Podcast Ep. 134 The Case For Index Funds: Why Optometrists Should Embrace Passive Investing

[00:00:04] Evon: Hey everybody. Welcome back to the Optometry Money Podcast where we’re helping ODs all over the country make better and better decisions around their money, their careers, and their practices. I am your host, Evon Mendrin, Certified Financial Planner(TM) practitioner and owner of Optometry Wealth Advisors an independent financial planning firm just for optometrists nationwide.

[00:00:25] And thank you so much for listening. Really appreciate your time and attention this week and today’s episode. We are gonna dive all into index funds and index investing, and you have probably, if you spent any amount of time online or in a lot of these online groups for optometrists, you probably have seen index funds thrown around as a way to invest.

[00:00:46] And I wanna dive into the history. And the evidence making the case of why index investing makes sense for you for optometrists and why active investment management is likely to cost you returns over the long run. Because you have a choice to make. Ultimately, we all have to decide as we Earn money, as your practice is creating additional cash flow and you are investing it in your retirement and other accounts, you have to decide how to invest it.

[00:01:18] And you have to have an approach that, number one, you understand, number two, that there’s evidence for it’s, it’s likely to work in the long run and that you can stick with. Even through times where it’s uncomfortable and very often that choice is going to be somewhere between should I take an active investment approach. Should I try to, or should I use mutual funds where the manager is trying to pick individual stocks or individual investments or time the swings in markets and try to outperform the market as a whole?

[00:01:53] Or should I take a more passive investment approach where I’m simply trying to get the investment returns of the broad market over time And so I wanna take a look at where the evidence leads. And for me personally, I’ve gone through an evolution myself,

[00:02:08] my experience as a professional now working in my 11th year. going back to college, we were studying fundamental analysis, like diving into financial statements and trying to put a valuation to companies and probably not very good to be honest with you. but that, that sort of informed my approach early on.

[00:02:26] And then, almost a decade ago, working at one of those large corporate financial companies that sells their own active mutual funds, and getting sort of the Kool-Aid, of working in a company like that. And then over the years just questioning that and examining the evidence where, what does the evidence say about which approach we should take when investing?

[00:02:47] And for me, in managing my own family’s money, and in my firm, the investment approach in my firm with our duty to manage client dollars in their best interest. The evidence points to the most rational way to invest being a passive style of investing or systematic, you might hear it called, or rules-based approach to investing.

[00:03:09] And the way I define passive is that, you or the fund that you’re using are not trying to pick individual companies or individual investments or to time swings in markets trying to outperform. But instead invest broadly in a broadly diversified way across the whole market with a clear set of rules that are systematic, that are able to be replicated and that are transparent.

[00:03:34] And very often this approach leads to lower costs and index funds are probably the most common and well-known form of passive investing. And so I wanna dive into the history and evidence behind that.

[00:03:46] What Is An Index? And What Are Index Funds?

[00:03:46] Evon: Let’s start with. What are indexes? What is an index? Well, an index is simply a list of investments that’s trying to represent a broad market or a broad category.

[00:03:57] It’s a list of investments with a set of rules that tells you who is in the list. For example, the S&P 500, which is the, the index that many people just sort of hang their hats on. this is a list created by Standard & Poors, and it tracks the largest group of companies in the United States. Um, the Russell 3000, the Dow Jones US Total Stock Market Index.

[00:04:23] Those are examples of indexes of lists that invest in the broad US stock market as a whole. there are also indexes for international, for example, MSCI EAFE Index, EAFE Index. Covers large and medium sized companies across developed non-US markets overseas.

[00:04:43] There’s also an index that invests across the entire global market, or the world outside of the US and so you have all of these lists that are trying to invest in these broad markets or even broad categories. For example, all real estate investment trusts that are publicly traded in the United States. These are lists with a set of rules. Sometimes a human committee that helps decide who is in the list. And their goal is simply to try to represent or or track a broad market or broad category. And.

[00:05:15] Index funds are just mutual funds or exchange traded funds, ETFs that try to replicate that index.

[00:05:23] So for example, an S&P 500 index fund is a fund that’s trying to replicate the performance of the S&P 500. And you’ll find index funds tracking all sorts of these indexes – US, globally, international or whatever it may be.

[00:05:38] And I’ll add not all indexes or index funds are created equal. you’ll find indexes that are sort of thematic or industry specific, like defense or tech or marijuana or a lot of different things like that. What you’ll find is there are thousands of indexes and there’s actually more indexes than there are stocks.

