Tuesday, July 14, 2015

The Biggest Investing Sin Exposed

One of the biggest sins in investing, is investing money without a clear plan or strategy to accomplish specific goals. This investing sin causes investors to chase unrealistic returns, and to abandon one strategy for the next when things get tough. A common trait of successful investors is identifying their investment objectives, and then devising a plan to accomplish those. The important part after that is patiently sticking to your plan even when things get tough. It is unrealistic to assume that any real strategy can deliver results that are always better than everyone elses, and can also generate consistent profits all the time. Investors who fail to understand this, end up abandoning strategies at their temporarily weak point, and then wasting precious years that could have caused the capital to compound and accomplish their goals.

I believe that in order to be successful in investing, one needs to select a strategy, and stick to it for decades. This allows the power of compounding to do its magic. If you switch investing methods/styles every few years, because you chase what is hot, you are not going to let compounding do the heavy lifting for you. In addition, if you have high portfolio turnover, your compounding will be negatively affected, because you will be paying more in commissions, taxes and fees.


Recently, I have noticed that many investors have embraced one strategy which is sold as the best strategy out there. This strategy is supposed to provide better results than everyone else, and seems easy and cost effective to implement. The supporters of this strategy have real zeal in defending it, and can provide a lot of good arguments why it is perfect for all investors. They even go to recommend it to everyone, as a one size fits all approach, regardless of any understanding behind an individuals risk tolerance, experience, emotional ability to handle stock price fluctuations, knowledge, goals and objectives. The strategy I am referring to is index investing. Some of the arguments are very appealing, even I am sometimes considering whether maybe I am doing it all wrong. My other concern is that people are being told to buy index funds regardless of valuation. Buying securities at inflated prices is a recipe for disaster. Overvaluation in indexes between 1998 – 2000 was one of the reasons why stock markets delivered lackluster performance over the subsequent 15 – 17 years. As I have argued before, if you are a know nothing investor, who has an access to a 401 (k) plan, then over 90% of you should be in the funds in that plan. The important thing is to have a plan, and stick to it. This is one of the points I am arguing for in this article series anyways. I actually believe that long-term results on a diversified portfolio of dividend growth stocks will be close to results of a S&P 500 after 20 - 25 years. So indexing is nothing special - it is just a way for  ordinary know nothing investors to buy a portfolio of assets, and hold for the long run. You might say that dividend investors, who create dividend portfolios that throw off cash every quarter are similar to index investors. But hard-core index investors don't see it this way for whatever reason.

There is a massive influx of money that is chasing index funds. I am curious to see how this plays out. The contrarian in me is concerned any time I learn about a strategy that its participants believe is invincible and bulletproof and better than anything else. This could create poor returns for participants, despite their rosy expectations, particularly when they lack sophistication and experience dealing with the vagaries of Mr Market. When too much money starts chasing a strategy, it ceases to work for a while. When people see easy money, they chase the strategy that produced them in the past, usually to the detriment of that strategy. When expectations change, the long-term returns could still be good 20 – 25 years down the road. However, this is preceded by a long initial period of flat or negative returns. This was the case with the Nifty-Fifty in 1972, as well as Dot-Com stocks in 2000, and Emerging Markets in 2007 – 2008. As a case in point, I have a friend who has never invested in stocks, yet in 2014 he bought his first Vanguard funds. While a person who buys an index fund today and holds for 20 – 25 years would likely do fine, I am concerned about those who will abandon ship at the first time of trouble or at some earlier point in time. It is also possible however that we have a few decades before what I am fearing becomes true.

There are several individuals I have followed, which have become recent converts to index investing. Based on their documented history of chasing hot strategies, and chasing the best strategy, it is yet to be seen whether they will stick to their new strategy or not when things get tough. After all, investing feels safest when a strategy is on a hot streak. When stocks have been going up for 7 years in a row, indexing seems like a no-brainer – you get market returns without really doing any work. When I start getting feedback that I should just abandon all stock picking altogether, and just index, I start asking myself if we are seeing a bubble in indexing that could go terribly wrong. Relying mostly on total returns like indexing is very easy, after stock markets have only gone up for the past 7 years. It is yet to be seen whether, the investor who chases returns and jumps strategies will have the mental fortitude to stick to their plan during the next bear market.

