April 24, 2025 • 40 mins
Questions? Thoughts? Send a Text to The Optometry Money Podcast!
How should optometrists approach investing their hard-earned money? With thousands of mutual funds and countless investment strategies, deciding can feel overwhelming. In this episode, Evon dives deep into index investing—explaining clearly why passive investing through broad market index funds consistently outperforms active management.
He explores the fascinating history of index funds, the robust academic research behind them, and exactly why an evidence-based, passive approach makes sense for optometrists. Evon also breaks down common misconceptions around "settling for average" and explains how choosing simplicity, lower costs, and broad diversification can significantly boost long-term investment success.
You likely aim to take an evidence-based approach to optometry, and Evon's suggestion is to take the same approach to finance and investing.
Highlights of the Episode:
- What Exactly Are Index Funds?
Evon defines indexes and index funds clearly, showing how they provide easy access to broad markets at low cost. - The Fascinating History Behind Index Funds
Learn how groundbreaking academic research in the 1960s and 70s led to the creation of index funds, and why the initial skepticism turned into widespread adoption. - Evidence of Index Funds Outperforming Active Management
Evon shares compelling data, such as the SPIVA Report findings, showing that over 80-90% of active managers fail to beat their benchmark index over long periods. - Why Active Investing Often Falls Short
Explaining why consistently outperforming the market through active investing is incredibly challenging. - Fees and Taxes Matter
Understand how high fees and tax inefficiencies can significantly erode your returns, making index funds even more attractive. - Diversification is Your Friend
Evon details shocking statistics about individual stock performance and shows how index funds naturally diversify your portfolio, increasing your odds of owning top-performing stocks. - Simplicity is Strength
Discover why investing doesn't need to be complex, and how simplicity through index investing can lead to better investment behavior and results.
Resources Mentioned:
- Ep 94: Why Active Investment Management Fails with Andrew Berkin, PhD
- SPIVA Report - Year End 2024
- S&P's US Persistency Scorecard - Year End 2023
- Morningstar’s Active/Passive Barometer
- Hendrick Bessembinder (2018): Do Stocks Outperform Treasury Bills?
- Movie: DFA's Tune Out The Noise
- Book: A Random Walk Down Wall Street
Stay Connected:
- Click here to Subscribe to the Eyes On The Money Newsletter for weekly financial insights tailored specifically to optometrists.
- Have Questions? CLICK HERE to schedule a short introductory call
The Optometry Money Podcast is dedicated to helping optometrists make better decisions around their money, careers, and practices. The show is hosted by Evon Mendrin, CFP®, CSLP®, owner of Optometry Wealth Advisors, a financial planning
Mark as Played
Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Evon (00:04):
Hey everybody.
Welcome back to the OptometryMoney Podcast where we're
helping ODs all over the countrymake better and better decisions
around their money, theircareers, and their practices.
I am your host, Evon Mendrin,Certified Financial Planner(TM)
practitioner and owner ofOptometry Wealth Advisors an
independent financial planningfirm just for optometrists
(00:24):
nationwide.
And thank you so much forlistening.
Really appreciate your time andattention this week and today's
episode.
We are gonna dive all into indexfunds and index investing, and
you have probably, if you spentany amount of time online or in
a lot of these online groups foroptometrists, you probably have
seen index funds thrown aroundas a way to invest.
(00:46):
And I wanna dive into thehistory.
And the evidence making the caseof why index investing makes
sense for you for optometristsand why active investment
management is likely to cost youreturns over the long run.
Because you have a choice tomake.
Ultimately, we all have todecide as we Earn money, as your
(01:08):
practice is creating additionalcash flow and you are investing
it in your retirement and otheraccounts, you have to decide how
to invest it.
And you have to have an approachthat, number one, you
understand, number two, thatthere's evidence for it's, it's
likely to work in the long runand that you can stick with.
(01:29):
Even through times where it'suncomfortable and very often
that choice is going to besomewhere between should I take
an active investment approach.
Should I try to, or should I usemutual funds where the manager
is trying to pick individualstocks or individual investments
or time the swings in marketsand try to outperform the market
(01:52):
as a whole?
Or should I take a more passiveinvestment approach where I'm
simply trying to get theinvestment returns of the broad
market over time And so I wannatake a look at where the
evidence leads.
And for me personally, I've gonethrough an evolution myself, my
experience as a professional nowworking in my 11th year.
going back to college, we werestudying fundamental analysis,
(02:14):
like diving into financialstatements and trying to put a
valuation to companies andprobably not very good to be
honest with you.
but that, that sort of informedmy approach early on.
And then, almost a decade ago,working at one of those large
corporate financial companiesthat sells their own active
mutual funds, and getting sortof the Kool-Aid, of working in a
(02:37):
company like that.
And then over the years justquestioning that and examining
the evidence where, what doesthe evidence say about which
approach we should take wheninvesting?
And for me, in managing my ownfamily's money, and in my firm,
the investment approach in myfirm with our duty to manage
client dollars in their bestinterest.
(02:58):
The evidence points to the mostrational way to invest being a
passive style of investing orsystematic, you might hear it
called, or rules-based approachto investing.
And the way I define passive isthat, you or the fund that
you're using are not trying topick individual companies or
individual investments or totime swings in markets trying to
(03:20):
outperform.
But instead invest broadly in abroadly diversified way across
the whole market with a clearset of rules that are
systematic, that are able to bereplicated and that are
transparent.
And very often this approachleads to lower costs and index
funds are probably the mostcommon and well-known form of
(03:42):
passive investing.
And so I wanna dive into thehistory and evidence behind
that.
Let's start with.
What are indexes?
What is an index?
Well, an index is simply a listof investments that's trying to
represent a broad market or abroad category.
It's a list of investments witha set of rules that tells you
who is in the list.
(04:02):
For example, the S&P 500, whichis the, the index that many
people just sort of hang theirhats on.
this is a list created byStandard Poors, and it tracks
the largest group of companiesin the United States.
Um, the Russell 3000, the DowJones US Total Stock Market
(04:22):
Index.
Those are examples of indexes oflists that invest in the broad
US stock market as a whole.
there are also indexes forinternational, for example, MSCI
EAFE Index, EAFE Index.
Covers large and medium sizedcompanies across developed
non-US markets overseas.
(04:43):
There's also an index thatinvests across the entire global
market, or the world outside ofthe US and so you have all of
these lists that are trying toinvest in these broad markets or
even broad categories.
For example, all real estateinvestment trusts that are
publicly traded in the UnitedStates.
These are lists with a set ofrules.
(05:04):
Sometimes a human committee thathelps decide who is in the list.
And their goal is simply to tryto represent or or track a broad
market or broad category.
And.
Index funds are just mutualfunds or exchange traded funds,
ETFs that try to replicate thatindex.
So for example, an S&P 500 indexfund is a fund that's trying to
(05:28):
replicate the performance of theS&P 500.
And you'll find index fundstracking all sorts of these
indexes US, globally,international or whatever it may
be.
And I'll add not all indexes orindex funds are created equal.
you'll find indexes that aresort of thematic or industry
specific, like defense or techor marijuana or a lot of
(05:54):
different things like that.
What you'll find is there arethousands of indexes and there's
actually more indexes than thereare stocks.
But what you're gonna find witha lot of those is that they're
just.
Active approaches, activemanagement approaches with a
passive sticker, added ontothem.
They are as one study notes"passive in name" only their
(06:18):
really just active investmentapproaches sort of wrapped up in
the skin of an index.
They may have index in thetitle.
But they're really just activemanagement strategies, and if
you are investing in some ofthese indexes, a lot of the
times you'll see tech indexessuggested by people.
I mean, let's just call it whatit is.
You're making an activeinvestment decision.
This is an active bet wrapped upin an in an index.
(06:42):
That's not what I'll be talkingabout through this conversation.
I am focused on here wholemarket index funds.
Not sort of those really activebets wrapped up in an index.
So let's talk about the historyof index funds and the, to me
anyways, the, the history isfascinating because it's wrapped
up in sort of this revolution inresearch around financial
(07:05):
markets and innovation.
I mean, the index funds were ahuge innovation in investing
that have benefited how manymillions of investors all over
the world.
And the case for indexing reallystarts in academia.
If you go back to sixties andseventies, maybe late fifties,
there's a bit of an academicresearch renaissance, especially
(07:27):
centered around the Universityof Chicago.