[00:06:04] But what you’re gonna find with a lot of those is that they’re just. Active approaches, active management approaches with a passive sticker, added onto them. They are as one study notes “passive in name” only their really just active investment approaches sort of wrapped up in the skin of an index.

[00:06:22] They may have index in the title. But they’re really just active management strategies, and if you are investing in some of these indexes, a lot of the times you’ll see tech indexes suggested by people. I mean, let’s just call it what it is. You’re making an active investment decision.

[00:06:38] This is an active bet wrapped up in an in an index. That’s not what I’ll be talking about through this conversation. I am focused on here whole market index funds. Not sort of those really active bets wrapped up in an index.

[00:06:53] History and Research Behind Index Funds

[00:06:53] Evon: So let’s talk about the history of index funds and the, to me anyways, the, the history is fascinating because it’s wrapped up in sort of this revolution in research around financial markets and innovation.

[00:07:07] I mean, the index funds were a huge innovation in investing that have benefited how many millions of investors all over the world. And the case for indexing really starts in academia. If you go back to sixties and seventies, maybe late fifties, there’s a bit of an academic research renaissance, especially centered around the University of Chicago.

[00:07:28] As more data was available, and more importantly, computing power allowed researchers to have a better understanding of. How markets actually behave, how individual stocks and markets actually perform, and importantly, how active fund managers perform. And they have the ability now to compare that to the overall broad market or different categories.

[00:07:55] And there was research back then around how to build portfolios. For example, 1952, Harry Markowitz wrote about this, what we call the modern portfolio theory. Basically looking at your mix of investments as a whole and the importance of diversification. Bill Sharp in 1964 wrote about the capital asset pricing model, which, if you’ve taken an MBA course, you probably still see this, taught even though technically the, the model itself isn’t really usable in, in real life.

[00:08:23] But I mean, these are groundbreaking theories and research around how to build and manage portfolios. And you see research around how stock prices appear to follow a sort of a “random walk”. Reacting to new information as it comes in without having predictability in where they’re going to go, especially in the distant future.

[00:08:43] Much to the dismay of technical traders trying to look at charts and make predictions around price movements. You see research from Michael Jensen back to 1968, around how active managers failed to beat the market after adjusting for risk and fees and basically look no different than what you’d expect from just pure statistical chance or randomness.

[00:09:04] Gene Fama in 1970 wrote about the efficient market hypothesis. Burton Malkiel in 1973 wrote his first edition of the book, A Random Walk Down Wall Street, sort of putting all this in terms that the general public can understand and proposing the idea of a fund that simply buys the broad market sort of ahead of his time.

[00:09:24] he wasn’t the first one or the only one to, to come up with this idea, but he is the first one sort of proposing it to the general public. At 1971 and 1973, is when, when the first index funds were actually created in practice. So the first time that academics in Wells Fargo and one other investment firm really started to take these academic theories and research and put it into practice, but these early ones were only for institutional, investors like pension funds. Jack Bogle, 1976 is the first one that took that idea and made it available for everyday investors. and he did that through Vanguard. and the first fund was a fund tracking the S&P 500.

[00:10:11] So not even the full US stock market, but as much of it as was possible at the time. And index funds, of course, were mocked by the active investment management in Wall Street Industry. Why settle for average is something that was commonly said. It was called un-American, Vanguard in particular, their first index fund was, was initially mocked as “Bogle’s Folly”.

[00:10:35] It couldn’t even raise enough dollars to initially buy the full S&P 500. They had to sort of mimic it statistically as well as they could. But through all of that mocking, it turns out that what we know now is that boring was actually pretty brilliant.

[00:10:54] This was a true innovation in investing and it gets me excited. I don’t know if it gets you excited, but I mean it’s, it’s hard to overstate just how helpful this was to allowing investors to really easily access broad global financial markets and put their dollars to work.

[00:11:13] The Evidence of Why Index Investing Works

[00:11:13] Evon: And let’s talk about the evidence of why indexing works and why active investing consistently falls short, and why we should expect it to continue to do so. So as we go back to that decision, okay. Should we, you know, look at your 401k lineup. Should we be picking those active mutual funds? Or should we be taking a more passive approach?