Of course indexing is not a one size fits all approach that will guarantee riches for all of us. Different index investors will have starkly different expected returns, depending on their asset allocations. The index investor who owns 100% US stocks through an index fund will have a different return than the index investor who also has a sizeable allocation to international stocks. Each of those investors will have a starkly different expected return from that of an investor who holds US, International and Fixed Income funds. There is a plethora of index funds, and ETFs, for every sector, country or tilt to choose from. There are value or growth funds, equal weight or market weight, small cap, mid cap or large-cap. In addition, some international index funds have large variability as well, since you have developed, emerging and frontier markets. I would say that the past 7 – 8 years were relatively good for a dividend growth investor who focuses on US dividend growth multinationals. It was better to be a dividend growth investor than an index investor who had allocation to US index funds. It was even better to have a portfolio of dividend growth stocks than a portfolio of US stocks, International stocks and Fixed income over the past 7 – 8 years. However, as we all know, past performance is not an indicator of future returns. Of course, this is also the reason why I am skeptical about some investors who have recently switched to investing – I fear they switched because of recent good past performance of index funds.

My sample of three is not representative at all. These are individuals I have found through my browsing of the internet. If these individuals stick to their new found strategy for the next 20 - 30 years, I believe they will have high odds of succeeding. If they switch strategies however, I would be worried for them.....

Since this article is getting too long, I broke it down to two separate posts. Please stay tuned for part two.

Full Disclosure: None



Relevant Articles:

Why I am a dividend growth investor?
Is international exposure overrated?
The Four Percent Rule is Dependent on Dividend Yields
Dividend income is more stable than capital gains
How to generate income from your nest egg

18 comments:

  1. Ciao DGI,
    Totally agree with you, there is a very strong movement in Europe as well on the index funds, the new trend seems to invest Long/Short on a series of instruments/markets. But it's all about the target that you have in mind in my opinion, many many investors don't even know what a "decent" return can be these days. Some of my friends think 10% is a "good" return... When I tell them that 10% is absolutely fantastic and there are very risky instruments that can get it (but you can also loose everything) they look at me as if I am crazy... I have started Drip investing recently, and I am making an awful lot of mistakes in this first part of my experience, but I am resolute that the strategy that I have in mind is good enough for me and despite seeing a lot of red numbers I keep on going as I am quite sure that the long run will see me on the "green" side of the spectrum. But as you said it takes a lot of consistency, patience and strong nerves...

    ciao ciao

    Stal

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    1. The important first step is knowing what the desired end result is. Then second step is determining how to get there. When you rinse and repeat consistently, you create good habits, that will carry out the investment plan for years, until the goals are reached.

      I think most people view investing from the mentality of a gambler - many believe investing is all about making 100% return instantly. These are the people who end up losing a lot of money, and never really embrace investing.

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  2. When I saw the title of this post, I thought it would be overpaying for an asset. But I think not having a clearly defined mission/purpose/timeframe/goal is even worse. It leads to many other sins, such as overpaying.

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    1. If you do not have a clear "business plan", you will chase strategies, investments, end up overpaying, and paying a lot of unnecessary expenses. Worst of all, one will end up depressed of their failure, and likely start believing that "the market is rigged" or "noone can make money in stocks". You see these people everywhere. Or maybe I see them.

      As for my friend, he already expressed disappointment with his investments when there was a correction in early 2014. I am not sure if he kept his investment or not.

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    2. One thing studying history made me realize is to beware of utopianism. The end of history rarely is. And indexing does seem quite utopian.

      That said, I really hope it does work out. It's a very elegant solution, and it makes accessing the benefits of economic growth possible for a bigger slice than ever of the population.

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    3. One of the benefits of indexing is that "everyone can do it". Based on the logic in your post on "carrying capacity of strategies", and my knowledge of the "pari mutuel system of horse betting", I would agree that the idea that everyone can be rich is utopian. Ex... If you buy SPY at 30 times earnings, or if you cannot afford to hold on to your stocks for 20 years, your odds of success will be lower. If SPY dropping 5% - 10% makes you nervous, you might not be able to profit. If international stocks going up 5% - 10% in a year better than your US stocks makes you jealous - you might not stick to investing in SPY/VTI.

      I do believe that the ones that will succeed will be those who buy, hold and forget their account password...

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  3. True point DGI, I am also wondering how long the indexing trend will turn out to be good. I am sure, many investors will drop out again, once indizes will move down or sideways with the market.

    At the end, the main ingredient for success is persistence. Every strategy might work, but most people switch repeatedly looking for the quickest and easiest way to become rich quick.

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    1. You are correct that constantly switching strategies is a fool's errand. Unfortunately, many investors get jealous when someone else claims to be making more than them, so they switch strategies. When you teach yourself to quit all the time, you learn to quit all the time. If you switch from dividend growth investing, to index investing, what is there to stop you from switching again when the stock market experiences a bear market?

      You hit the nail on the head by saying that to be successful, you have to be persistent in your approach, and to take pleasure in the getting rich slowly method of investing.