As more data was available, andmore importantly, computing
power allowed researchers tohave a better understanding of.
How markets actually behave, howindividual stocks and markets
actually perform, andimportantly, how active fund
managers perform.
(07:48):
And they have the ability now tocompare that to the overall
broad market or differentcategories.
And there was research back thenaround how to build portfolios.
For example, 1952, HarryMarkowitz wrote about this, what
we call the modern portfoliotheory.
Basically looking at your mix ofinvestments as a whole and the
(08:09):
importance of diversification.
Bill Sharp in 1964 wrote aboutthe capital asset pricing model,
which, if you've taken an MBAcourse, you probably still see
this, taught even thoughtechnically the, the model
itself isn't really usable in,in real life.
But I mean, these aregroundbreaking theories and
research around how to build andmanage portfolios.
And you see research around howstock prices appear to follow a
(08:33):
sort of a"random walk".
Reacting to new information asit comes in without having
predictability in where they'regoing to go, especially in the
distant future.
Much to the dismay of technicaltraders trying to look at charts
and make predictions aroundprice movements.
You see research from MichaelJensen back to 1968, around how
(08:53):
active managers failed to beatthe market after adjusting for
risk and fees and basically lookno different than what you'd
expect from just purestatistical chance or
randomness.
Gene Fama in 1970 wrote aboutthe efficient market hypothesis.
Burton Malkiel in 1973 wrote hisfirst edition of the book, A
Random Walk Down Wall Street,sort of putting all this in
(09:15):
terms that the general publiccan understand and proposing the
idea of a fund that simply buysthe broad market sort of ahead
of his time.
he wasn't the first one or theonly one to, to come up with
this idea, but he is the firstone sort of proposing it to the
general public.
At 1971 and 1973, is when, whenthe first index funds were
(09:39):
actually created in practice.
So the first time that academicsin Wells Fargo and one other
investment firm really startedto take these academic theories
and research and put it intopractice, but these early ones
were only for institutional,investors like pension funds.
Jack Bogle, 1976 is the firstone that took that idea and made
(10:03):
it available for everydayinvestors.
and he did that throughVanguard.
and the first fund was a fundtracking the S&P 500.
So not even the full US stockmarket, but as much of it as was
possible at the time.
And index funds, of course, weremocked by the active investment
management in Wall StreetIndustry.
(10:24):
Why settle for average issomething that was commonly
said.
It was called un-American,Vanguard in particular, their
first index fund was, wasinitially mocked as"Bogle's
Folly".
It couldn't even raise enoughdollars to initially buy the
full S&P 500.
They had to sort of mimic itstatistically as well as they
could.
(10:44):
But through all of that mocking,it turns out that what we know
now is that boring was actuallypretty brilliant.
This was a true innovation ininvesting and it gets me
excited.
I don't know if it gets youexcited, but I mean it's, it's
hard to overstate just howhelpful this was to allowing
(11:06):
investors to really easilyaccess broad global financial
markets and put their dollars towork.
And let's talk about theevidence of why indexing works
and why active investingconsistently falls short, and
why we should expect it tocontinue to do so.
So as we go back to thatdecision, okay.
Should we, you know, look atyour 401k lineup.
(11:29):
Should we be picking thoseactive mutual funds?
Or should we be taking a morepassive approach?
Well, let's look at what theevidence suggests.
and there is a long body ofresearch going back to 1960s,
showing consistently that activeinvestment managers struggle,
have a really poor track recordof outperforming their index
(11:52):
category benchmarks.
They do a really poor jobhistorically at outperforming
the market as a whole.
And some examples of that, onethat is most available to you
and everyone else is this SPIVAReport, which is created by
Standard Poors who obviouslycreates their own indexes,
right?
For, for managers to replicate.
(12:13):
But they put out this reporteach and every year, and the
results are sort of laughablyconsistent.
For example, if we look at allmutual funds in the US that
invest in large stocks.
Over 15 year periods, almostjust about 90% of them
underperform the S&P 500, 10years.
It's about se the same results.
(12:34):
Even if we go to one yearperiods a time, roughly 65% of
them underperform the S&P 500index.
So worse than a coin flip, evenin really short term periods, if
we go to all US based indexfunds.
93% of them over a 15 yearperiod underperformed the S&P's
Index Benchmark.
(12:54):
Similar results for smallcompany mutual funds, over long
periods of time.
if we look at global andinternational funds, global
funds, 92% of global fundsunderperformed the S&P global
Index.
Similar results for emergingmarkets and for developed
international funds.
(13:14):
The results are consistent.
The vast majority of activemanagers fail to outperform
their index benchmarks.
And this is certainly the case,the longer the time horizon, and
we are, for the most part, longterm investors, right?
We have to look at what approachis gonna work most likely over
the long term.
And I'll throw a link to the shin the show notes to, to all
(13:35):
these things I'm mentioning.
Morningstar also puts their ownversion of this.
They have the Active and PassiveBarometer.
They even go to 20 year timehorizons.
The results are pretty similaracross categories.
We have, research from 1997.
From Carhart he sees no evidenceof consistent skill, and winners
rarely persist to continue to bewinners.
(13:57):
Fama and French has shown thatmost positive performance seen
in fund data is statisticallyindistinguishable from luck
rather than skill.
Only a tiny sliver of fundsactually showed true sign of
skill, at least statistically.
And on a net return, meaningafter fees, what you as an
investor actually get.
Almost no funds beat theirbenchmark after costs.
(14:20):
Hank Bessembinder looked at dataabout what percentage of US
stock mutual funds beat SPY,which is an ETF, that it invests
that tracks in the S&P 500, andhe saw that on a monthly basis,
47% of mutual funds outperformSPY.
So even in really short termtime horizons, like one month
periods it's worse than a coinflip annually, it's actually a
(14:42):
little bit worse.
Only 41% of them outperformedSPY.
Over a decade, 38%, and over afull 30 year sample period, only
30% of them outperformed.
His methodology, the way hetracks that, is actually a
little bit more favorable thanthe SPIVA reports, but it's
still really bad.
And on top of that, only 45% ofindividual funds beat the SPY
(15:06):
before fees.
So there's maybe some evidencethat a small percentage of
managers are skilled, but theirfees are bigger than their skill
on average.
And, and we can go on and on.
What's quite clear from theevidence we have is that active
fund managers are reallyunlikely to outperform simply
(15:27):
investing in the broad marketthrough an index.
And what that tells us asinvestors then is that if we're
going to try to take that anactive investment approach, if
we're gonna try to pick anactively managed mutual fund,
we're also really unlikely to,to outperform simply using an
index in a broad market indexfund.
Which is interesting becausethe, the common argument against
(15:50):
passive investing is that whysettle for average, but the
people that say that, I don'tthink they have an understanding
of what average means.
Because if you are investing inthe broad market through an
index, you're actually puttingyourself historically in the top
20% of performing funds.
On a consistent basis.
I mean the data around this isconsistent year after year or
(16:11):
study after study.
And what's also interesting isthat we need active investors,
capital markets.
Financial markets need activeinvestors to keep markets
functioning, we need activeinvestors to set prices.
We need active investors toprovide liquidity.
So when even index funds, forexample, need to purchase stock
well active managers provide thestock for them to purchase, when
(16:34):
even index funds need to sellcompanies that are outta the
index, well active managersprovide a market, they may be
the ones purchasing that fromthose index funds.
So we need active managers toprovide liquidity.
We need active managers to setprices.
Efficiently.
We need active managers for allof this financial plumbing to
work.
(16:54):
We would just rather youoptometrists not participate in
their game.
So why is that the case?
Why?
Is the evidence so stronglyagainst active investment
management and so strongly inthe favor of using something
like an index fund of passiveinvesting.
Well, one of the reasons isbecause this is what we would
expect from financial andinvestment theory.
(17:18):
You probably don't want to hearabout financial theory, but to
take one example, if we go backto Gene Fama's efficient market
hypothesis, well, what does thatmean?
Well.
The efficient market hypothesisis a model for understanding how
markets set prices forcorporations and other assets
and how markets work.
And what it says is that at somelevel, the prices that you see
(17:41):
already reflect publicly known,available information about that
business for a stock, forexample, and prices react
quickly to new information as itcomes in.