[00:11:35] The Vast Majority of Active Managers Fail to Beat Their Index Benchmark

[00:11:35] Evon: Well, let’s look at what the evidence suggests. and there is a long body of research going back to 1960s, showing consistently that active investment managers struggle, have a really poor track record of outperforming their index category benchmarks. They do a really poor job historically at outperforming the market as a whole.

[00:11:58] And some examples of that, one that is most available to you and everyone else is this SPIVA Report, which is created by Standard & Poors who obviously creates their own indexes, right? For, for managers to replicate. But they put out this report each and every year, and the results are sort of laughably consistent.

[00:12:19] For example, if we look at all mutual funds in the US that invest in large stocks. Over 15 year periods, almost just about 90% of them underperform the S&P 500, 10 years. It’s about se the same results. Even if we go to one year periods a time, roughly 65% of them underperform the S&P 500 index.

[00:12:40] So worse than a coin flip, even in really short term periods, if we go to all US based index funds. 93% of them over a 15 year period underperformed the S&P’s Index Benchmark. Similar results for small company mutual funds, over long periods of time. if we look at global and international funds, global funds, 92% of global funds underperformed the S&P global Index.

[00:13:10] Similar results for emerging markets and for developed international funds. The results are consistent. The vast majority of active managers fail to outperform their index benchmarks. And this is certainly the case, the longer the time horizon, and we are, for the most part, long term investors, right?

[00:13:28] We have to look at what approach is gonna work most likely over the long term.

[00:13:33] And I’ll throw a link to the sh in the show notes to, to all these things I’m mentioning. Morningstar also puts their own version of this. They have the Active and Passive Barometer.

[00:13:42] They even go to 20 year time horizons. The results are pretty similar across categories. We have, research from 1997. From Carhart he sees no evidence of consistent skill, and winners rarely persist to continue to be winners. Fama and French has shown that most positive performance seen in fund data is statistically indistinguishable from luck rather than skill. Only a tiny sliver of funds actually showed true sign of skill, at least statistically. And on a net return, meaning after fees, what you as an investor actually get. Almost no funds beat their benchmark after costs.

[00:14:20] Hank Bessembinder looked at data about what percentage of US stock mutual funds beat SPY, which is an ETF, that it invests that tracks in the S&P 500, and he saw that on a monthly basis, 47% of mutual funds outperform SPY.

[00:14:34] So even in really short term time horizons, like one month periods it’s worse than a coin flip annually, it’s actually a little bit worse. Only 41% of them outperformed SPY. Over a decade, 38%, and over a full 30 year sample period, only 30% of them outperformed. His methodology, the way he tracks that, is actually a little bit more favorable than the SPIVA reports, but it’s still really bad.

[00:15:01] And on top of that, only 45% of individual funds beat the SPY before fees. So there’s maybe some evidence that a small percentage of managers are skilled, but their fees are bigger than their skill on average. And, and we can go on and on. What’s quite clear from the evidence we have is that active fund managers are really unlikely to outperform simply investing in the broad market through an index.

[00:15:30] And what that tells us as investors then is that if we’re going to try to take that an active investment approach, if we’re gonna try to pick an actively managed mutual fund, we’re also really unlikely to, to outperform simply using an index in a broad market index fund. Which is interesting because the, the common argument against passive investing is that why settle for average, but the people that say that, I don’t think they have an understanding of what average means.

[00:15:57] Because if you are investing in the broad market through an index, you’re actually putting yourself historically in the top 20% of performing funds. On a consistent basis. I mean the data around this is consistent year after year or study after study.

[00:16:12] And what’s also interesting is that we need active investors, capital markets. Financial markets need active investors to keep markets functioning, we need active investors to set prices. We need active investors to provide liquidity. So when even index funds, for example, need to purchase stock well active managers provide the stock for them to purchase, when even index funds need to sell companies that are outta the index, well active managers provide a market, they may be the ones purchasing that from those index funds.

[00:16:42] So we need active managers to provide liquidity. We need active managers to set prices. Efficiently. We need active managers for all of this financial plumbing to work. We would just rather you optometrists not participate in their game.

[00:16:59] Reasons Index Investing Works – Financial Theory Suggests it Should

[00:16:59] Evon: So why is that the case? Why? Is the evidence so strongly against active investment management and so strongly in the favor of using something like an index fund of passive investing.

