Oh dear, I think I am getting rather long-winded as time goes by. Warning : 2000-words behemoth post coming up. I have come to realise a large proportion of TI readers are new to the concept of investing and have stumbled upon Index Investing as a viable long-term strategy. The more I’ve tried to write bite-size nuggets of information, the more I have found it necessary to focus the readability and usefulness of the blog post instead. After thinking about it, I felt that reading the content in its entirety would benefit would-be Index Investors more.
Ready for the journey, fellow Turtle Investors?
An abundance of resources always advocate index investing as the ideal approach for the average investor. One of the most famous of them all is Warren Buffett. His plan for his heirs once he is “gone” is simple –
My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.
It is important to be clear on one thing. Do not be mistaken – many of you can, and will beat market returns. I am sure of it. The only point I want to highlight is that investing is a zero-sum game. If you can beat the market and earn 10% higher returns, than someone else must be earning 10% lower returns. Which side of the market will you end up on?
“Invest in index funds!” – Anonymous
Anyone knows how to say this, but talk is cheap. Did anyone bother to mention to you the potential pitfalls of Index Investing? When we’re simply reading on Index Investing, it always seems so easy, isn’t it? After we take a few seconds to digest what it means, things start to become a little fuzzy – at least for me back then. How does it actually work? Why does it work? Perhaps I’m not one of the brighter ones?
This post is targeted at beginner investors trying to make sense of how returns are actually made via Index Investing. In all likelihood, this blog post can and most probably will contain errors.
Index Investing Scenario : One-Time Lump-Sum Investment
Let us walk through a simple scenario then. Let’s assume that we have invested a lump sum at the start of 2011, when the SPDR STI ETF price is at $3.33 and the market has sort of “recovered”. Looking at the SPDR STI ETF today ($3.42 as of writing), we would have made a grand total of 9 cents per share.
What? Four years, and that’s like 2 cents each year! Pfft. And I thought Index Investing rocks huh?
You see, many people associate profit with capital gain, which of course is directly related to the price of the ETF we’re buying. Solely looking at price, it wouldn’t be wrong to look at a mere couple of cents gain. However, you are missing out on another important aspect.
Index Funds Pay Dividends
Regardless of whether you’re talking about index funds or exchange traded funds (ETFs) that tracks an index, they basically hold a basket of stocks in their portfolio. Some stocks pay more dividends, some counters pay less dividends, while some may not pay out anything at all. When we aggregate them together, we do get dividends, just that the yield is not going to be that high.
For example, the SPDR STI ETF currently has a dividend yield of 2.77%. If you have invested in SPDR STI ETF back at the start of 2011 and held the shares the entire time, you would have gotten 9 dividends payouts (twice a year) totaling $0.396 per share. Ah, now it looks better. Not mind-blowing, but still something a little “decent”.
Until now, we’re just illustrating a simple scenario of one-time lump-sum investment at a single point in time. Clearly, going 100% into equities at one go might not be the best option. What if this isn’t the case? What can we do to supercharge our returns?
Dollar-Cost Averaging (DCA) Lowers Average Cost Per Share
Dollar-Cost Averaging is described as the technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high.
What this achieves is that the average cost per share eventually becomes smaller. At the same time, it lessens the risk of investing a large amount in a single investment, which was what we did earlier. In local Singapore context, you can simply sign up for a regular investment plan with POSB, OCBC, PhilipCapital or Maybank Kim Eng. All four have an option to DCA with STI ETF.
Once again, this point is always being repeated again and again. Buy index funds and dollar-cost average. Let’s try and make this idiot-proof. So what if I am able to lower my average cost? Well, this makes it easier, and more likely, for me to sell my equities at a price that is higher than what I’ve paid for them.
Profit = Buy Low & Sell High
Simple logic, but difficult to achieve consistently. This is why it is frequently repeated that Index Investing isn’t about timing the market, but time in the market. The market is (usually) cyclical in nature, with a long-term upward trend. In the short-term, what goes up, must come down, and vice versa. With sufficient time in the market, we drive down average cost per share (Buy Low), collect dividends, and wait until it is a “suitable time” to exit the market (Sell High).
The next question to ask is obvious – what exactly is a “suitable time”? How high is high supposed to be? Before we go there, I want to make a quick mention on investment fees and investor behaviour.
Managing Fees & Behaviour
When it comes to investing, there are two factors we can truly control – the fees we pay, and our behaviour.
Fees are incurred as transaction costs when buying or selling equities. Trade less, spend less. Perhaps some brokerage also charge you a fee for holding your counters. Also, if you use funds, a less obvious form of fees is funds expense ratio – gotta feed the fund manager after all, don’t we? Dividend Withholding Tax could take a bite out of returns although it is not exactly a form of fee.
We can’t control how a single stock will perform. We can’t control how a fund (portfolio of stocks) will perform. We can’t control how the local or global market will perform. What we can control (we would like to think so) is our behaviour in response to market conditions. Easier said than done, ha!
