Kernel's Dean Anderson makes the case for investing in equity markets using index funds, and to reject 'trading' and trying to pick winners

Kernel's Dean Anderson makes the case for investing in equity markets using index funds, and to reject 'trading' and trying to pick winners

This is a repost of an article by Kernel, an index investing platform. It is here with permission.


Opinion

Whether you were harmed by 1987’s wild west, or misplaced trust in a fast-talking-salesman or a newspaper ad promising great guaranteed returns from a finance company prior to 2007, many people have been scared away from the share market.

This fear has forced would-be investors into the low net yield (that’s profit after expenses and taxes) world of residential property. That’s a pity, because the share market is a very safe place to invest if you obey some simple rules.

For the record, our products at Kernel are not the panacea, we don’t hate property, banks or any type of asset (they all have their place), but we do want to help you understand wealth creation and some of the tricks previously reserved for the rich.

In this article we are going to face that fear head on and why thinking you need to pick stocks to invest is a bad use of your time.

The number one mistake that new investors make is that they confuse “trading” with “investing”.

A trader is hardly more than a professional gambler, looking for a short-term profit and ways to tilt the table in their favour. Whether a trader is looking at their portfolio hourly, daily or weekly, the chances of “winning” and justifying the time spent are less than statistically possible.

No matter whether you are researching companies in a fundamental way, a macroeconomic way or a technical way – you would be better to flip a coin or learn how to count cards at the casino. 

More simply, there is no get rich quick solution that doesn’t involved high risk, high stakes and a lot of luck.  

Investing on the other hand, is buying shares for the long-term, with no expected sale date that is less than a few years. All the noise created by traders disappears and your actual growth in wealth from the share market is always the greatest.

So why do share markets crash?

Those front page events of doom, gloom and traders in despair. Well it is quite simple really; it is collective speculation whether that company or the whole world is going to be better or worse than currently expected in the future. If news comes out, where the majority of those watching closely (i.e. traders) think the future will be worse, the price will fall. Sometimes fast, because there are few wanting to buy anymore, at least not without a big discount.

The number two mistake most investors make is trying to pick winners.

Below is the chart of the growth of companies in the NZX50 for the 15 years through Dec. 31, 2018. This chart shows us that 15% of the companies are worth less than half what they started at, whilst 5% of the companies are worth 10 times more.

Source: S&P Dow Jones Indices

It would be great to pick the 5% wouldn’t it? That’s what everyone aims to do. We will cover in subsequent articles why that is (almost) impossible, even for experts.

More importantly, the average return is higher than the median return (the median being the middle of all the companies). This is because stock returns can go up more than 100%, but only down 100%.

What does this mean for you?

You have a 50/50 chance of picking a stock that will perform above the median, but that doesn’t mean you are likely to beat the average return.

In order to get the average return, you have to do more than just pick the great companies – you also need to avoid the bad companies and foresee when the good are becoming bad and vice versa. Sounds like a lot of hard work, doesn’t it?

So investing is all too time-consuming and scary…as we started with. Except, if you understand these concepts and use the benefits of index investing, it is neither time-consuming or scary. 

This is one of the reasons index investing has increased in appeal around the world. Index funds are now the majority of new funds invested in the US. The internet and increased access to information has exposed the common misconceptions about how markets work and how to best grow wealth.

The evidence showing the shift in funds from other investments into index-linked products shows just how much investors are coming to understand this.


This is a repost of an article by Kernel, an index investing platform. It is here as part of a range of views.

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

We welcome your comments below. If you are not already registered, please register to comment.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.

16 Comments

Comment Filter

Highlight new comments in the last hr(s).

This is an advertorial spruiking index funds ....

... here's the go , by their nature index funds are market followers ... they rebalance holdings up or down after the action has happened .... they sell stocks that're marked down , regardless that the company now may represent outstanding value ... and they buy after a stock is revalued upwards ...

Who goes to the supermarket to buy the baked beans because the price has been put up ?

So true.

Why would an index fund need to buy more of a stock that increases in value? They already have holdings in the company which will have themselves appreciated - no need to buy more as a matter of course. If some miracle happens and Fletcher's go up by 50% tomorrow, the index fund's weighting automatically adjusts as their existing Fletcher's holdings increase in value - no need to buy more. The reverse happens when prices go down.

The one particular area where you have a point is when companies enter and exit the index - this may lead to 'clumpy' buying and selling when a whole bunch of index funds need to buy in or sell out of a particular company at the same time.

Personally, I would recommend index funds to anyone other than those who get pleasure from active investing and all the work it involves (which I do, despite knowing the maths is against me. A guilty pleasure.)

Index funds are a form of passive investing, and they hold every stock in an index. The S&P 500, for example, owns big-name companies, including Apple, Microsoft and Google. Buffett told CNBC's Squawk Box recently that if someone invested $10,000 in an index fund back in 1942, it would be worth $51 million today.

If only you had invested that 10K in 1942 when you were 20 Gummy?

You could buy two, maybe three, houses in California for 10K in 1942.

Would they now be worth $51M?

No but the twenty year old Gummy only had a couple of dimes to rub together at that time..

I don’t think you understand how an index fund works.

.

GBH,

You seem to have lost the plot entirely. If what you say was true, which it isn't, why have Index funds come to dominate the market. Are they all just stupid?

Have you looked at the performance of index against active funds? if you were right, surely the active funds would produce superior performance consistently, but they don't.

Investing in the share market doesn't have to be overly time consuming, or scary at all.

A good place to start is to look at the industry you work in, the brands you interact with, and the services you use. This will give you a good base to research a stock further, as you already have knowledge or familiarity with the company.

Good advice...Xero comes to mind

This is a risky path to go down unless you have an edge on all the other investors out there i.e. you know something they have not factored in or have under/overvalued in their analysis of the company. Picking winners is a losers game. you are far more likely to come out ahead by holding the whole market. This allows you to allocate money in the same proportion as the combined knowledge of all participants whilst greatly reducing the return-killing fees.

Also focusing on one sector gives you a concentrated risk. An external factor could affect the whole sector at once. Diversification across sectors, geographies and currencies will minimise this risk.

Where did I say focus on one sector only?? I said, it is a great idea for investors to further research stocks / companies of industries, brands & services they may be familiar with. Remember, fund managers have their own agendas & lives to look after, how could you possibly trust & pay them to look after stocks you don't know much about?

returns can go up more than 100%, but only down 100%

That would be a good marketing line for Sky City Casino.

The corollary is that a 50% loss requires a 100% gain to break even.

Your access to our unique content is free - always has been. But ad revenues are diving so we need your direct support.

Become a supporter

Thanks, I'm already a supporter.