[00:17:11] Well, one of the reasons is because this is what we would expect from financial and investment theory. You probably don’t want to hear about financial theory, but to take one example, if we go back to Gene Fama’s efficient market hypothesis, well, what does that mean? Well.

[00:17:26] The efficient market hypothesis is a model for understanding how markets set prices for corporations and other assets and how markets work. And what it says is that at some level, the prices that you see already reflect publicly known, available information about that business for a stock, for example, and prices react quickly to new information as it comes in.

[00:17:53] Favorable information would see the price quickly rise to reflect that. Poor information would see the price decline to reflect that.

[00:18:02] and what is the market? Well, the market’s not just a squiggly line on the screen. The market is made up of thousands and thousands of investors all over the world.

[00:18:11] The vast majority of which that are actually investing and setting prices are professional institutional managers. And all of these investors are looking at the information that’s available about these companies, about their financials, the outlook for their industry, political risks, things like that, and their own needs and preferences, and coming to a conclusion around how that company is going to fare in the near future and how it’s earnings are going to change in the near future, and how certain or uncertain that is, and based on those opinions they make buying and selling decisions based on and based on their opinions, on their conclusions.

[00:18:51] They make buying and selling decisions and all of that, buying and selling activity sets prices for these stocks. And so prices reflect sort of the aggregate combined opinion of all investors in that company or of all investors in the market. And if you think about, if you own an Optometry practice, think about your own practice.

[00:19:14] Imagine if you opened up your financials, your books, to thousands of practice consultants to other practice owners, to private equity investors, and all of these investors and all of these people were able to constantly look at your financials. and run valuations, and were all constantly sending you offers to buy and sell ownership in your practice.

[00:19:39] Well, if you took all of those offers and averaged them out, you’d have a pretty good idea of what the fair market value of your practice is. And that’s essentially what’s happening every day on a, on a constant basis for all these, all these investments.

[00:19:54] And so that’s what’s meant by an efficient market. These prices are reflecting on some level all of the information that’s publicly available and we wouldn’t expect prices to be perfect. We don’t expect markets to be perfectly efficient. Not even the original author would suggest that.

[00:20:12] but pretty efficient. They set fair prices at least more fair than you and I are able to real, to take advantage of. And if that’s the case, if these prices are set fairly, we would not expect active managers to be able to consistently – either you or professionals – to be able consistently find mispriced investments.

[00:20:35] Because ultimately if you’re at making active decisions. What you’re trying to do is find stocks that are not priced correctly. You’re saying the market has mispriced this, I believe it should be priced higher, so I’m gonna buy it cheaper, or I believe it’s overpriced and so I’m gonna sell it short.

[00:20:52] Right. That’s essentially what’s happening. And so if that’s the case, we wouldn’t expect investors to consistently be able to find mispriced investments. The analogy that I think is pretty good is that, yeah, you might find a a hundred dollars bill on the floor.

[00:21:08] You know, if you find it, pick it up. But that doesn’t mean that you should spend your life trying to make a living of finding a hundred dollars bills on the floor. It’s very likely that as soon as someone finds them, they’re gonna be picked up. And that’s essentially a way to think about it.

[00:21:20] And to add to that, as I talked about in my episode with Andrew Berkin, who was a co-author of the book, The Incredible Shrinking Alpha. he describes how there are less and less non-professional investors to take advantage of. So that’s really, you OD as more and more are moving away from active management to things like index funds and there are more and more professional analysts, managers that have never been more well equipped, that have never had better data and tools and have never been better educated and trained. And that’s the competition. I mean, that’s really the competition that we’re, we’re running against.

[00:21:56] And they are all fighting for a smaller and smaller amount of outperformance. And to think of us as individual non-professional investors, the more you start to learn about how markets behave and the evidence around that, and the likelihood that if you are trading, it’s pretty likely that an active professional manager’s on the other side of your trade, that’s who you’re competing with.

[00:22:17] You start to understand that we have no advantage. We don’t have information that the market as a whole doesn’t have, especially those professional managers we’re competing with. We don’t have an ability to act on or interpret the as information more quickly or better than everyone else. And so the more you learn, the more you start to understand just how unlikely it is that you’re gonna be successful trying to actively pick stocks or time markets.

[00:22:42] So the first sort of point to that is that this is what investment research and theory would suggest should happen.

