Recipe for Poverty: Investing in market indices!

Everyone's heard of passive investing. If you just invest in a market index fund and let it ride, you will beat several active investors. A staggering 70-80% money managers can not beat the index (such as S&P 500, DJIA). This is what legendary investors like Peter Lynch, John Bogle also preached and practiced. They apprently did well. But something does not feel right. Here's a proof:

The chart shows S&P 500 index plotted over a 12 year time frame from 63 to 75 where investor basically didn't make a dime. If you invested in let's say SPY (S&P 500 index derivative) in 1963 and had a need to take your money out in 1975, your net return would be a big ZERO %.

Now 12 years is a very long time frame for anyone to get 0% return in a supposedly risky investoment like stocks (even if it is an index). This umbrella pattern (new term alert..Owner: moi) also repeats over medium term horizons like 4-5 years (chart below is S&P returns from 1997 to 2003).

Proponents of market indexing would rush and show you a similar chart from 1950 to 2008 where S&P shows a very healthy return that averages 7.2% annually.

Ok good. But man, I got no patience to wait 50+ years. And this then means only young investors should invest in a market index. Even then, there are life events that might force you to withdraw your money. So market indexing seems like a rip off at best. I would say 10-15 years is what the definition of long term should be. Anything above that is pretty boring in this age of instant gratification. In fact 10 years itself is pretty long in this CNBC era where new HOT stocks tips emerge every other minute.

So did Bogle and Lynch lie? Not really. That's probably why they recommended a diversified portfolio of index funds. It is still active investing albeit in a passive instrument. You still need to do the due diligence of picking appropriate market sectors for the current business cycle and then pick index funds (ETFs are pretty good for this) for those market sectors. And that's why they also teach you importance of rebalancing. When a phrama sector goes out of favor at the bottom of business cycle, you do not buy pharma ETFs. Here's a good business cycle and favorable sector map (Courtesy: Blog: Three Cents).

e.g. Pharma (# 3) is a poor sector at the Top. Financials (like now in 2008) is a good sector to invest in an early bull cycle.

So today in June -08, can you go and start buying Citi, JPMC, Merill right away? May be not. The issue is you don't know if this is the bottom and hence beginning of "Early bull" on the chart. Also, you are not sure who is headed the Bear Stearns way. Well, this is where Bogle's advice helps. For an average investor, best bet would be to start investing in an index of the financials (XLF). Start buying at dips and accumulating a core position to get ready for the upcoming upturn. There's always one coming! :)

Overall, market indexing is a rip off. Picking individual sector indices and timing the entry and exit according to business cycle above seems like a decent, at least not shoot yourself in the foot, strategy.

Value Investing

Graham, Buffet, Tweedy Brown and so many have practiced value investing for years and have done exceedingly well. So why doesn't everyone just copy it. Because, human beings naturally are born speculators. Gambling is probably in our blood. Stocks bring out that spinstinct (my own term: Speculative Instinct) very effectively. Hence most of the world becomes a momentum investor. Very few have the emotional discipline to stay in the game for the long term. Investing, more so than many things in the world, boils down to emotional discipline.