Index Funds

It’s a general guideline that people who do not follow the market obsessively should invest in index funds. Compare to mutual funds, they are lower cost, and over time tend to perform about as well, particularly when costs are taken into account. Compared to investing in individual stocks, they are much lower risk, because they are more diversified. Also people who do not follow the market obsessively tend to be extremely bad at timing their moves in and out of the market.

However, investing in index funds only makes sense if you believe that the overall stock market is going to go up over time. The New York Times has a nice graph showing the S&P 500 return on an annual basis since 1920 compared with inflation. There are plenty of time spans where the S&P 500 did not keep up with inflation—the dark red areas. Note that in the light red the index did keep up with inflation, but the average return was less than 3%. The green areas are relatively infrequent.

What this tells us is that the stock market tends to increase slightly faster than inflation on average, and that there are big chunks of time where it does not. But why should the stock market increase faster than inflation at all? While clearly the stock market often has nonsensical prices for individual stocks, these seem unlikely to persist across the whole market for decades at a time. But growing faster than inflation over a long period of time implies that money is coming in from somewhere. We have to assume that it is not the case that people are increasingly pulling out their savings to invest in the stock market, so the money must be being created. Normally creating money tends to lead to inflation over time, but here we see the stock market growing faster than inflation. So it seems to me that the money must be coming from a slow but steady increase in the size of the overall economy, presumably due to increased productivity.

This means that you should invest in index funds if you believe that the economy is going to continue to grow. It also means that, realistically, you can not expect a large return over time. The economy has historically grown, but it has not grown all that much faster than inflation. You should certainly take that into account if you expect to retire on your savings. In particular it’s easy to trick yourself into looking at the absolute values of your projected savings without taking inflation into account.

It’s also interesting to consider that while the growth of the economy does over time mean that there is more money to invest, there is no rule which says that that money must be invested in the stock market. That is historically what has happened. Why should we expect it to always happen in the future? The short-term market has become a mugs game, in which professional traders with high-powered computers are going to outdo any ordinary person. The long-term market is full of established companies with executives who work with directors to siphon off ever-increasing salaries and build short-term stock pops at the expense of the long-term management of the company. I don’t see any signs that these problems are leading most investors to avoid the stock market, but it seems possible that it could happen—at least as possible as having housing prices drop across the entire country for the first time ever.

So what should you do with your money? I think the main thing to do, assuming you don’t care to follow it obsessively, is to not count on it to grow fast. There are a lot of very safe investments you can make, such as Treasury Inflation-Protected Securities (TIPS). It may be a comfort to know that you won’t lose money.

And what if you don’t have any money to invest, as is true for the majority of people in the U.S.? Then you’ll need to plan to live on Social Security; it’s not much money, but it’s much better than nothing. There are few jobs with pensions any more, and existing pensions are under heavy threat. Or, you could just never retire; at least you’ll be helping the economy grow for everybody else.

2 Comments »

  1. al said,

    February 9, 2011 @ 9:20 pm

    That’s a rather long post, I guess it can be resumed to “the higher the risk you take, the higher the gain, the strongest might be the fall.”.

    That said, about your last paragraph, maybe it’s time for US citizen to stop pretending to a way of life they cannot afford. Banks did not create the crisis, poor americans did. Enslaved by their own weakness, greed.

    In the same idea, it will be interesting to follow the congress fight about potential debt ceiling increase, which currently limit the govt to a debt of 14.3 trillion. I fear that any increase will only make things worth in the future if spending is not cut…

    [Let me precise that I’m no republican. I just think that when you spend money you do not have and borrow to pay your debt, you should be ready to default.]

  2. cmccabe said,

    March 9, 2011 @ 5:03 pm

    Thanks for the thoughtful post, Ian.

    A lot of people have bought into the idea that equities can only go one direction– up– in the long term. They accept it uncritically, the same way many people believed that house prices could only go up a few years ago.

    I remember reading an article in the Economist (sorry, it’s behind a paywall) which commented that the Japanese stock market has basically produced no return in real terms since 1980. The losses of the 90s wiped out the gains of the 80s, and the following decade was flat. Aside from individual winners and losers, the market as a whole was pretty much a wash.

    Some people believe that unfavorable demographics may one day doom the US stockmarket to a similar fate, as oldies start withdrawing more money while not enough kids start paying in. It’s hard to know where to put your money.

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