Favorable information would seethe price quickly rise to
reflect that.
Poor information would see theprice decline to reflect that.
(18:02):
and what is the market?
Well, the market's not just asquiggly line on the screen.
The market is made up ofthousands and thousands of
investors all over the world.
The vast majority of which thatare actually investing and
setting prices are professionalinstitutional managers.
And all of these investors arelooking at the information
(18:23):
that's available about thesecompanies, about their
financials, the outlook fortheir industry, political risks,
things like that, and their ownneeds and preferences, and
coming to a conclusion aroundhow that company is going to
fare in the near future and howit's earnings are going to
change in the near future, andhow certain or uncertain that
is, and based on those opinionsthey make buying and selling
(18:46):
decisions based on and based ontheir opinions, on their
conclusions.
They make buying and sellingdecisions and all of that,
buying and selling activity setsprices for these stocks.
And so prices reflect sort ofthe aggregate combined opinion
of all investors in that companyor of all investors in the
(19:09):
market.
And if you think about, if youown an Optometry practice, think
about your own practice.
Imagine if you opened up yourfinancials, your books, to
thousands of practiceconsultants to other practice
owners, to private equityinvestors, and all of these
investors and all of thesepeople were able to constantly
look at your financials.
(19:30):
and run valuations, and were allconstantly sending you offers to
buy and sell ownership in yourpractice.
Well, if you took all of thoseoffers and averaged them out,
you'd have a pretty good idea ofwhat the fair market value of
your practice is.
And that's essentially what'shappening every day on a, on a
(19:51):
constant basis for all these,all these investments.
And so that's what's meant by anefficient market.
These prices are reflecting onsome level all of the
information that's publiclyavailable and we wouldn't expect
prices to be perfect.
We don't expect markets to beperfectly efficient.
Not even the original authorwould suggest that.
(20:12):
but pretty efficient.
They set fair prices at leastmore fair than you and I are
able to real, to take advantageof.
And if that's the case, if theseprices are set fairly, we would
not expect active managers to beable to consistently either you
or professionals to be ableconsistently find mispriced
(20:34):
investments.
Because ultimately if you're atmaking active decisions.
What you're trying to do is findstocks that are not priced
correctly.
You're saying the market hasmispriced this, I believe it
should be priced higher, so I'mgonna buy it cheaper, or I
believe it's overpriced and soI'm gonna sell it short.
Right.
That's essentially what'shappening.
And so if that's the case, wewouldn't expect investors to
(20:57):
consistently be able to findmispriced investments.
The analogy that I think ispretty good is that, yeah, you
might find a a hundred dollarsbill on the floor.
You know, if you find it, pickit up.
But that doesn't mean that youshould spend your life trying to
make a living of finding ahundred dollars bills on the
floor.
It's very likely that as soon assomeone finds them, they're
(21:17):
gonna be picked up.
And that's essentially a way tothink about it.
And to add to that, as I talkedabout in my episode with Andrew
Berkin, who was a co-author ofthe book, The Incredible
Shrinking Alpha.
he describes how there are lessand less non-professional
investors to take advantage of.
So that's really, you OD as moreand more are moving away from
(21:38):
active management to things likeindex funds and there are more
and more professional analysts,managers that have never been
more well equipped, that havenever had better data and tools
and have never been bettereducated and trained.
And that's the competition.
I mean, that's really thecompetition that we're, we're
running against.
And they are all fighting for asmaller and smaller amount of
(21:59):
outperformance.
And to think of us as individualnon-professional investors, the
more you start to learn abouthow markets behave and the
evidence around that, and thelikelihood that if you are
trading, it's pretty likely thatan active professional manager's
on the other side of your trade,that's who you're competing
with.
You start to understand that wehave no advantage.
(22:20):
We don't have information thatthe market as a whole doesn't
have, especially thoseprofessional managers we're
competing with.
We don't have an ability to acton or interpret the as
information more quickly orbetter than everyone else.
And so the more you learn, themore you start to understand
just how unlikely it is thatyou're gonna be successful
trying to actively pick stocksor time markets.
(22:43):
So the first sort of point tothat is that this is what
investment research and theorywould suggest should happen.
Hey ODs, time for a quick break.
If you're enjoying the podcast,don't miss my Weekly Eyes On the
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(23:04):
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The second important part ofthat is that fees and taxes are
a huge drag on performance.
(23:26):
There are a huge barrier, again,there's a long body of academic
research going back to 1968 thatshows that active managers don't
add enough value on average tocover their fees and especially
taxes, even when there'sevidence that managers have
skill and may on averageoutperform their appropriate
benchmark, that extra value andoutperformance quickly goes away
(23:49):
after fees, and especially looksworse after taxes, which is
really important if you areusing a taxable brokerage
account.
And you're using activemanagers, active investment
funds in that account, or ifyour professional that you're
working with is using a list ofactive managers in that account.
You really have to question theimpact that it's going to have
(24:12):
on taxes because those activemanagers are going to trade more
and that trading's very likelycreate more capital gains, and
that capital gains income ispassed on to you, the owner of
the fund, and it's gonna end upon your tax return.
You really have to question howefficiently that is and how much
of a drag those taxes are gonnabe on the performance.
And the cost here include theexplicit costs.
(24:34):
So the, the things you actuallysee, like the commissions if you
are buying, A share mutualfunds, I, I question why those
still exist, but the commissionson the front end are a part of
that.
and the annual expense ratiosare a part of that as well.
As well as the trading costs,you don't see those are the
trading costs from the activityof the manager itself.
(24:54):
So those costs are a huge partof that.
And again, there's, there'sevidence that would suggest that
even before fees, most managerson average would not outperform
the index.
But even where it's the casethat they do that quickly goes
away after fees.
There's a Morningstar paper at2016 that I'll link to.
and Morningstar is a businessthat basically analyzes funds,
(25:18):
right?
That's sort of their business.
And, what they found was thatthe single best predictor of
future fund performance was theexpense ratios.
It wasn't the only predictor,but it was the most prominent
predictor.
And sometimes what you'll see aswell is that there are so-called
"closet indexers", where thefund managers own so many stocks
(25:38):
within the category that they'rebasically either purposely or
not just mimicing the index andcharging the higher expenses for
that.
So you're sort of getting theworst of both worlds.
You're not quite getting theindex market performance, but
you're also paying the higherfees for that.
So fees and taxes are a hugecomponent to that.
Another reason index funds workso well is that they're broadly
(26:00):
diversified, which is reallyimportant.
Because when you look atresearch around individual
stocks, how markets work, stockmarkets are highly skewed.
What that means is that moststocks actually perform poorly
and a relative few amount ofstocks perform exceptionally
(26:21):
well, and that few percentage,that small percentage is what
actually drives the return ofmarkets as a whole.
for example, Hank Bessembinderin 2018 wrote, Do Stocks
Outperform Treasury Bills?, andthe the information is
fascinating.
So he looked at US stocks goingback from 1926 to 2016, and
(26:42):
looking at individual stocks.
So individual companies.
Only 42.6% of those individualstocks had lifetime returns,
greater higher than one month,US Treasury bills, which is
basically a cash equivalent, soless than half of them over
their lifetime had returns thatwere higher than a cash
(27:04):
equivalent.
Over half of those individualstocks had negative lifetime
returns.
And the most frequent outcome.
So if you list all of theoutcomes of those companies, the
most frequent one, the mostfrequent outcome over their full
lifetime was a 100% loss, was afull loss of investment.
(27:26):
And in his simulations, just 4%of stocks accounted for all of
the net Wealth created by themarket as a whole, which is just
incredible to think about howpoorly most individual stocks
perform.
he continued that research in2019, Do Global Stocks
Outperform US Treasury Bills?,and he saw similar results and
(27:48):
actually worse results when youlook at stocks globally.
And so while we often talk aboutthe average returns of market as
a whole, you know, we talkabout, hey, the US stock market
on average, going backthroughout history performed
this, or, you know, the globalstock market on average
performed this per year.
And that's fun to talk aboutaverages, but it's a much
(28:08):
different story when lookingunder the hood at how individual
companies perform.
And even when we talk aboutbuying the dip, for example, I.
When you talk about buying thedip with an individual stock, it
is not the same at all whenyou're talking about buying the
dip.
