How research into failing stock-pickers inspired the Index Fund (and the latest development)

Technology enables immediate access to everything wherever and whenever we want it. That’s a good thing when it comes to staying in touch with friends and family, or learning about world events. When it comes to investing and money management, I fear faster and easier ways of investing will allow some people to lose more money faster and easier.

I spoke about this in my recent video on speculating in fantasy football, not with your money. The position of easy access to investing tech makes it even more important to adopt a long-term investment plan designed for you  that doesn’t try to actively pick stocks or time the market. After all, the purpose of having an investment plan is so you can relax, so you don’t look at the markets every day, and ask yourself, “How am I doing?”

Investors actively trading are not just potentially missing out on the expected return of the market, they’re stressed out, worrying about how the news alert they just received will impact their long-term financial health, and whether they can or should do anything about it.

I don’t blame investors who follow this route; the financial services profession hasn’t done a good enough job educating them that the academically-proven, best approach for their long-term financial well-being is to make a plan, implement it, and stick with it.

But the profession has done a great job selling index funds. Over the past decade, the percentage of the stock market that is passively held (not actively-traded) has grown considerably, with equity index funds representing 52% of the US equity fund market at the end of 2021. But are investors now using index investing to actively pick stocks?

Using Index Funds to implement an active investment strategy

Data from Dimensional shows that some investors appear to be using index funds to pursue an active investment approach. For example, the largest S&P 500 ETF had the highest average daily trade volume of US-listed securities in 2021, at $31 billion. So instead of picking individual stocks, people seem to be acting like stock pickers when buying and selling index funds and ETFs.

Despite the overwhelming evidence and compelling story to the contrary.

When economist Michael Jensen published his landmark 1968 paper, which showed that active stock pickers added no consistent value, other academics soon confirmed his insights. More than five decades and 50 years of data later, the theory still holds up. There are some stock pickers who experience success, but we don’t know how to identify them before the fact. We can’t separate skill from luck. Picking stocks is more like gambling than investing (again, back to my video).

The birth of the index fund

This academic research inspired the birth of the index fund, which allowed investors not only to buy the broad stock market, but also to track the performance of the manager and compare costs. Dimensional Fund Advisors’ CEO and founder, David Booth, worked on one of the first index funds. When he went on to co-founded Dimensional, they built strategies that were informed by indices but weren’t limited by the same mechanical constraints. David accepted this research early on and built a company based on it. He still believes it 50 years later.

Getting you out of the guessing game 

Dimensional have always viewed marketing as a way to educate financial professionals and investors. In fact, they started by working with institutions and only expanded to individual investors by working with financial advisers like us who could help teach their clients how to think about the market and invest for the long term.

But despite all this great work, I fear it will only get worse. Exchange Traded Funds (ETFs) make it easier to trade. So do free platforms that allow people to actively trade on their phones. I have nothing against ETFs, but they are tools, and they have to be used effectively - by trained professionals. 

Which is why investors may need an adviser more than ever - to help keep you from jumping from one thing to another. Our approach is to get you out of the game of worrying and guessing by having a plan that can provide peace of mind. It’s a sensible approach you can live with. The financial profession has made great strides improving the investment options available, but we have more work to do helping investors with those options. There are great solutions right in front of people. As a profession, we need to do a better job of educating current and potential clients. How the bulk of our society lives out their later years depends on it.

If you would like a second opinion on your investment plan, feel free to book a free 30-minute call with me.