JUST PLAIN TALK: Index funds perfect for average investor, and members of Congress
Years ago, when I started writing, I asked an accomplished journalist for advice. Unexpectedly their response was to read other writers, particularly outstanding ones. One of my favorites, Jonathan Clements, started a blog, Humble Dollar, featuring others' work and his. Sometimes I agree, sometimes not, but often they provide a different view or "take" per The Motley Fool's stylebook.
John Kim (Sept. 25) pointed out the strategy of owning individual stocks either directly or with an actively managed mutual fund faces challenging headwinds. Conversely, chances for success are higher with broad market index funds. Anytime anyone says they have a better idea than index funds, my BS meter goes full red.
Kim cited work by Dr. Hedrick Bessembinder, Arizona State University, showing that most publicly traded common stocks (57%) failed to outperform one-month Treasury bills, one of the safest investments on the planet, assuming Congress doesn't act petulantly. Astonishingly only a tiny slice, 4%, of the 26,000 companies studied, generated the entire gain over 30 day T-bills.
The chances of picking winners are tiny, but there's another and more treacherous pitfall awaiting.
Statistically, investors sell winners and hold on to losers. Peter Lynch called it watering the weeds and pulling up the flowers. Individual investors aren't automatons like Dr. Spock; we invest emotionally. Behavioral economists Hersh Shefrin and Meir Statman coined the term "disposition effect." We create a mental account subconsciously, and selling at a loss is painful, so we do everything possible to avoid it. Conversely, selling a winner makes us feel good. Thus, winning positions are easy to sell.
"Prospect Theory" compounds matters ever further where losses have to be offset by even more significant gains. In short, it takes much more than a $1,000 gain to offset a $1,000 loss. Again, it's counter-intuitive; the tax code rewards losses and penalizes gains. Stocks have unlimited potential on the upside, but stocks can go to zero. Of the original 12 companies in Dow Jones Industrial Average, only one, General Electric, still exists. Regarding individual stocks, Bessembinder's work indicates bankruptcy was the most likely occurrence.
While humans can't invest like robots, index funds offer a robotic-like way to match market returns. Owning a broad-market index fund assures you of owning the narrow swath of winners since index funds own them by default. As a bonus, index funds have lower operating fees and are more tax-efficient than actively managed funds. In his 2019 update, Bessembinder asserts wealth creation will continue to be concentrated going forward.
Not only are index funds perfect for the average investor, but they should also be mandatory for members of Congress. Federal legislators often are privy to sensitive information unavailable to the general public. They should not have to divest any holdings when elected. Still, while serving, index funds should be their only allowed investment. My recommendation doesn't burden them; the Thrift Savings Plan, offered to civilian and military government employees, is one of America's best 401K
You can't always get what you want, but Buz Livingston, CFP, can help you figure out what you need. For specific advice, visit livingstonfinancial.net or drop by 2050 West County Highway 30A, M1 Suite 230.