With a market as a whole with anindividual stock buying the dip
has a much different and muchwider range of outcomes than the
(28:30):
whole broad market, and so thisis sort of a reality check for.
Us as individual investors andfor pro for professional
managers.
Most stocks underperform andmany lose money, and the results
are highly skewed.
And you see similar results withfund managers too, within funds.
And so if you're an active fundmanager, if you're one of those
(28:52):
managers having to run aninvestment fund, you're having
to have the higher expenses ofan investment team and more data
and research.
You have to look different than,than the broad market in order
to outperform with your skill.
And the more you look different,the more it's going to increase
the chances, the odds of notowning those best performing
(29:16):
stocks.
I.
Or underweighting them.
And if an active manager's toodiversified, then you end up
with that closet indexing issuethat I mentioned earlier.
Index funds on the other hand bydefinition, are gonna own all of
the stocks within the marketthat they're tracking.
You're gonna own, yes, the worstperforming assets.
That's a part ofdiversification.
(29:38):
But you're also going to own thebest.
You're gonna own the wholehaystack rather than trying to
find the needle, you're going toget the returns of the market as
a whole.
And if you as an individual, OD,if you're trying to pick stocks,
you really should consider andread and think about the
statistics and research likethis.
(29:59):
You need to have a really goodunderstanding of just how
unlikely it is that you're goingto be able to consistently be
successful if you're trying totime markets or pick individual
stocks.
I mean, you're essentiallytaking on casino like outcomes
here where you're hoping forthat home run pick, but you're
most likely not going to win.
(30:19):
And when asked recently in aninterview why investors keep
trying to pick individualstocks.
The author's answer was numberone, either investors have a
preference for that skewness, soyou're really looking for the
possibility of that really highreturn.
Even if it's really unlikely ormore likely, it's investor
(30:41):
overconfidence.
So we really have to have a goodunderstanding of the odds that
we're working with.
And you are competing with anever-growing amount of the
smartest and most well-equippedprofessionals on the planet for
a really small percentage ofhome run hitters.
I.
so the skewness of howindividual stock returns show up
(31:02):
and the importance ofdiversification is an important
reason why index fund and indexfund investing works.
Another important aspect of thatis that even for those managers
that do really well.
There's very little evidence ofpersistency in the data.
Funds that do well in priorperiods, do not continue to do
(31:23):
well in future periods.
And some explanations of thisthat come from research is,
well, number one, is that datadoesn't show any evidence of
skill for managers.
And even good performance issimply from luck or statistical
randomness.
And if returns are random, thenwe wouldn't expect there to be
(31:43):
any persistency orpredictability with future
returns.
another explanation that comesfrom research, which is a bit
more generous to managersconsidering just really how
smart they are and well equippedthey are.
finance does attract some of themost intelligent people out
there.
another explanation is thatfunds simply get too big if they
(32:05):
have a specific investmentapproach, and that leads to
outperformance.
Too much cash flowing into thefund leads to the manager not
being able to invest the dollarsefficiently.
And for example, a managerthat's investing in sort of the
smallest companies in the UnitedStates.
And if more cash is piling in,they can't any longer just
(32:26):
invest in only the smallestcompanies.
They have to start buying mediumsized companies, for example,
and eating away at theirstrategy, and again, they start
to look more and more like theindex.
I've seen over time.
Funds close the close theirfunds to new investors.
To sort of counter this, theysimply can't bring in dollars to
infinity and invest in the sameway.
(32:47):
And even Warren Buffett, youlook at Warren Buffett's
investor letters, he's writtento his investors about the same
thing happening with BerkshireHathaway, about Berkshire
getting too big and having toomuch money.
in order to set properexpectations for the investors,
they're not going to get thesame returns as in the past.
And what we also see is thateven when there are skilled
(33:08):
managers and people rationallyput their dollars into the fund,
the fees of the fund end up sohigh that any outperformance of
that manager just ends up in thepocket of the management team
and not the investors.
However, interestingly, theworst performing funds they do
show persistency.
So the worst performing funds doshow evidence that they continue
(33:31):
to be among the worst performingfunds.
So you can have a manager withlow skill, charging high fees,
and you can feel prettyconfident that you're reliably
gonna get under performance.
And so not only is it unlikelythat active managers as a whole
outperform the index benchmark,but even for those managers that
do, it's very unlikely thatthose managers continue to do
(33:53):
well.
So you're essentially playing agame where you have to
constantly reselect andre-identify the managers ahead
of time.
Over and over and over again,knowing that the odds are so
against you.
And what's unfortunate is thatwhen you look at 401k plans, for
example, when you look at thefund lineup, what do you see?
Well, you see a list of fundsand you see recent returns.
(34:16):
You see year to date returns,one year returns, three years,
five years, even 10 years is areally short term time horizon.
But those return numbers aren'thelpful to making the choice of
how to invest.
Past recent returns are not anindicator of how future returns
are gonna look for an activemanager.
And you'll hear sometimes, Hey,look at this fund.
(34:38):
Look at how XYZ mutual fundperformed in the past.
But all you can really say aboutthat is that yes, investors at
that time received thatperformance, but that doesn't
tell you how the fund in thefuture will perform.
And from the data we have, weshouldn't expect that to
continue.
And we do see that investorsplow money into funds after
(35:03):
great performance.
Investors aren't identifyingthem ahead of time, they're
chasing investment performanceafter it's happening, but they
don't see that great performancecontinue.
And the average investor, if youlook at studies around this, the
average investor's dollars.
End up underperforming the funditself because of the timing of
(35:24):
investors' decision making ofwhen to buy and sell into these
funds.
And we recent example, KathyWoods ARKK Fund is an incredible
example of this.
And you'll see this commonlycalled the behavior gap in
investing in seen across studiesusing different methodologies to
show that on average investorsthemselves, their dollars, often
(35:46):
underperforms the funds thatthey're investing in because of
their, their own behavior.
And then one last thing thathelps the case of index funds is
its simplicity.
Very often complexity is aselling point for the mutual
fund or Wall Street industry.
And very often what I see isthat with a new client, I'll see
(36:06):
that they're coming from XYZ bigbox investment company and they
have all of their accountsmanaged separately.
And each account has a long listof 10 to 20 mutual funds, and
very often, a long list ofactively managed funds without,
in my opinion, any real rhyme orreason of why they're all there.
And this complexity isunnecessary.
(36:27):
Very often you can recreate thatmix of investments with far
fewer funds.
I mean, even from one globalmarket index fund to five or, or
very close to that, you don'tneed high complexity to be
successful as an investor.
Very often complexity leads toworse outcomes and worse
decisions, and so being able tovery simply invest in the broad
(36:53):
market as a whole veryinexpensively is a huge benefit
to investors.
It allows you to keep thingsclean and tidy and simple, and
it keeps more investment choicesoutta your hands, which tends to
lead to better investorbehavior.
And so that simplicity is reallyimportant.
I don't think investing needs tobe complex.
(37:13):
I think very often investingshould like be like watching a
tree grow.
Yes, you plant the seed, youplant the tree, you water it
over time, maybe you trim thehedges over time, but most of
the time you're simply allowingit to grow.
And if you are overcut it, ifyou're over hedging it, it tends
to damage the tree and tends todamage its growth.
(37:35):
And so I think investing veryoften should be thought of in
the same way.
Good investment approaches canbe handled with simplicity.
And sort of to wrap this up,when we look at the evidence,
the evidence in my opinion verystrongly points us to a passive
investment approach.
And index funds are a great wayto do that.
I'm not in a position here on apodcast to advise everyone how
(37:57):
to invest, but I think the dataand evidence are quite clear to
say that most investors shouldconsider broad market index
investing as their investmentapproach.
And that's due to number onefinancial theory, suggesting
that that's that that's what weshould expect.
number two costs in terms of theexpenses of the investment as
(38:18):
well as taxes are a huge barrierto the performance of active
managers.
I.
Number three, diversification'sreally important because markets
are highly skewed.
There's a very small percentageof stocks that actually drive
markets, and it's not likelythat in aggregate, all active
investors are going to pick thatsmall percentage of stocks.
And number three, simplicity isa huge part of having an
(38:39):
investment approach that you canstick with successfully.
And one closing thought on thatis that index funds are a tool.
Still have to decide how toinvest in terms of how much
stocks versus bonds isappropriate for you and how that
changes over time.
