Index Funds and Diversification

All investing involves risk. Even not investing involves risk that monetary inflation will erode the value of cash you hold. Selecting good investments involves careful and rigorous analysis. But this only requires a little education, not an especially distinguishing talent. For example, a little effort will reveal many individual stocks that may comprise a sound investment portfolio. The time this requires is probably less of an effort than obtaining investment ideas from popular financial magazines or television programs. The problem is that there is a learning process. A portfolio comprised of a few selected stocks contains an element of risk that's not embodied in a mutual fund containing many more stocks.

So does diversification provide a convenient solution? Truly, a single gamble on the future does indeed create a large variation in returns; more variation leads to earning less income than a diversified and continually re-balanced buy-and-hold strategy. But this is only true if the probability outcome of a gain or loss is equal. Truly, the probability that a randomly selected security will rise or fall is equal. That is, there is a 50 percent chance it will rise and a 50 percent chance it will fall. It's the same as flipping a randomly selected coin. However, the probability for a specific security is different. Just like the probability of flipping a specific coin to come up heads every time can be affected by altering its physical property of weight distribution.

A common justification for diversification (other than that "everyone knows" diversification works), usually involves the sound observation that distinctive asset classes grow at varying speeds. But, don't you want to own the leaders in future price improvement. Isn't there some analysis that indicates which assets represent the best value? Or is there no distinction whatsoever (except in hindsight) between the prospects of every asset? Of course such an evaluation process takes time...and ability. But doesn't one at least have some idea that a Ted Williams baseball card is probably going to be better to own than a Glen Beckert card? If so, one can skip the Beckert card (unless ownership holds some personal value) and go straight to examining the price and quality of the Williams card?

For instance, in the 2000 to 2002 bear market, a portfolio consisting mostly of REITs, small-cap stocks, and value stocks would have performed well enough to avoid the bear. But such classes being held in the 2008 market plunge would not have protected an investor. In 2008, when the US stock market lost 37 percent of its value, the Barclays Aggregate Bond Index gained 5.2 percent. But wouldn't a rigorous analysis have revealed at least a hint of where to find apparently superior values?

There are people who managed to buy in 2008 the stocks of Washington Mutual, General Motors, Thornburg Realty Trust, and Citigroup. A safe guess is that these people did not conduct any research into the market prospects for these companies. If any research had been performed, surely it would have revealed other companies with better likelihood of stability and success. In doing so, this would have limited risk.

Of course, risk might have also have been reduced by spreading purchases among more holdings, such as by purchasing ETFs. This would have assured (nearly) market returns - which are pretty good during economic booms...and pretty lousy during economic busts. After all, by using the technique of owning "everything" via ETFs, one still ends up owning the dogs - just in lesser quantity relative to other positions.

That's what owning a bundled security - like an ETF - is all about...making out fairly well in good times and assuring yourself of losing big in bad times...but maybe not as big as would occur by speculative stock purchases after conducting no research.

Investors in a bundle of securities enjoy the convenience of not making decisions about individual securities and providing the relative safety of diversification. Despite the apparent safety of diversification, the process of risk assessment is more difficult. Obscured is the individual risk of each security within the bundle.

Hard times for a few of the securities in the bundle cause investors to cash their claims against the bundlers. This requires the bundlers to sell assets in order to raise capital. Meanwhile, other bundlers hold the same assets, which they see declining in value as the sellers mark down the prices to raise money.

This impairs the performance of the other bundlers, who must also sell assets to raise money. The contagious deleveraging depresses prices along all assets - not just the initially troubled ones.

Because of the convenience of the bundles, investors avoided the cost of gathering information about individual securities. People without enough information to make judgments on their own regard the behavior of others as guided by information the others do possess. But information is hardly necessary for the bundlers when capital is easily attracted due to an economic boom since investors possess little information and are satisfied with the safety of diversification.

A boom reinforces this confidence. During economic declines, the psychological contagion causing more deleveraging - that is equally irrational as the boom confidence - saps both capital and the confidence to deploy it. Financial assets all along the line tend to decline.

But after the crisis stage abates, there can be winners even in a bust. Moreover, while investors in bundles stay on the sidelines due to lack of information, the value of information increases. Analysis of that information is critical because not all actors possessing the same information will take the same action. Economic decisions are subjective. People apply to information their individual experiences, doctrines, and emotions in determining their responses. Informed judgment - rather than contagion becomes the means for enlightened investment selection.

Index funds provide a very useful function to many investment portfolios. Plus, there are some investment classes to which exposure is best obtained via exchange traded funds (ETFs) - most of which are based upon indices. That said, there is something troubling about asking whether to buy index funds or managed mutual funds. There are, in fact, drawbacks to both. This should really be two questions: (1) whether actively managed mutual funds are better than selecting individual securities for oneself and (2) whether investing in an index is better than one making individual securities selections. Both index funds and actively managed funds are in competition with the singular alternative of creating a distinctive portfolio of individual securities.