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[00:23:21] Fees and Taxes Are a Major Drag on Returns

[00:23:21] Evon: The second important part of that is that fees and taxes are a huge drag on performance. There are a huge barrier, again, there’s a long body of academic research going back to 1968 that shows that active managers don’t add enough value on average to cover their fees and especially taxes, even when there’s evidence that managers have skill and may on average outperform their appropriate benchmark, that extra value and outperformance quickly goes away after fees, and especially looks worse after taxes, which is really important if you are using a taxable brokerage account.

[00:23:59] And you’re using active managers, active investment funds in that account, or if your professional that you’re working with is using a list of active managers in that account. You really have to question the impact that it’s going to have on taxes because those active managers are going to trade more and that trading’s very likely create more capital gains, and that capital gains income is passed on to you, the owner of the fund, and it’s gonna end up on your tax return.

[00:24:25] You really have to question how efficiently that is and how much of a drag those taxes are gonna be on the performance. And the cost here include the explicit costs. So the, the things you actually see, like the commissions if you are buying, A share mutual funds, I, I question why those still exist, but the commissions on the front end are a part of that.

[00:24:46] and the annual expense ratios are a part of that as well. As well as the trading costs, you don’t see those are the trading costs from the activity of the manager itself.

[00:24:54] So those costs are a huge part of that. And again, there’s, there’s evidence that would suggest that even before fees, most managers on average would not outperform the index.

[00:25:06] But even where it’s the case that they do that quickly goes away after fees. There’s a Morningstar paper at 2016 that I’ll link to. and Morningstar is a business that basically analyzes funds, right? That’s sort of their business. And, what they found was that the single best predictor of future fund performance was the expense ratios.

[00:25:26] It wasn’t the only predictor, but it was the most prominent predictor. And sometimes what you’ll see as well is that there are so-called “closet indexers”, where the fund managers own so many stocks within the category that they’re basically either purposely or not just mimicing the index and charging the higher expenses for that. So you’re sort of getting the worst of both worlds. You’re not quite getting the index market performance, but you’re also paying the higher fees for that. So fees and taxes are a huge component to that.

[00:25:57] Index Fund Diversification Skews the Odds in Your Favor

[00:25:57] Evon: Another reason index funds work so well is that they’re broadly diversified, which is really important. Because when you look at research around individual stocks, how markets work, stock markets are highly skewed. What that means is that most stocks actually perform poorly and a relative few amount of stocks perform exceptionally well, and that few percentage, that small percentage is what actually drives the return of markets as a whole.

[00:26:28] for example, Hank Bessembinder in 2018 wrote, Do Stocks Outperform Treasury Bills?, and the the information is fascinating. So he looked at US stocks going back from 1926 to 2016, and looking at individual stocks. So individual companies.

[00:26:46] Only 42.6% of those individual stocks had lifetime returns, greater higher than one month, US Treasury bills, which is basically a cash equivalent, so less than half of them over their lifetime had returns that were higher than a cash equivalent.

[00:27:06] Over half of those individual stocks had negative lifetime returns. And the most frequent outcome. So if you list all of the outcomes of those companies, the most frequent one, the most frequent outcome over their full lifetime was a 100% loss, was a full loss of investment. And in his simulations, just 4% of stocks accounted for all of the net Wealth created by the market as a whole, which is just incredible to think about how poorly most individual stocks perform.

[00:27:40] he continued that research in 2019, Do Global Stocks Outperform US Treasury Bills?, and he saw similar results and actually worse results when you look at stocks globally. And so while we often talk about the average returns of market as a whole, you know, we talk about, hey, the US stock market on average, going back throughout history performed this, or, you know, the global stock market on average performed this per year.

[00:28:06] And that’s fun to talk about averages, but it’s a much different story when looking under the hood at how individual companies perform. And even when we talk about buying the dip, for example, I. When you talk about buying the dip with an individual stock, it is not the same at all when you’re talking about buying the dip.

[00:28:23] With a market as a whole with an individual stock buying the dip has a much different and much wider range of outcomes than the whole broad market, and so this is sort of a reality check for. Us as individual investors and for pro for professional managers. Most stocks underperform and many lose money, and the results are highly skewed.

[00:28:43] And you see similar results with fund managers too, within funds. And so if you’re an active fund manager, if you’re one of those managers having to run an investment fund, you’re having to have the higher expenses of an investment team and more data and research. You have to look different than, than the broad market in order to outperform with your skill.