      Thanks for stopping by!

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  4. Thought provoking post for sure. I am an indexer with a large taxable portfolio who is enamored with the idea of building a dividend producing portfolio. I don't for these reasons: 1) complexity that my non-financial literate survivors would have to deal with, 2) I believe that a portfolio of 30-40 dividend paying stocks is likely to have roughly the same performance as the SP500 or total stock market, 3) tax efficiency I don't need the extra cash from dividends to live on, so why pay unnecessary taxes which is essentially a drag on performance, and 4) the expense ratio of Vanguard Index Funds make ownership of the entire market ALMOST free. I pay the expense ratio gladly to free up time for other leisure activities.

    I believe the fears from abandonment of an indexing approach are overblown. If some investors drop out of an index strategy for an active approach, there is still a limited universe of publicly traded stocks to choose from which collectively are still the market. Never forget that for every seller, there MUST be a buyer. The fact of the matter is that LONG term returns in the stock market are driven by earnings not the shifting whims of retail investors.

    I think the key point brought up in the article is to select a strategy and stick to it. IMO, it will be much easier to stick with an index strategy over a lifetime of investing, especially as I age and my interest or mental capacity wanes. As much as love the idea of dividend investing, I don't think it makes sense FOR ME. Having said that, I love this site because it reinforces fundamental concepts of investing as opposed to speculation.

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    1. Thanks for stopping by and commenting. I have no problem with investors choosing index investing over dividend growth investing or vice versa ( or choosing some other type of investment method). If you find something that works for you, you should stick to it.

      The important thing is to find a method that works for you, and know when to stick to it. I think indexing is fine, but if you are buying S&P 500 or VTI at 30 times earnings, you might be doing yourself a disservice. Also, if you panic when prices go down, you might be doing yourself a disservice.

      This of course is more about educating yourself, because as a DGI I know I would be making a mistake if I panic during the next bear market and sell. I would also make a mistake if I buy a stock above 30 times earnings. As you said, for every seller there is a buyer. So when one panics and sells at the next correction, someone else is buying ;-) When they panic and sell though, they can buy another asset class - fixed income, real estate etc.




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  5. Thank's for sharing your thoughts on that cause I've noticed this trend too and I must admit it sometimes gets me worry but the beginners out there. Just like any type of investment, index investing can suit some but has to be done properly. Consistency has shown its letter of trust.

    Cheers,

    Mike

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    1. Thanks for stopping by TDG. It is an interesting trend to observe, which could make certain asset managers/mutual fund companies obsolete. It looks like your holding Blackrock is potentially going to profit though.

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  6. Great post DGI! I'm glad to see a counter opinion to the common phrase "indexing is for everyone". I believe we are or will be in an indexing bubble. Investing wisdom tells us to "buy low", anyone buying indexes today is "buying high". It'll be interesting to see how many people abandon the "indexing ship" when markets tumble.

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    1. I agree. It is particularly dangerous to tell people you know nothing about to just go and index. Yet, many are being told to do that, without understanding anything about stock market investing, cycles, valuation etc. It is also very easy to say just index, after we have had a 6 year bull market. I am waiting to see what happens next..

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  7. When your own strategy gets too popular it can be bad news! What would you do if dividend growth investing got too popular, and uninformed masses of investors were rushing in to buy up dividend stocks with little knowledge, driving down the yields to dangerous lows?

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    1. Dividend growth investing will never get too popular, because there is some work involved - index funds sound much more appealing to others.This prevents the majority of investors from even considering this approach. The amount going to dividend stocks is just a drop in the bucket relative to the HUNDREDS OF BILLIONS OF DOLLARs chasing index funds. Hence the biggest risk is that since so much money is chasing index funds, they will stop being effective at some point in the future. Plus, a large portion of dividend investors just chase yield - they are not interested in dividend growth investing.

      And most importantly, if you ever checked my site, you would know that I buy only when my valuation parameters are met. Hence, as long as the businesses I buy are priced well, and grow, I will earn good returns.

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    2. How many dividend stocks are not in an index fund too? If indexing gets too popular could they be affected? If there are no stocks that match your valuation parameters will you stop buying stocks?

      I'll admit I don't read your site much. I'm curious about how dividend growth investing can avoid the fate that has overcome nearly every outperforming investment strategy in history.

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    3. In the past 25 years, there have always been quality dividend growth stocks available at attractive valuations.

      The rest of your questions were already answered above.

      The fact that you spoke about "yield" in your first comment shows me that you don't understand what dividend growth investing is, nor do you understand my response to you. Hence, any time spent educating you has no ROI for me.

      Good luck!

      DGI

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