You have to decide which indexesto use to fill those categories.
You still have to decide whichcategories of funds, like for
(39:02):
example, bonds to put in pre-taxretirements versus other type of
accounts.
Which accounts to use from a taxplanning perspective.
You still have to decide how todraw from them as you get to
retirement.
While they are a really usefultool, there are still important
financial planning decisionsthat you have to plan around
over your lifetime.
So hopefully this was helpfulfor you to learn more about the
history behind index funds andthe research and evidence behind
(39:25):
why they work.
If you have any questions,please reach out.
If you are wondering whether youare invested in a way that is
evidence-based, that issupported by research, please
reach out.
We'd love to talk to you over aquick introductory call.
We can learn about yourinvestments and the questions on
your mind financially, and how Ihave helped optometrists all
over the country navigate thosesame things.
(39:46):
I am gonna throw everything Imentioned here into the show
notes, along with additionalbooks and videos to watch.
So hopefully those will behelpful for you as well.
And stay tuned for next week.
Next week I'm gonna talk abouthow this same academic research
continues and I'll talk aboutwhy, even though I love index
funds.
I don't actually start withindex funds in my own investment
approach, and next week'sepisode will be a guide for
(40:09):
optometrist on factor-basedinvesting.
So stay tuned.
Appreciate your time.
Thanks for listening.
We'll catch you on the nextepisode.
In the meantime, take care.
Hey everybody.
Welcome back to the OptometryMoney Podcast where we're
helping ODs all over the countrymake better and better decisions
around their money, theircareers, and their practices.
I am your host, Evon Mendrin,Certified Financial Planner(TM)
practitioner and owner ofOptometry Wealth Advisors an
independent financial planningfirm just for optometrists
(00:24):
nationwide.
And thank you so much forlistening.
Really appreciate your time andattention this week and today's
episode.
We are gonna dive all into indexfunds and index investing, and
you have probably, if you spentany amount of time online or in
a lot of these online groups foroptometrists, you probably have
seen index funds thrown aroundas a way to invest.
(00:46):
And I wanna dive into thehistory.
And the evidence making the caseof why index investing makes
sense for you for optometristsand why active investment
management is likely to cost youreturns over the long run.
Because you have a choice tomake.
Ultimately, we all have todecide as we Earn money, as your
(01:08):
practice is creating additionalcash flow and you are investing
it in your retirement and otheraccounts, you have to decide how
to invest it.
And you have to have an approachthat, number one, you
understand, number two, thatthere's evidence for it's, it's
likely to work in the long runand that you can stick with.
(01:29):
Even through times where it'suncomfortable and very often
that choice is going to besomewhere between should I take
an active investment approach.
Should I try to, or should I usemutual funds where the manager
is trying to pick individualstocks or individual investments
or time the swings in marketsand try to outperform the market
(01:52):
as a whole?
Or should I take a more passiveinvestment approach where I'm
simply trying to get theinvestment returns of the broad
market over time And so I wannatake a look at where the
evidence leads.
And for me personally, I've gonethrough an evolution myself, my
experience as a professional nowworking in my 11th year.
going back to college, we werestudying fundamental analysis,
(02:14):
like diving into financialstatements and trying to put a
valuation to companies andprobably not very good to be
honest with you.
but that, that sort of informedmy approach early on.
And then, almost a decade ago,working at one of those large
corporate financial companiesthat sells their own active
mutual funds, and getting sortof the Kool-Aid, of working in a
(02:37):
company like that.
And then over the years justquestioning that and examining
the evidence where, what doesthe evidence say about which
approach we should take wheninvesting?
And for me, in managing my ownfamily's money, and in my firm,
the investment approach in myfirm with our duty to manage
client dollars in their bestinterest.
(02:58):
The evidence points to the mostrational way to invest being a
passive style of investing orsystematic, you might hear it
called, or rules-based approachto investing.
And the way I define passive isthat, you or the fund that
you're using are not trying topick individual companies or
individual investments or totime swings in markets trying to
(03:20):
outperform.
But instead invest broadly in abroadly diversified way across
the whole market with a clearset of rules that are
systematic, that are able to bereplicated and that are
transparent.
And very often this approachleads to lower costs and index
funds are probably the mostcommon and well-known form of
(03:42):
passive investing.
And so I wanna dive into thehistory and evidence behind
that.
Let's start with.
What are indexes?
What is an index?
Well, an index is simply a listof investments that's trying to
represent a broad market or abroad category.
It's a list of investments witha set of rules that tells you
who is in the list.
(04:02):
For example, the S&P 500, whichis the, the index that many
people just sort of hang theirhats on.
this is a list created byStandard Poors, and it tracks
the largest group of companiesin the United States.
Um, the Russell 3000, the DowJones US Total Stock Market
(04:22):
Index.
Those are examples of indexes oflists that invest in the broad
US stock market as a whole.
there are also indexes forinternational, for example, MSCI
EAFE Index, EAFE Index.
Covers large and medium sizedcompanies across developed
non-US markets overseas.
(04:43):
There's also an index thatinvests across the entire global
market, or the world outside ofthe US and so you have all of
these lists that are trying toinvest in these broad markets or
even broad categories.
For example, all real estateinvestment trusts that are
publicly traded in the UnitedStates.
These are lists with a set ofrules.
(05:04):
Sometimes a human committee thathelps decide who is in the list.
And their goal is simply to tryto represent or or track a broad
market or broad category.
And.
Index funds are just mutualfunds or exchange traded funds,
ETFs that try to replicate thatindex.
So for example, an S&P 500 indexfund is a fund that's trying to
(05:28):
replicate the performance of theS&P 500.
And you'll find index fundstracking all sorts of these
indexes US, globally,international or whatever it may
be.
And I'll add not all indexes orindex funds are created equal.
you'll find indexes that aresort of thematic or industry
specific, like defense or techor marijuana or a lot of
(05:54):
different things like that.
What you'll find is there arethousands of indexes and there's
actually more indexes than thereare stocks.
But what you're gonna find witha lot of those is that they're
just.
Active approaches, activemanagement approaches with a
passive sticker, added ontothem.
They are as one study notes"passive in name" only their
(06:18):
really just active investmentapproaches sort of wrapped up in
the skin of an index.
They may have index in thetitle.
But they're really just activemanagement strategies, and if
you are investing in some ofthese indexes, a lot of the
times you'll see tech indexessuggested by people.
I mean, let's just call it whatit is.
You're making an activeinvestment decision.
This is an active bet wrapped upin an in an index.
(06:42):
That's not what I'll be talkingabout through this conversation.
I am focused on here wholemarket index funds.
Not sort of those really activebets wrapped up in an index.
So let's talk about the historyof index funds and the, to me
anyways, the, the history isfascinating because it's wrapped
up in sort of this revolution inresearch around financial
(07:05):
markets and innovation.
I mean, the index funds were ahuge innovation in investing
that have benefited how manymillions of investors all over
the world.
And the case for indexing reallystarts in academia.
If you go back to sixties andseventies, maybe late fifties,
there's a bit of an academicresearch renaissance, especially
(07:27):
centered around the Universityof Chicago.
As more data was available, andmore importantly, computing
power allowed researchers tohave a better understanding of.
How markets actually behave, howindividual stocks and markets
actually perform, andimportantly, how active fund
managers perform.
(07:48):
And they have the ability now tocompare that to the overall
broad market or differentcategories.
And there was research back thenaround how to build portfolios.
For example, 1952, HarryMarkowitz wrote about this, what
we call the modern portfoliotheory.
Basically looking at your mix ofinvestments as a whole and the
(08:09):
importance of diversification.
Bill Sharp in 1964 wrote aboutthe capital asset pricing model,
which, if you've taken an MBAcourse, you probably still see
this, taught even thoughtechnically the, the model
itself isn't really usable in,in real life.
But I mean, these aregroundbreaking theories and
research around how to build andmanage portfolios.
And you see research around howstock prices appear to follow a
(08:33):
sort of a"random walk".
Reacting to new information asit comes in without having
predictability in where they'regoing to go, especially in the
distant future.
Much to the dismay of technicaltraders trying to look at charts
and make predictions aroundprice movements.
You see research from MichaelJensen back to 1968, around how
(08:53):
active managers failed to beatthe market after adjusting for
risk and fees and basically lookno different than what you'd
expect from just purestatistical chance or
randomness.