[00:29:08] And the more you look different, the more it’s going to increase the chances, the odds of not owning those best performing stocks. I. Or underweighting them. And if an active manager’s too diversified, then you end up with that closet indexing issue that I mentioned earlier. Index funds on the other hand by definition, are gonna own all of the stocks within the market that they’re tracking.

[00:29:33] You’re gonna own, yes, the worst performing assets. That’s a part of diversification. But you’re also going to own the best. You’re gonna own the whole haystack rather than trying to find the needle, you’re going to get 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 and read and think about the statistics and research like this.

[00:29:59] You need to have a really good understanding of just how unlikely it is that you’re going to be able to consistently be successful , if you’re trying to time markets or pick individual stocks. I mean, you’re essentially taking on casino like outcomes here where you’re hoping for that home run pick, but you’re most likely not going to win.

[00:30:19] And when asked recently in an interview why investors keep trying to pick individual stocks. The author’s answer was number one, either investors have a preference for that skewness, so you’re really looking for the possibility of that really high return. Even if it’s really unlikely or more likely, it’s investor overconfidence.

[00:30:43] So we really have to have a good understanding of the odds that we’re working with. And you are competing with an ever-growing amount of the smartest and most well-equipped professionals on the planet for a really small percentage of home run hitters. I. so the skewness of how individual stock returns show up and the importance of diversification is an important reason why index fund and index fund investing works.

[00:31:09] Good Performing Managers Don’t Continue to Perform Well

[00:31:09] Evon: Another important aspect of that is that even for those managers that do really well. There’s very little evidence of persistency in the data. Funds that do well in prior periods, do not continue to do well in future periods. And some explanations of this that come from research is, well, number one, is that data doesn’t show any evidence of skill for managers.

[00:31:34] And even good performance is simply from luck or statistical randomness. And if returns are random, then we wouldn’t expect there to be any persistency or predictability with future returns. another explanation that comes from research, which is a bit more generous to managers considering just really how smart they are and well equipped they are.

[00:31:57] finance does attract some of the most intelligent people out there. another explanation is that funds simply get too big if they have a specific investment approach, and that leads to outperformance. Too much cash flowing into the fund leads to the manager not being able to invest the dollars efficiently.

[00:32:16] And for example, a manager that’s investing in sort of the smallest companies in the United States. And if more cash is piling in, they can’t any longer just invest in only the smallest companies. They have to start buying medium sized companies, for example, and eating away at their strategy, and again, they start to look more and more like the index.

[00:32:36] I’ve seen over time. Funds close the close their funds to new investors. To sort of counter this, they simply can’t bring in dollars to infinity and invest in the same way. And even Warren Buffett, you look at Warren Buffett’s investor letters, he’s written to his investors about the same thing happening with Berkshire Hathaway, about Berkshire getting too big and having too much money.

[00:32:59] in order to set proper expectations for the investors, they’re not going to get the same returns as in the past. And what we also see is that even when there are skilled managers and people rationally put their dollars into the fund, the fees of the fund end up so high that any outperformance of that manager just ends up in the pocket of the management team and not the investors.

[00:33:23] However, interestingly, the worst performing funds they do show persistency. So the worst performing funds do show evidence that they continue to be among the worst performing funds. So you can have a manager with low skill, charging high fees, and you can feel pretty confident that you’re reliably gonna get under performance.

[00:33:40] Recent Past Investment Returns to Not Reliably Predict Future Returns

[00:33:40] Evon: And so not only is it unlikely that active managers as a whole outperform the index benchmark, but even for those managers that do, it’s very unlikely that those managers continue to do well. So you’re essentially playing a game where you have to constantly reselect and re-identify the managers ahead of time.

[00:34:02] Over and over and over again, knowing that the odds are so against you. And what’s unfortunate is that when you look at 401k plans, for example, when you look at the fund lineup, what do you see? Well, you see a list of funds and you see recent returns. You see year to date returns, one year returns, three years, five years, even 10 years is a really short term time horizon.

[00:34:24] But those return numbers aren’t helpful to making the choice of how to invest. Past recent returns are not an indicator of how future returns are gonna look for an active manager. And you’ll hear sometimes, Hey, look at this fund. Look at how XYZ mutual fund performed in the past.

[00:34:43] But all you can really say about that is that yes, investors at that time received that performance, but that doesn’t tell you how the fund in the future will perform. And from the data we have, we shouldn’t expect that to continue. And we do see that investors plow money into funds after great performance.

