Index investing or passive investment has grown incredibly over the last 10 years. But is it really so great during prolonged market falls? Markets do go down, and usually experience periods of much sideways movement.

Do you really have the patience?

Index investing

For the inexperienced investor, selecting a long-term investment starts off pretty easy. Either buy some shares, property or just put the money into a term deposit. And there’s certainly no shortage of information available to assist this endeavour.

But it’s only when confronted with the more technical aspects of the investing process that things start to get somewhat more difficult. Considerations such as entry and exit and how best to maximise returns and minimise risk to name just a few.

To counter this lack of technical knowledge, investment newcomers often take their lead from pre- vailing crowd behaviour and just follow the strongest trend at the time of investing. Or to put it more colloquially, they hop on whatever the current ‘gravy train’ happens to be, and then proceed to ride it into the ground!

Sadly, investment strategies based solely on ‘following the crowd’ are seriously lacking in even a modicum of investigative research and are therefore usually doomed to failure. As I used to always say during my advising days, allegorizing a herd of stampeding Zebra for my investment homilies’, “most of the zebra’s don’t know exactly why they’re running, they just do”.

Investing without research is stupid and investing by following someone else who hasn’t done any research, is plain idiotic. It would probably be one of the highest- risk investment strategies on the planet.

I can tell you, I have seen many self-directed investors during my 25 years in the advice industry, and a lot of their investment success was a result of good luck rather than good management. Although many of them would have you believe differently.

Investing in index funds

Currently, there’s a major trend toward index investing or passive investment. It seems the investing public just can’t get enough of these products. And the product producers are pumping them out by the hundred’s. Closed-end funds, open-ended funds, listed or unlisted, large or small-cap, you name it and there’s an index fund waiting for your investment.

And nowhere is this trend more evident than in the Robo-advice space. Index investment is just about custom-made for use with Robo-advice apps such as Raiz. In fact, I would probably suggest that without index funds, Robo-advice would certainly be far less prominent in today’s market. (By the way, I have written a review of the Raiz app, check it out here)

But this flocking to index investment may not always be a smart idea. Here’s why. Since the GFC, the global economy has been grinding out a solid, long-term economic recovery. And stock markets across the globe have been prospering as a result. Having come off very low bases from the GFC, most markets have achieved record highs and are displaying phenomenal five and ten-year performance figures.

And it is these performance figures that are providing wonderful marketing bait to lure potential investors. Throw in some very low fees, and it suddenly becomes easy to account for their popularity.

All things must pass

But as the great George Harrison once said, ‘All things must pass’ and buoyant share markets are certainly no exception. And when markets do fall, an index investment will track every, single, downward point of that fall. And it will happen with absolutely no fund-manager intervention, or any protective strategies available.

And all those investors experiencing big losses for the first time will soon realise that indexes are actually performance benchmarks rather than investment strategies, and whose ‘raison d’être’ is to merely float on the whims of investor sentiment. Yikes!!!!!!!

Accordingly, should the markets move into a determined bear market phase, indexes are doomed to remain bouncing along the bottom until the bright light of economic salvation can be spotted on the horizon. But this could be in 6, 12 or 18 months time. In fact, the duration of a bear market is not set, and can quite easily be measured in years, and lots of them.

For example, currently, the Australian market is yet to achieve its pre-GFC high. So any investor who bought the index anywhere between 6,100 and 6,829 will still be underwater 10 years later. Now that’s what I call long term! And check out the Japanese Nikkei index from its high during the ’80s to what it is today. That one will surprise you.

This, therefore, makes me sceptical of investor intent when they are embracing any long-term in- vestment. Commitment to an investment strategy through’ thick and thin’ is the key to wealth creation, but a great many current index investors wouldn’t have considered long periods of underperformance.

Staying passive with passive investment

Many years ago, there was a famous (around this part of the world anyway) stockbroker who was fond of saying ‘people feel losses far more than they feel gains’ Now this was not ground-breaking information by any means, as the field of cognitive psychology had firmly established this fact.

Rather, it encapsulated in a colloquial way the real motivations of investors. That is, they expect to be making money, but they absolutely hate to lose it. I can even throw my own anecdotal weight be- hind this as I always found when markets went up; I didn’t hear a peep from my clients. But when a large fall occurred; my phone would literally be ringing off the hook!

And so what does all that mean. Well, when an index falls, it can remain well and truly down for quite long periods. The average person is just not suited to these long periods of losing money. No matter how many grandiose plans investors made to buy up everything during a bear market, it never happens.

The ensuing investment malaise is just too insurmountable to be ‘gung-ho’ with money. And there- fore the long-term underperformance of an index investment creates incredible dissatisfaction with investors; I have seen it time and time again. And, as a result, everyone decides to sell out which is further pushing the index down! A vicious circle has begun.

When you invest in an index fund, you are certainly guaranteed to hit the top of the market, but you are also guaranteed to get the very bottom as well. Indexes being conglomerates can remain under- performing for sustained periods of time whilst other individual shares are actually shooting the lights out.

Diversity in investment

Now I personally am not advocating one type of investment over another. The many and varied combinations of managed funds, ETF ’s, listed funds et al, gives an investor a wide selection. I would, however, suggest caution if you are committing 100% of your investment funds to an index product.

Spreading a portfolio across different assets, regions and management styles is a standard risk mitigation technique but it can’t be achieved if you solely choose index investments.

As with every investment you make, the old rule applies ‘don’t put all your eggs in one basket’. So think carefully regarding index investing and don’t be swayed by fees alone. Investment costs are important considerations but cheap fees should not always be the primary motivation for commit- ting your money. When we do get a bear market, you’ll actually resent paying anything, as all you will be getting for your fees will be losses!

Oh, and by the way, take a look at Listed Investment Companies (LIC’s) as an alternative or even better, a complimentary part of the portfolio.

And finally, here’s is an article about the great Warren Buffett winning a million-dollar bet. It involved him advocating a passive index investment to outperform an actively managed fund. In fact, he is glowing about the benefits of index investing, whilst accepting his $1 million dollar winnings (which went to charity).

All in all, it is a very convincing article showing the benefits of 100% index investing from the world’s greatest investor. But one very important factor wasn’t mentioned as a major contributor to the victory. In fact, I might even suggest, the omitted factor actually provided his victory. See if you can spot it and let me know in the comments below. (Hint; be fearful when others are greedy and greedy when others are fearful)
Thank you for reading, see you next time. Homepage