Gene Fama in 1970 wrote aboutthe efficient market hypothesis.
Burton Malkiel in 1973 wrote hisfirst edition of the book, A
Random Walk Down Wall Street,sort of putting all this in
(09:15):
terms that the general publiccan understand and proposing the
idea of a fund that simply buysthe broad market sort of ahead
of his time.
he wasn't the first one or theonly one to, to come up with
this idea, but he is the firstone sort of proposing it to the
general public.
At 1971 and 1973, is when, whenthe first index funds were
(09:39):
actually created in practice.
So the first time that academicsin Wells Fargo and one other
investment firm really startedto take these academic theories
and research and put it intopractice, but these early ones
were only for institutional,investors like pension funds.
Jack Bogle, 1976 is the firstone that took that idea and made
(10:03):
it available for everydayinvestors.
and he did that throughVanguard.
and the first fund was a fundtracking the S&P 500.
So not even the full US stockmarket, but as much of it as was
possible at the time.
And index funds, of course, weremocked by the active investment
management in Wall StreetIndustry.
(10:24):
Why settle for average issomething that was commonly
said.
It was called un-American,Vanguard in particular, their
first index fund was, wasinitially mocked as"Bogle's
Folly".
It couldn't even raise enoughdollars to initially buy the
full S&P 500.
They had to sort of mimic itstatistically as well as they
could.
(10:44):
But through all of that mocking,it turns out that what we know
now is that boring was actuallypretty brilliant.
This was a true innovation ininvesting and it gets me
excited.
I don't know if it gets youexcited, but I mean it's, it's
hard to overstate just howhelpful this was to allowing
(11:06):
investors to really easilyaccess broad global financial
markets and put their dollars towork.
And let's talk about theevidence of why indexing works
and why active investingconsistently falls short, and
why we should expect it tocontinue to do so.
So as we go back to thatdecision, okay.
Should we, you know, look atyour 401k lineup.
(11:29):
Should we be picking thoseactive mutual funds?
Or should we be taking a morepassive approach?
Well, let's look at what theevidence suggests.
and there is a long body ofresearch going back to 1960s,
showing consistently that activeinvestment managers struggle,
have a really poor track recordof outperforming their index
(11:52):
category benchmarks.
They do a really poor jobhistorically at outperforming
the market as a whole.
And some examples of that, onethat is most available to you
and everyone else is this SPIVAReport, which is created by
Standard Poors who obviouslycreates their own indexes,
right?
For, for managers to replicate.
(12:13):
But they put out this reporteach and every year, and the
results are sort of laughablyconsistent.
For example, if we look at allmutual funds in the US that
invest in large stocks.
Over 15 year periods, almostjust about 90% of them
underperform the S&P 500, 10years.
It's about se the same results.
(12:34):
Even if we go to one yearperiods a time, roughly 65% of
them underperform the S&P 500index.
So worse than a coin flip, evenin really short term periods, if
we go to all US based indexfunds.
93% of them over a 15 yearperiod underperformed the S&P's
Index Benchmark.
(12:54):
Similar results for smallcompany mutual funds, over long
periods of time.
if we look at global andinternational funds, global
funds, 92% of global fundsunderperformed the S&P global
Index.
Similar results for emergingmarkets and for developed
international funds.
(13:14):
The results are consistent.
The vast majority of activemanagers fail to outperform
their index benchmarks.
And this is certainly the case,the longer the time horizon, and
we are, for the most part, longterm investors, right?
We have to look at what approachis gonna work most likely over
the long term.
And I'll throw a link to the shin the show notes to, to all
(13:35):
these things I'm mentioning.
Morningstar also puts their ownversion of this.
They have the Active and PassiveBarometer.
They even go to 20 year timehorizons.
The results are pretty similaracross categories.
We have, research from 1997.
From Carhart he sees no evidenceof consistent skill, and winners
rarely persist to continue to bewinners.
(13:57):
Fama and French has shown thatmost positive performance seen
in fund data is statisticallyindistinguishable from luck
rather than skill.
Only a tiny sliver of fundsactually showed true sign of
skill, at least statistically.
And on a net return, meaningafter fees, what you as an
investor actually get.
Almost no funds beat theirbenchmark after costs.
(14:20):
Hank Bessembinder looked at dataabout what percentage of US
stock mutual funds beat SPY,which is an ETF, that it invests
that tracks in the S&P 500, andhe saw that on a monthly basis,
47% of mutual funds outperformSPY.
So even in really short termtime horizons, like one month
periods it's worse than a coinflip annually, it's actually a
(14:42):
little bit worse.
Only 41% of them outperformedSPY.
Over a decade, 38%, and over afull 30 year sample period, only
30% of them outperformed.
His methodology, the way hetracks that, is actually a
little bit more favorable thanthe SPIVA reports, but it's
still really bad.
And on top of that, only 45% ofindividual funds beat the SPY
(15:06):
before fees.
So there's maybe some evidencethat a small percentage of
managers are skilled, but theirfees are bigger than their skill
on average.
And, and we can go on and on.
What's quite clear from theevidence we have is that active
fund managers are reallyunlikely to outperform simply
(15:27):
investing in the broad marketthrough an index.
And what that tells us asinvestors then is that if we're
going to try to take that anactive investment approach, if
we're gonna try to pick anactively managed mutual fund,
we're also really unlikely to,to outperform simply using an
index in a broad market indexfund.
Which is interesting becausethe, the common argument against
(15:50):
passive investing is that whysettle for average, but the
people that say that, I don'tthink they have an understanding
of what average means.
Because if you are investing inthe broad market through an
index, you're actually puttingyourself historically in the top
20% of performing funds.
On a consistent basis.
I mean the data around this isconsistent year after year or
(16:11):
study after study.
And what's also interesting isthat we need active investors,
capital markets.
Financial markets need activeinvestors to keep markets
functioning, we need activeinvestors to set prices.
We need active investors toprovide liquidity.
So when even index funds, forexample, need to purchase stock
well active managers provide thestock for them to purchase, when
(16:34):
even index funds need to sellcompanies that are outta the
index, well active managersprovide a market, they may be
the ones purchasing that fromthose index funds.
So we need active managers toprovide liquidity.
We need active managers to setprices.
Efficiently.
We need active managers for allof this financial plumbing to
work.
(16:54):
We would just rather youoptometrists not participate in
their game.
So why is that the case?
Why?
Is the evidence so stronglyagainst active investment
management and so strongly inthe favor of using something
like an index fund of passiveinvesting.
Well, one of the reasons isbecause this is what we would
expect from financial andinvestment theory.
(17:18):
You probably don't want to hearabout financial theory, but to
take one example, if we go backto Gene Fama's efficient market
hypothesis, well, what does thatmean?
Well.
The efficient market hypothesisis a model for understanding how
markets set prices forcorporations and other assets
and how markets work.
And what it says is that at somelevel, the prices that you see
(17:41):
already reflect publicly known,available information about that
business for a stock, forexample, and prices react
quickly to new information as itcomes in.
Favorable information would seethe price quickly rise to
reflect that.
Poor information would see theprice decline to reflect that.
(18:02):
and what is the market?
Well, the market's not just asquiggly line on the screen.
The market is made up ofthousands and thousands of
investors all over the world.
The vast majority of which thatare actually investing and
setting prices are professionalinstitutional managers.
And all of these investors arelooking at the information
(18:23):
that's available about thesecompanies, about their
financials, the outlook fortheir industry, political risks,
things like that, and their ownneeds and preferences, and
coming to a conclusion aroundhow that company is going to
fare in the near future and howit's earnings are going to
change in the near future, andhow certain or uncertain that
is, and based on those opinionsthey make buying and selling
(18:46):
decisions based on and based ontheir opinions, on their
conclusions.
They make buying and sellingdecisions and all of that,
buying and selling activity setsprices for these stocks.
And so prices reflect sort ofthe aggregate combined opinion
of all investors in that companyor of all investors in the
(19:09):
market.
And if you think about, if youown an Optometry practice, think
about your own practice.
Imagine if you opened up yourfinancials, your books, to
thousands of practiceconsultants to other practice
owners, to private equityinvestors, and all of these
investors and all of thesepeople were able to constantly
look at your financials.
