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Index Investing Isn’t What You Think

Index Investing Isn’t What You Think

In times of change, learners inherit the earth, while the learned find themselves beautifully equipped to deal with a world that no longer exists.”
– Eric Hoffer

I love this quote as it accurately describes the current investing environment.

Index investing is the current rage because it is easy to understand with a one-decision-and-done allure, and it is cheap.  Indexing works most of the time, but other times it can be a disaster. 

Wall Street academics and their PR machine have investors brainwashed to believe that Index investing, with average returns being the goal, is the smart way to go.  Personally, I think having a goal to be just average is sort of like hoping your children get C’s in school.  It is sort of sad.

As Hoffer alludes, the world is changing economically, and investing fads that worked in the past may no longer do so.  Legendary investor Sir John Templeton, founder of the Templeton Funds, now part of the Franklin mutual fund complex, had a quote that “all things cycle in and out of favor, investments and investment styles.”  And right now, the cycles look to be changing.

A valuable insight came to me back in 1994 when I did a research paper for The Adviser’s Network newsletter on why the regulators allowed the largest companies to distort the leading indexes so much.  The S&P 500 Index represents 80% of all dollars invested in the US stock market.  Amateur investors often think that the S&P is made up of 500 companies equally weighted with each representing 1/500th of the Index, but it is not. 

Currently, the ten largest companies in the S&P 500 Index, ranked by the amount of money it would take to buy all the shares, make up almost 30% of the index weighting. By contrast, the ten smallest companies make up only 0.1% of the index weighting.  This is called Market Capitalization weighting.

I don’t ever remember seeing so few companies dominating the headline performance of the Index as we have had in 2021.

If Apple, the largest company, goes up enough to move the Index up 1%, it would take 185 of the smallest companies making a move of the same magnitude to move the Index up the same amount.  There is something wrong with that picture!

This capitalization weighting of the Index leverages small moves by the big companies that affect the headline price of the Index.  Even large moves by smaller companies hardly make a blip in the Index.  The last few years the big tech companies that dominate the top of the S&P 500 have gone up and up, driving the Index higher even though most of its companies have underperformed. 

But even redwoods don’t grow to the sky, which is why Hoffer’s quote resonates with me today.

What I realized while writing that research paper long ago was that the issue was created by the marketplace driving up prices, and correcting it was being left to the market, also.

What that means is that if the largest companies begin to falter, their size leverage will pull the Indexes down much faster than if all stocks enjoyed an equal weight in the Index.  During the next bear market, the capitalization-weighted S&P 500 may go down further than other measures due to this phenomenon.  I would like to say when that happens Index investors will realize that their world has changed and change with it.  However, most are brainwashed into ignoring the market so they are likely to wait until they have devastating, perhaps life-changing results.  Index investors are “the learned,” not the learners.

If you think investing has become so easy that anyone can do it by buying an index fund, perhaps that should be your clue that the investing world is about to change.

Joe Kennedy, the father of President John F. Kennedy, became an investment legend when he sold shortly before the stock market crash of 1929.  When asked how he knew when to sell, Kennedy replied, “when my cab driver began giving me investment advice.”  He knew then that investing had become too easy and the inevitable cycles of the market were about to make it very difficult.  Joe Kennedy became one of the richest men in the country because of that insight.  We can all learn from him.

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We all wish you a prosperous New Year.