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Understanding Investing

“It takes above average intelligence to understand index investing” -Tuan Phan

Index Investing is Simple

Being a passive investor is simple and straightforward. The strategy can be implemented by any individual at any intelligence level. The person’s gender, age, ethnicity, country, religion, etc has no impact. In fact, one of the key benefits of passive investing is that it requires very little financial knowledge to achieve the same or superior results to the professionals with the best knowledge and experience in the investing field!

Passive investing simply involves buying and holding a diversified portfolio of low-cost index funds, with the goal of matching the performance of the overall market. This approach is based on the belief that the market as a whole is efficient and that it is difficult, if not impossible, to consistently beat the market through individual stock picking or market timing.

Nowadays, investors can create an account, set up their portfolio through their mobile phone from the comfort of home and for near zero costs! In fact, many robo-advisors and automated investment platforms have made it even easier for individuals to get started with passive investing, as they provide personalized investment advice and portfolio management at a lower cost than traditional financial advisors.

Given all of this, why did I assert that indexing requires above average intelligence to understand?

Despite the overwhelming theoretical and empirical evidence showing index funds are better for most investors in the long run, index funds only caught up to active funds in 2022. This seems baffling at first until you look at the underlying reasons why so much money continues to be placed in active funds.

Index Investing is Counterintuitive

Indexing is a deliberate choice of strategy that is completely counterintuitive to traditional views of investing. Most people assume that a successful investor requires formal education and many years of experience to succeed, just like other endeavors in life e.g. beingeg being an engineer, pilot or a doctor.

Skill Myth

People generally believe that skilled fund managers or individual investors must have the skill and experience to consistently beat the market through active management by identifying undervalued stocks or timing the market correctly. However, research has shown that active management often results in higher fees, lower returns, and greater risk than passive investing as discussed in our previous post: Investing is a Solved Game.

Marketing Myths

The investment industry has an interest in making investors believe they can consistently beat the market and thus should avoid index funds. After Vanguard’s 1st index fund in 1976, active fund managers ran a massive, coordinated campaign to discredit index funds, labeling them “un-American”. The ad-hominem attacks have continued throughout the years with the most recent iteration comparing index funds with Marxism (also here).

Poster created by fund managers after Vanguard's 1st index fund around 1976

More Work = Better Fallacy

Added to this, we naturally believe that working harder often gives better results. The “no pain, no gains” motto exemplifies this belief. Active management requires much research and calculations into companies’ data while indexing appears to be blindly copying without much thought. It’s no wonder that people are willing to accept the talking points from fund managers that “active” provides superior performance.

Cost = Quality Fallacy

Another reason many believe they need to pay a professional is costs. In everyday life, items that cost more are generally seen as better, i.e. more features, higher quality etc. It is therefore not a big leap for people to assume the same in the investment world – that active funds are generally better because they cost more! However, this is the complete opposite when it comes to investing. John Bogle said it best – “In investing, you get what you don’t pay for” in his 2005 keynote address, i.e., the more you pay for your (active) funds, the lower your expected returns.

Average = Bad Fallacy

Perhaps the biggest factor in indexing being counterintuitive is the concept of being average, something that is not desired! Being average - no one wants that stigma! This well-known fear is something active managers continue to exploit in their attempts to lure investors away from index funds.

A Small Edge Compounds

Indexing is counter intuitive because we are blinded by the short term rather than focusing on the long term. After any period, an index fund will have ~50% competing funds above and ~50% of funds below by definition. However, they have a slight edge over all the active funds due to lower costs. This edge grows over time against individual active funds so that in the long term, the amount of active funds that can beat the index fund rounds to 0%!

This is akin to the casino’s edge. With every spin, roulette gamblers have ~50% chance of winning betting on red or black while the house has a small edge due to the 0/00 green numbers. In the long run, the house ends up beating everyone!

As you can see, it takes a lot of knowledge and intelligence to actively choose to be a passive investor!

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