I’ve manually purchased STI ETFs on a monthly basis previously. The lowest price was $3.10, and the highest was $3.48 – ouch. The market never did return to that height. Not yet, but it will. If you can do it easily, good for you! Else, automated DCA takes care of it for it. Set it up and forget about it.
If we can optimize the two factors within our control, it is safe to say our chances of making better returns would thus be higher.
Automating Buy/Sell Behaviour
Ideally, we would all like to buy low and sell high. Now, that doesn’t always happen. Some of us who lived through the dot-com bust have heard of the direct opposite happening – people were dumping their stocks at a fraction of what they paid for due to fear of losing everything.
My initial dilemma was that it is difficult (or impossible) to determine when exactly is prices considered high or low since we only have historical data to compare to. I later found out that P/E ratio would be a useful gauge of the “expensiveness” of the entire market, but let’s put that aside for the moment.
What if we could benchmark it against something? My search for an answer led to me Bogleheads. The solution is remarkably simple. Instead of going 100% equities, we add a bond component (in my case, a bond ETF) into the mix. By nature, equities and bonds does not have a direct and obvious correlation to one another. Don’t worry, perfection is not required. We don’t need a negative correlation. So now, what ever happens to our index, we can compare it with respect to our bonds.
Asset Allocation – An investment strategy that aims to balance risk and reward by apportioning a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon.
Portfolio Re-balancing – The process of realigning the weightings of one’s portfolio of assets. Rebalancing involves periodically buying or selling assets in your portfolio to maintain your original desired level of asset allocation.
This is where asset allocation plays an important part – see the quote by Warren Buffet at the start of the post. No matter what allocation you use (it can be 90/10 or 70/30 etc) you determine a re-balancing threshold or trigger. Perhaps you want to do so when the allocation deviates by 5%. Or every half-yearly. Or like what Andrew Hallam likes to say, re-balance on your birthday.
I like how this automates the buy/sell behaviour by taking profits when equities goes up with respect to bonds, and investing when equities goes down. Buy low(er), and sell high(er) – at little chunks.
An important point to make is that I wouldn’t get too carried away with re-balancing. Excessive re-balancing rakes up trading fees, which is one of the two factors we can actually control. Pour fresh funds into the lagging component to minimise selling of bonds to buy equities.
Having Bonds In My Portfolio
By adding bonds as a second asset class, there are several benefits from this strategy.
- Reduced volatility of portfolio
- Dividends from bonds provide a source of fresh funds (in addition to salary/income) for investment during bear market
- In a severe bear market, depending on just income and dividends may not be sufficient to bring your portfolio back to your desired asset allocation. You thus have a third source of funds/ammunition/warchest in the form of your bond component. Even in a severe bear market, bonds are going to hold up pretty well (with respect to equities). Sell some of it, and buy equities.
I cannot stress enough on how important this third point is. Big money is made right here. This is how portfolios belonging to the likes of Andrew Hallam grew enormously at lightning speed. Be fearful when others are greedy. Remember I mentioned that investment is a zero-sum game? Because people are fearful of the unknown, they are dumping their stocks at a fraction of their purchase price but here you are, scooping them up at fire-sale prices. To make your job easier, you don’t even have to choose which ones to buy since we’re buying the entire index/market.
(image source : www.nikkoam.com.sg)
Some value investors I know are stock piling cash in preparation of the next bear market. Some dividend investors I know are counting on the cash-flow from their holdings to provide fresh funds to make purchase during the next crash.
Index Investors? We are kind of like a little bit of both. Our dividends may not be a lot but it helps. We may not stash a lot of cash, but we have the option to sell bonds to purchase equities. This is how we Index Investors do it.
Pitfalls of Index Investing
I don’t believe that there is a perfect investment strategy. Despite the vast wealth of resources supporting Index Investing, I constantly looked for potential weaknesses with Index Investing, regardless of whether it is in Singapore or not. Below is one aspect that seldom gets mentioned at all.
Recall earlier that I mentioned using the P/E ratio as a useful estimate of the “expensive-ness” of the market? Most of the time, Mr. Market goes up and down in a cyclical manner. However, when prices have reached abnormally high levels, returning to the last peak may not be merely a matter of years. Under this situation, please use your common sense!
I can easily quote two case studies here. During the infamous Nikkei bubble in the 1980s, stock market euphoria pushed prices to astronomical levels. Take a guess at the index’s P/E ratio back then? Not 40. Not 50 either. It went up all the way to nearly 70! For comparison sake, Straits Times Index historical P/E ratio about 16. How about Nasdaq’s dot-com bubble? You won’t be able guess it. A freaking hundred and seventy-five! 175.
By putting together what I have learnt, I do hope that it will help answer many of the questions that you may have if you’re thinking of getting started with Index Investing. If you need more help, two of the most popular posts on this blog will give you some practical ideas of how to start your Index Investing journey. Like my Facebook page for interesting articles relating to Index Investing, and subscribe to my blog!
Still can’t get enough? Grab a cup of coffee or tea and watch the two excellent videos below. Live long, and prosper.