[00:35:04] Investors aren’t identifying them ahead of time, they’re chasing investment performance after it’s happening, but they don’t see that great performance continue. And the average investor, if you look at studies around this, the average investor’s dollars. End up underperforming the fund itself because of the timing of investors’ decision making of when to buy and sell into these funds.

[00:35:28] And we recent example, Kathy Woods ARKK Fund is an incredible example of this. And you’ll see this commonly called the behavior gap in investing in seen across studies using different methodologies to show that on average investors themselves, their dollars, often underperforms the funds that they’re investing in because of their, their own behavior.

[00:35:51] The Simplicity of Index Funds Are to Your Advantage

[00:35:51] Evon: And then one last thing that helps the case of index funds is its simplicity. Very often complexity is a selling point for the mutual fund or Wall Street industry. And very often what I see is that with a new client, I’ll see that they’re coming from XYZ big box investment company , and they have all of their accounts managed separately. And each account has a long list of 10 to 20 mutual funds, and very often, a long list of actively managed funds without, in my opinion, any real rhyme or reason of why they’re all there.

[00:36:25] And this complexity is unnecessary. Very often you can recreate that mix of investments with far fewer funds. I mean, even from one global market index fund to five or, or very close to that, you don’t need high complexity to be successful as an investor. Very often complexity leads to worse outcomes and worse decisions, and so being able to very simply invest in the broad market as a whole very inexpensively is a huge benefit to investors. It allows you to keep things clean and tidy and simple, and it keeps more investment choices outta your hands, which tends to lead to better investor behavior. And so that simplicity is really important. I don’t think investing needs to be complex.

[00:37:13] I think very often investing should like be like watching a tree grow. Yes, you plant the seed, you plant the tree, you water it over time, maybe you trim the hedges over time, but most of the time you’re simply allowing it to grow. And if you are overcut it, if you’re over hedging it, it tends to damage the tree and tends to damage its growth.

[00:37:35] And so I think investing very often should be thought of in the same way. Good investment approaches can be handled with simplicity.

[00:37:43] Wrap Up

[00:37:43] Evon: And sort of to wrap this up, when we look at the evidence, the evidence in my opinion very strongly points us to a passive investment approach. And index funds are a great way to do that. I’m not in a position here on a podcast to advise everyone how to invest, but I think the data and evidence are quite clear to say that most investors should consider broad market index investing as their investment approach.

[00:38:08] And that’s due to number one financial theory, suggesting that that’s that that’s what we should expect. number two costs in terms of the expenses of the investment as well as taxes are a huge barrier to the performance of active managers. I. Number three, diversification’s really important because markets are highly skewed.

[00:38:26] There’s a very small percentage of stocks that actually drive markets, and it’s not likely that in aggregate, all active investors are going to pick that small percentage of stocks. And number three, simplicity is a huge part of having an investment approach that you can stick with successfully.

[00:38:42] And one closing thought on that is that index funds are a tool. Still have to decide how to invest in terms of how much stocks versus bonds is appropriate for you and how that changes over time.

[00:38:54] You have to decide which indexes to use to fill those categories.

[00:38:58] You still have to decide which categories of funds, like for example, bonds to put in pre-tax retirements versus other type of accounts. Which accounts to use from a tax planning perspective. You still have to decide how to draw from them as you get to retirement.

[00:39:13] While they are a really useful tool, there are still important financial planning decisions that you have to plan around over your lifetime.

[00:39:19] So hopefully this was helpful for you to learn more about the history behind index funds and the research and evidence behind why they work. If you have any questions, please reach out. If you are wondering whether you are invested in a way that is evidence-based, that is supported by research, please reach out.

[00:39:36] We’d love to talk to you over a quick introductory call. We can learn about your investments and the questions on your mind financially, and how I have helped optometrists all over the country navigate those same things. I am gonna throw everything I mentioned here into the show notes, along with additional books and videos to watch.

[00:39:51] So hopefully those will be helpful for you as well. And stay tuned for next week. Next week I’m gonna talk about how this same academic research continues and I’ll talk about why, even though I love index funds.

[00:40:03] I don’t actually start with index funds in my own investment approach, and next week’s episode will be a guide for optometrist on factor-based investing. So stay tuned. Appreciate your time. Thanks for listening. We’ll catch you on the next episode. In the meantime, take care.