(19:30):
and run valuations, and were allconstantly sending you offers to
buy and sell ownership in yourpractice.
Well, if you took all of thoseoffers and averaged them out,
you'd have a pretty good idea ofwhat the fair market value of
your practice is.
And that's essentially what'shappening every day on a, on a
(19:51):
constant basis for all these,all these investments.
And so that's what's meant by anefficient market.
These prices are reflecting onsome level all of the
information that's publiclyavailable and we wouldn't expect
prices to be perfect.
We don't expect markets to beperfectly efficient.
Not even the original authorwould suggest that.
(20:12):
but pretty efficient.
They set fair prices at leastmore fair than you and I are
able to real, to take advantageof.
And if that's the case, if theseprices are set fairly, we would
not expect active managers to beable to consistently either you
or professionals to be ableconsistently find mispriced
(20:34):
investments.
Because ultimately if you're atmaking active decisions.
What you're trying to do is findstocks that are not priced
correctly.
You're saying the market hasmispriced this, I believe it
should be priced higher, so I'mgonna buy it cheaper, or I
believe it's overpriced and soI'm gonna sell it short.
Right.
That's essentially what'shappening.
And so if that's the case, wewouldn't expect investors to
(20:57):
consistently be able to findmispriced investments.
The analogy that I think ispretty good is that, yeah, you
might find a a hundred dollarsbill on the floor.
You know, if you find it, pickit up.
But that doesn't mean that youshould spend your life trying to
make a living of finding ahundred dollars bills on the
floor.
It's very likely that as soon assomeone finds them, they're
(21:17):
gonna be picked up.
And that's essentially a way tothink about it.
And to add to that, as I talkedabout in my episode with Andrew
Berkin, who was a co-author ofthe book, The Incredible
Shrinking Alpha.
he describes how there are lessand less non-professional
investors to take advantage of.
So that's really, you OD as moreand more are moving away from
(21:38):
active management to things likeindex funds and there are more
and more professional analysts,managers that have never been
more well equipped, that havenever had better data and tools
and have never been bettereducated and trained.
And that's the competition.
I mean, that's really thecompetition that we're, we're
running against.
And they are all fighting for asmaller and smaller amount of
(21:59):
outperformance.
And to think of us as individualnon-professional investors, the
more you start to learn abouthow markets behave and the
evidence around that, and thelikelihood that if you are
trading, it's pretty likely thatan active professional manager's
on the other side of your trade,that's who you're competing
with.
You start to understand that wehave no advantage.
(22:20):
We don't have information thatthe market as a whole doesn't
have, especially thoseprofessional managers we're
competing with.
We don't have an ability to acton or interpret the as
information more quickly orbetter than everyone else.
And so the more you learn, themore you start to understand
just how unlikely it is thatyou're gonna be successful
trying to actively pick stocksor time markets.
(22:43):
So the first sort of point tothat is that this is what
investment research and theorywould suggest should happen.
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The second important part ofthat is that fees and taxes are
a huge drag on performance.
(23:26):
There are a huge barrier, again,there's a long body of academic
research going back to 1968 thatshows that active managers don't
add enough value on average tocover their fees and especially
taxes, even when there'sevidence that managers have
skill and may on averageoutperform their appropriate
benchmark, that extra value andoutperformance quickly goes away
(23:49):
after fees, and especially looksworse after taxes, which is
really important if you areusing a taxable brokerage
account.
And you're using activemanagers, active investment
funds in that account, or ifyour professional that you're
working with is using a list ofactive managers in that account.
You really have to question theimpact that it's going to have
(24:12):
on taxes because those activemanagers are going to trade more
and that trading's very likelycreate more capital gains, and
that capital gains income ispassed on to you, the owner of
the fund, and it's gonna end upon your tax return.
You really have to question howefficiently that is and how much
of a drag those taxes are gonnabe on the performance.
And the cost here include theexplicit costs.
(24:34):
So the, the things you actuallysee, like the commissions if you
are buying, A share mutualfunds, I, I question why those
still exist, but the commissionson the front end are a part of
that.
and the annual expense ratiosare a part of that as well.
As well as the trading costs,you don't see those are the
trading costs from the activityof the manager itself.
(24:54):
So those costs are a huge partof that.
And again, there's, there'sevidence that would suggest that
even before fees, most managerson average would not outperform
the index.
But even where it's the casethat they do that quickly goes
away after fees.
There's a Morningstar paper at2016 that I'll link to.
and Morningstar is a businessthat basically analyzes funds,
(25:18):
right?
That's sort of their business.
And, what they found was thatthe single best predictor of
future fund performance was theexpense ratios.
It wasn't the only predictor,but it was the most prominent
predictor.
And sometimes what you'll see aswell is that there are so-called
"closet indexers", where thefund managers own so many stocks
(25:38):
within the category that they'rebasically either purposely or
not just mimicing the index andcharging the higher expenses for
that.
So you're sort of getting theworst of both worlds.
You're not quite getting theindex market performance, but
you're also paying the higherfees for that.
So fees and taxes are a hugecomponent to that.
Another reason index funds workso well is that they're broadly
(26:00):
diversified, which is reallyimportant.
Because when you look atresearch around individual
stocks, how markets work, stockmarkets are highly skewed.
What that means is that moststocks actually perform poorly
and a relative few amount ofstocks perform exceptionally
(26:21):
well, and that few percentage,that small percentage is what
actually drives the return ofmarkets as a whole.
for example, Hank Bessembinderin 2018 wrote, Do Stocks
Outperform Treasury Bills?, andthe the information is
fascinating.
So he looked at US stocks goingback from 1926 to 2016, and
(26:42):
looking at individual stocks.
So individual companies.
Only 42.6% of those individualstocks had lifetime returns,
greater higher than one month,US Treasury bills, which is
basically a cash equivalent, soless than half of them over
their lifetime had returns thatwere higher than a cash
(27:04):
equivalent.
Over half of those individualstocks had negative lifetime
returns.
And the most frequent outcome.
So if you list all of theoutcomes of those companies, the
most frequent one, the mostfrequent outcome over their full
lifetime was a 100% loss, was afull loss of investment.
(27:26):
And in his simulations, just 4%of stocks accounted for all of
the net Wealth created by themarket as a whole, which is just
incredible to think about howpoorly most individual stocks
perform.
he continued that research in2019, Do Global Stocks
Outperform US Treasury Bills?,and he saw similar results and
(27:48):
actually worse results when youlook at stocks globally.
And so while we often talk aboutthe average returns of market as
a whole, you know, we talkabout, hey, the US stock market
on average, going backthroughout history performed
this, or, you know, the globalstock market on average
performed this per year.
And that's fun to talk aboutaverages, but it's a much
(28:08):
different story when lookingunder the hood at how individual
companies perform.
And even when we talk aboutbuying the dip, for example, I.
When you talk about buying thedip with an individual stock, it
is not the same at all whenyou're talking about buying the
dip.
With a market as a whole with anindividual stock buying the dip
has a much different and muchwider range of outcomes than the
(28:30):
whole broad market, and so thisis sort of a reality check for.
Us as individual investors andfor pro for professional
managers.
Most stocks underperform andmany lose money, and the results
are highly skewed.
And you see similar results withfund managers too, within funds.
And so if you're an active fundmanager, if you're one of those
(28:52):
managers having to run aninvestment fund, you're having
to have the higher expenses ofan investment team and more data
and research.
You have to look different than,than the broad market in order
to outperform with your skill.
And the more you look different,the more it's going to increase
the chances, the odds of notowning those best performing
(29:16):
stocks.
I.
Or underweighting them.
And if an active manager's toodiversified, then you end up
with that closet indexing issuethat I mentioned earlier.
Index funds on the other hand bydefinition, are gonna own all of
the stocks within the marketthat they're tracking.
You're gonna own, yes, the worstperforming assets.
That's a part ofdiversification.
(29:38):
But you're also going to own thebest.
You're gonna own the wholehaystack rather than trying to
find the needle, you're going toget the returns of the market as
a whole.
And if you as an individual, OD,if you're trying to pick stocks,
you really should consider andread and think about the
statistics and research likethis.
(29:59):
You need to have a really goodunderstanding of just how
unlikely it is that you're goingto be able to consistently be
successful if you're trying totime markets or pick individual
stocks.
