy of the book if I could get my hands on it haha. All reading material is valuable to me

  31. tigerhar May 2, 2012 at 5:49 pm #

    Another rookie investor here who would feel completely lost without this site and its recommended reading. It’s hard to say no to a chance at a free book, so please consider me for the draw.

  32. Annick May 2, 2012 at 9:01 pm #

    Please add me to the draw! I hate having my ex-advisor remind me that “active management is the way of the future” while we’re switching our accounts to discount brokerage.

  33. Mike H May 2, 2012 at 10:17 pm #

    Always enjoy your Blog.

  34. Canadian Couch Potato May 2, 2012 at 10:46 pm #

    Thanks to everyone who left a comment. I love these giveaways, because it encourages otherwise shy readers to post comments!

    @Patrick S: There has been some concern that widespread indexing could distort prices. But remember that all companies have a finite number of shares, so money “pouring in” to index funds simply means that stocks are being sold by other investors and purchased by index funds. It’s a zero-sum game.

    @Aravind: have a look at my model portfolios. Yes, I think there is value to diversifying globally. Owning the S&P 500 and the NASDAQ is actually very poor diversification, because these indexes are all US companies and they have many holdings in common.

  35. uptoolate May 2, 2012 at 10:57 pm #

    Hey Dan. Keep the great articles coming. Put me down for the draw.

  36. Nav May 3, 2012 at 2:57 am #

    I got the last comment on May 2nd, hence I should get the book.

  37. Ken Hesketh May 3, 2012 at 1:56 pm #

    Sounds like the sort of advise I could use. I have been in my own business for more than 30 years and have reached that point in my life when I would prefer to worry less about my assets and more about my golf swing Also my real life business has been quite sucessful and I have largely cash assets and need an alternative to the 1% offered by government bonds and other “safe” investments. I would love to win your book but failing that I will buy a copy. Where do I do this? This morning is the first time I have delved into your website (on the recomendation of my physician son in law) and I am looking forward to spending more time researching this subject.

  38. Canadian Couch Potato May 3, 2012 at 2:04 pm #

    @Ken: Welcome to the blog. Alan Fustey’s book is available via Amazon.

    My own book, The MoneySense Guide to the Perfect Portfolio, is a more general resource for index investors:
    http://www.moneysense.ca/equity

  39. Jasmeet Gill May 3, 2012 at 4:10 pm #

    Sweet. Count me in.

  40. Helen May 8, 2012 at 3:07 pm #

    I still have faith on Indexing, but it hasn’t worked well for me in the past two year since I joined (currently, I am still in the negative side). Any comments on the performance trend of Global couch potato with TD index funds in the last two years? I need a little confidence boost…lol

  41. Canadian Couch Potato May 8, 2012 at 3:16 pm #

    @Helen: You need to be careful what you mean when you say “it hasn’t worked well.” Equity index funds give whatever the markets deliver, and most markets are down over the last two years. No investing strategy can be measured over such a short time frame.

    For the record, the Global Couch Potato was slightly positive in 2011 after returning about 8% in 2010 and 12% in 2009. Its 10-year return is just over 4%, which is clearly disappointing, but most investors did a lot worse.

Trackbacks/Pingbacks

  1. Best of Blogs – Soccer season | Retire Happy Blog - May 4, 2012

    […] The Canadian Couch Potato shared a great article this week that explains why The Models Are Broken – But Indexing Still Works. […]

  2. Best of Blogs – Soccer season - May 4, 2012

    […] The Canadian Couch Potato shared a great article this week that explains why The Models Are Broken – But Indexing Still Works. […]

  3. Länkar vecka 21 « Smarta Investeringar - May 27, 2012

    […] The Models Are Broken—But Indexing Still Works – Canadian Couch Potato […]

Leave a Reply