A Pirate’s Defense of Index Investing

I suppose you could call this part three of my supposedly two-part series on stuff I learned from reading Mr. Money Mustache. Irregardless of the general absurdity of the situation, index investing is just what I felt like writing about today.

Of course I realize MMM didn’t invent index investing (that was John Bogle, as far as I know.) But still, I learned about it from him so I thought it only right to give credit. Good form, and all.

Before we really get started I should mention I’m not going to get real technical here, which some of you may appreciate. There are a lot of good resources on the nuts-and-bolts of investing available, so I won’t bother with the details.

Plus, one of the nice things about index investing is that it relies on the economy doing what it tends to do in order to work, not on you being an expert on investing.

I’ll begin today’s discussion with this seemingly irrelevant exchange between Captain Hook and Henry Mills from ABC’s Once Upon A Time:

Hook: Do you know what the secret to winning is?

Henry: Practice?

Hook: Loaded dice.

Henry: That’s cheating.

Hook: Only if you get caught.

Henry: I’m pretty sure it’s cheating either way.

Hook: The point is, you win.

I’ve implicitly promised that these pirate-y bits of advice will work in real life, so obviously I’m not advocating actual cheating. Like on your taxes, for instance.

That kind of cheating is doesn’t work. It’s bad form, for one thing. And in the long-term it is likely to be counterproductive.

But there is something we can learn from this that relates to investing.

Hook is teaching Henry that the best way to win at gambling is not to gamble at all. Because if you know the outcome already (i.e. with loaded dice) you’ll win every time.

This is relevant because investing is essentially gambling. You’re making a bet that the stocks you buy will be worth more in the future, based on little to no first-hand knowledge of the companies you’re buying stocks in.

A lot of people pay someone else to make these bets for them, either through managed mutual funds or a financial advisor. The idea being that these people, through a combination of experience, talent, and necromancy, will be able to predict which stocks will beat the market.

The thing is, almost nobody does well at this in the long-term.

(“But I can think of people who do this!” you say.)

Of course you can. The rare few who have done this inevitably become famous. Because they’re rare. And it may not even have anything to do with them. With a playing field this big, some people will win tremendously just by chance.

People who win the lottery don’t win because they’re good at it. It’s the same with stocks. Most of it is just luck, and sooner or later whoever is picking your stocks is going to lose. Because they’re not Warren Buffet.

Even Warren Buffet (guy who made a vast fortune on the stock market) advocates index investing, because he knows most people are not him. What does that tell you?

So if we can’t rely on ourselves or someone else to beat the market consistently for us, how do we win?

Well, we win by being the market. Basically, you’re betting that in the long-term, the entire economy will do well. Which economy? Whatever you like. You can pick your country, the whole world, or a country with a strong economy like the United States.

Or all of the above, just in case a bomb gets dropped somewhere.

Historically, this bet wins by an average of 7% per year. Some years it goes down, others it goes up. But on average, it tends to go up.

And that’s not all.

Because you’re not paying some hot-shot to pick stocks for you, the fees for index funds are way lower. Less than one percent in a lot of cases, which is let’s say around 2% better than a lot of mutual funds (I have no idea what financial advisors charge but I imagine it’s similar.)

It varies of course, but it’s usually close to that and the principle works either way.

So in order for your stock picker to be better than just buying an index fund and getting on with your life, they have to consistently get returns greater than 9%, forever. (Or 7% plus whatever they charge you.)

That’s a tall order. Pretty much no one can do that.

And as much as I advocate believing in your own “specialness,” make no mistake. That’s not going to be you. Not long-term.

Even if you want to try, is it really worth the effort?

With index investing, you don’t have to be paranoid about every little thing that happens in the stock market. You just sit back, and know that your stocks will go up on average 7% per year regardless of what the talking heads on TV are freaking out about.

Which is nice because, let’s be honest, the stock market is by-and-large irrational.

Supposedly stocks are valued according to how much the company is worth. Or it would be that way if humans were rational creatures. But like the guy from Men in Black says:

A person is smart. People are stupid, panicky, dangerous animals.

(Sorry, couldn’t find a quote from an actual pirate for this.)

Hence every stock market bubble and financial crisis ever.

It’s also why for about the last two years or so, I can tell when Donald Trump has done something just by looking at what my stocks are doing.

Oh look, lots of red. Government shutdown, ah I see.

What does that have to do with the long-term prospects of the companies my index funds are made of? Nothing. At all.

But it does make a nice buying opportunity. Yay, the stocks are on sale!

I also don’t have to worry about buying the stocks of a company that goes belly-up. Because I’m betting on the whole economy, which is a really safe bet.

Now that may not technically be cheating, but the point is…you win.