Strike Three: Is Index Investing Really a Swing and a Miss?

The academic folks who created Active Share tell us that there are some actively managed mutual funds (but not many) that consistently outperform their indexes in excess of their higher costs. Meanwhile, folks at Morningstar tell us that most actively managed funds don’t outperform their indexes, despite their higher expense ratios. So, how are advisors supposed to assess these risks versus their potential rewards to arrive at smart recommendations and avoid Lewis’s “total stupidity”?

To my mind, we’re asking the wrong question here. I remember back in 1984 (yes, I’m an old guy), when (future presidential candidate) Ross Perot sold the company he’d founded, EDS, to General Motors for $2.4 billion. He then announced that he was investing the entire sum in a diversified portfolio of triple tax-free municipal bonds yielding around 4%. To explain his decision, he said: “I don’t like to pay taxes and hey, how much money do you need?”

Eight years later, in 1992, veteran financial planner and one of the founders of NAPFA, Jim Schwartz, wrote the seminal book for financial planners titled “Enough.” As the title implies, Schwartz’s book suggests that a financial planner’s job is to help his or her clients determine how much money would be “enough” to reach their goals and to create a financial plan that would enable them to get there taking the lowest possible risk. Ross Perot could have been his poster boy.

The issues for financial planners and other financial advisors haven’t changed today. Yes, good advisors minimize their clients’ risk through diversification, dollar-cost averaging and long-term investing. But the ultimate question is still how much risk their clients need to take to get where they want to go.

Today, the S&P 500’s total return for the past 20 years is 9% annually (which is about the same as the last 60 years). If your clients have a time horizon of more than 20 years, 9% is probably enough. If it isn’t, you can either suggest they rethink their goals, or you can up their risk and take a shot at picking some actively managed funds. Some will undoubtedly do better than that — the trick is knowing which ones.

The point here is that despite Michael Lewis’s concern, statistically, index investing is probably the lowest risk strategy that will enable most clients to reach their financial goals. Advisors’ judgment enters the picture when clients don’t have a sufficient timeframe or have higher than normal goals — or both. That’s when clients need help avoiding “total stupidity” and applying Schwartz’s principle of “Enough.”