I mean, you're essentiallytaking on casino like outcomes
here where you're hoping forthat home run pick, but you're
most likely not going to win.
(30:19):
And when asked recently in aninterview why investors keep
trying to pick individualstocks.
The author's answer was numberone, either investors have a
preference for that skewness, soyou're really looking for the
possibility of that really highreturn.
Even if it's really unlikely ormore likely, it's investor
(30:41):
overconfidence.
So we really have to have a goodunderstanding of the odds that
we're working with.
And you are competing with anever-growing amount of the
smartest and most well-equippedprofessionals on the planet for
a really small percentage ofhome run hitters.
I.
so the skewness of howindividual stock returns show up
(31:02):
and the importance ofdiversification is an important
reason why index fund and indexfund investing works.
Another important aspect of thatis that even for those managers
that do really well.
There's very little evidence ofpersistency in the data.
Funds that do well in priorperiods, do not continue to do
(31:23):
well in future periods.
And some explanations of thisthat come from research is,
well, number one, is that datadoesn't show any evidence of
skill for managers.
And even good performance issimply from luck or statistical
randomness.
And if returns are random, thenwe wouldn't expect there to be
(31:43):
any persistency orpredictability with future
returns.
another explanation that comesfrom research, which is a bit
more generous to managersconsidering just really how
smart they are and well equippedthey are.
finance does attract some of themost intelligent people out
there.
another explanation is thatfunds simply get too big if they
(32:05):
have a specific investmentapproach, and that leads to
outperformance.
Too much cash flowing into thefund leads to the manager not
being able to invest the dollarsefficiently.
And for example, a managerthat's investing in sort of the
smallest companies in the UnitedStates.
And if more cash is piling in,they can't any longer just
(32:26):
invest in only the smallestcompanies.
They have to start buying mediumsized companies, for example,
and eating away at theirstrategy, and again, they start
to look more and more like theindex.
I've seen over time.
Funds close the close theirfunds to new investors.
To sort of counter this, theysimply can't bring in dollars to
infinity and invest in the sameway.
(32:47):
And even Warren Buffett, youlook at Warren Buffett's
investor letters, he's writtento his investors about the same
thing happening with BerkshireHathaway, about Berkshire
getting too big and having toomuch money.
in order to set properexpectations for the investors,
they're not going to get thesame returns as in the past.
And what we also see is thateven when there are skilled
(33:08):
managers and people rationallyput their dollars into the fund,
the fees of the fund end up sohigh that any outperformance of
that manager just ends up in thepocket of the management team
and not the investors.
However, interestingly, theworst performing funds they do
show persistency.
So the worst performing funds doshow evidence that they continue
(33:31):
to be among the worst performingfunds.
So you can have a manager withlow skill, charging high fees,
and you can feel prettyconfident that you're reliably
gonna get under performance.
And so not only is it unlikelythat active managers as a whole
outperform the index benchmark,but even for those managers that
do, it's very unlikely thatthose managers continue to do
(33:53):
well.
So you're essentially playing agame where you have to
constantly reselect andre-identify the managers ahead
of time.
Over and over and over again,knowing that the odds are so
against you.
And what's unfortunate is thatwhen you look at 401k plans, for
example, when you look at thefund lineup, what do you see?
Well, you see a list of fundsand you see recent returns.
(34:16):
You see year to date returns,one year returns, three years,
five years, even 10 years is areally short term time horizon.
But those return numbers aren'thelpful to making the choice of
how to invest.
Past recent returns are not anindicator of how future returns
are gonna look for an activemanager.
And you'll hear sometimes, Hey,look at this fund.
(34:38):
Look at how XYZ mutual fundperformed in the past.
But all you can really say aboutthat is that yes, investors at
that time received thatperformance, but that doesn't
tell you how the fund in thefuture will perform.
And from the data we have, weshouldn't expect that to
continue.
And we do see that investorsplow money into funds after
(35:03):
great performance.
Investors aren't identifyingthem ahead of time, they're
chasing investment performanceafter it's happening, but they
don't see that great performancecontinue.
And the average investor, if youlook at studies around this, the
average investor's dollars.
End up underperforming the funditself because of the timing of
(35:24):
investors' decision making ofwhen to buy and sell into these
funds.
And we recent example, KathyWoods ARKK Fund is an incredible
example of this.
And you'll see this commonlycalled the behavior gap in
investing in seen across studiesusing different methodologies to
show that on average investorsthemselves, their dollars, often
(35:46):
underperforms the funds thatthey're investing in because of
their, their own behavior.
And then one last thing thathelps the case of index funds is
its simplicity.
Very often complexity is aselling point for the mutual
fund or Wall Street industry.
And very often what I see isthat with a new client, I'll see
(36:06):
that they're coming from XYZ bigbox investment company and they
have all of their accountsmanaged separately.
And each account has a long listof 10 to 20 mutual funds, and
very often, a long list ofactively managed funds without,
in my opinion, any real rhyme orreason of why they're all there.
And this complexity isunnecessary.
(36:27):
Very often you can recreate thatmix of investments with far
fewer funds.
I mean, even from one globalmarket index fund to five or, or
very close to that, you don'tneed high complexity to be
successful as an investor.
Very often complexity leads toworse outcomes and worse
decisions, and so being able tovery simply invest in the broad
(36:53):
market as a whole veryinexpensively is a huge benefit
to investors.
It allows you to keep thingsclean and tidy and simple, and
it keeps more investment choicesoutta your hands, which tends to
lead to better investorbehavior.
And so that simplicity is reallyimportant.
I don't think investing needs tobe complex.
(37:13):
I think very often investingshould like be like watching a
tree grow.
Yes, you plant the seed, youplant the tree, you water it
over time, maybe you trim thehedges over time, but most of
the time you're simply allowingit to grow.
And if you are overcut it, ifyou're over hedging it, it tends
to damage the tree and tends todamage its growth.
(37:35):
And so I think investing veryoften should be thought of in
the same way.
Good investment approaches canbe handled with simplicity.
And sort of to wrap this up,when we look at the evidence,
the evidence in my opinion verystrongly points us to a passive
investment approach.
And index funds are a great wayto do that.
I'm not in a position here on apodcast to advise everyone how
(37:57):
to invest, but I think the dataand evidence are quite clear to
say that most investors shouldconsider broad market index
investing as their investmentapproach.
And that's due to number onefinancial theory, suggesting
that that's that that's what weshould expect.
number two costs in terms of theexpenses of the investment as
(38:18):
well as taxes are a huge barrierto the performance of active
managers.
I.
Number three, diversification'sreally important because markets
are highly skewed.
There's a very small percentageof stocks that actually drive
markets, and it's not likelythat in aggregate, all active
investors are going to pick thatsmall percentage of stocks.
And number three, simplicity isa huge part of having an
(38:39):
investment approach that you canstick with successfully.
And one closing thought on thatis that index funds are a tool.
Still have to decide how toinvest in terms of how much
stocks versus bonds isappropriate for you and how that
changes over time.
You have to decide which indexesto use to fill those categories.
You still have to decide whichcategories of funds, like for
(39:02):
example, bonds to put in pre-taxretirements versus other type of
accounts.
Which accounts to use from a taxplanning perspective.
You still have to decide how todraw from them as you get to
retirement.
While they are a really usefultool, there are still important
financial planning decisionsthat you have to plan around
over your lifetime.
So hopefully this was helpfulfor you to learn more about the
history behind index funds andthe research and evidence behind
(39:25):
why they work.
If you have any questions,please reach out.
If you are wondering whether youare invested in a way that is
evidence-based, that issupported by research, please
reach out.
We'd love to talk to you over aquick introductory call.
We can learn about yourinvestments and the questions on
your mind financially, and how Ihave helped optometrists all
over the country navigate thosesame things.
(39:46):
I am gonna throw everything Imentioned here into the show
notes, along with additionalbooks and videos to watch.
So hopefully those will behelpful for you as well.
And stay tuned for next week.
Next week I'm gonna talk abouthow this same academic research
continues and I'll talk aboutwhy, even though I love index
funds.
I don't actually start withindex funds in my own investment
approach, and next week'sepisode will be a guide for
(40:09):
optometrist on factor-basedinvesting.
So stay tuned.
Appreciate your time.
Thanks for listening.
We'll catch you on the nextepisode.
In the meantime, take care.
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