Ahoy, Polloi

Jared Dillian | The 10th Man
April 30, 2015

In 2008, I lost a boatload of money in those index funds while my trading account, where I’d gone to mostly cash, was much less affected.

After that, I lost my taste for index funds. I called Vanguard, closed the account, and the company mailed a check to my house. I was glad to be rid of it, though at the time I didn’t really understand why.

Here’s Why

Index fund promoters like Jack Bogle and Burton Malkiel believe in efficient markets (I don’t, as I wrote here). They believe you can’t beat the index, so you might as well be the index, and you should get exposure to the index by dollar-cost averaging—like, by sending $300 checks to Vanguard every two weeks.

You buy when the market goes up. You buy when the market goes down.

It’s important to have the discipline to buy when the market goes down, but most people find that difficult because they freak out when the market drops. In practice, nobody does dollar-cost averaging properly, except for one guy I knew in the Coast Guard who bought all the way down in 2000 and in 2008. He’s a retired military guy and a millionaire, demonstrating that dollar-cost averaging works… if you don’t chicken out.

But everyone chickens out.

Now, this assumes that markets always go up. You wouldn’t want to dollar-cost average a prolonged bear market.

That’s an interesting question, right? In the US, stocks have always gone up. But elsewhere in the world, dollar-cost averaging would have gotten you in big trouble.

Civilizations rise, but they also fall from time to time. I don’t think we should naïvely assume that US stocks will go up throughout our lifetimes. They might not! I can think of a million reasons why they won’t.

Some people argue that you have to think bigger and consider other markets and other asset classes outside of local stocks—like bonds, real estate, international stocks, and commodities. If you own the entire universe of investable assets, then you get the “market return,” a concept familiar to people who have studied portfolio theory.

But even that can get you in trouble. In 2008, everything—and I mean everything—went down, except for US Treasury bonds… and cash. There was nowhere to hide.

But It’s Cheap

The expense ratio on the Vanguard 500 Index Fund Admiral Shares (VFIAX) is five basis points. Five! If you invest $100,000, they only charge you $50 a year. Incredible.

And depending on the year, index funds do outperform most active managers.

Seems like a no-brainer, right? Well, not so fast… there are two things to consider:

1. Active managers can go to cash. There’s a lot more pressure on portfolio managers to stay fully invested these days, but they do have the latitude to go to cash, which helps cushion against losses on the way down.
    
2. Nobody can take the drawdowns (except my Coast Guard friend). Everyone puked their index funds on the lows in 2009. Everybody. Then they bought back in with the index 100% higher.

The press beats up on hedge funds for underperforming the S&P 500 in bull markets and for their crappy performance in bear markets, but if you invest in an absolute-return vehicle, it’s unlikely that you’re going to have a 60% drawdown (as the stock market did in 2008–2009). Rich people tend to be a little pickier about losing money—they want to hang on to what they have.

I don’t know many rich people who are heavily invested in index funds. I don’t think I know any who are Vanguard customers.

Look at the Forbes list of billionaires. I’d bet the left arm of my firstborn son that not one of them made a billion investing in index funds.

Diworsification

Think about this. If you invest in an index fund, you invest in all the stocks—the good ones and the bad ones.

But why would you want to invest in the bad ones?

Hedge fund manager Stanley Druckenmiller had a private speaking gig in South Florida, the contents of which were leaked to the press. Druckenmiller made some not-so-nice comments about the Fed, which is what the stupid reporters picked up on, but he also talked about his investment philosophy, which was far more interesting.

If the best investor in the world tells you what his investment philosophy is, you should pay attention.

So Druckenmiller said he doesn’t believe in diversification. In fact, he tries to achieve the opposite of diversification—placing all his eggs in one basket. This he did with the pound sterling years ago, to great effect.

If you’re really convinced of something, why make it just 5, 10, or 20% of your portfolio? Go big. Make it 100% of your portfolio.

Of course, this sounds very scary to the index fund investor because he doesn’t know what to go big on.

So, as a rule of thumb: if you don’t know anything about investing, you invest in index funds, and you make the market return, which has been 6–8% historically. That’s the tax you pay for being a dumbass.

If you know what you’re doing1, you should have a very concentrated portfolio. You should try to make infinity.

For what it’s worth, I have about 20 securities in my portfolio, but most of it is taken up by three or four positions. It’s very concentrated.

Many people think trading is all about buying the lows and selling the highs. That’s the hallmark of a true piker. The entry and exit points are unimportant—it’s the size of the position that counts.

Last week I talked about my China trade. It’s a great trade, but guess what—I’m too small! Position sizing can take a lifetime to learn.

So index funds have their place, I suppose, but if this newsletter landed in your inbox, you probably have some interest in the markets above and beyond just passively writing checks to an index fund (and you might also be interested in Bull’s Eye Investor).

I think some people have this idea that if they invest in index funds, they have somehow absolved themselves of responsibility—that they will get their 6–8%.

They might not. That was a painful lesson for people to learn in 2008.

Bear markets have a way of sorting things out. Next time we have one, watch Vanguard’s assets. Stocks may be for the long run, but when the going gets tough, the tough send in redemption orders.

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