The Past Four Months Prove It: Passive Indexing Is Pure Portfolio Poison

Index investing was sold, hard, to investors - to the tune of $58 billion a month - as a safe, hassle-free way to ride stocks all the way to the moon.

Led by the High Priest of Indexing, John Bogle, and endorsed by Warren Buffett and other legendary investors, indexing was supposed to be the answer to all our investing goals.

"Buy a low-cost index, sit back, and let the magic happen."

But trade wars... U.S. President Donald Trump's vendetta against Amazon... North Korea... Iran... Italy... rising interest rates.... and more have all helped propel huge swings, and I suspect 2% daily swings were not what most new index investors were looking for when they made their initial investment.

It's not just volatile periods that present problems for index investors, either. It's a bad idea all the time - and here's why...

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The "Safe Haven" That's Neither Safe nor a Haven

The image of index investing is of a portfolio of nice, safe blue-chip companies that drive the market higher over time. When investors buy the index, they think they own nice, big, relatively safe stocks, like Procter and Gamble Co. (NYSE: PG), 3M Co. (NYSE: MMM), and maybe some low-risk tech stocks, like International Business Machines Corp. (NYSE: IBM). Those stocks are in the index, but they are not as big a part as a lot of investors think.

The top three stocks in the index are Apple Inc. (Nasdaq: AAPL), Microsoft Corp. (Nasdaq: MSFT), and Inc. (Nasdaq: AMZN). Facebook Inc. (Nasdaq: FB) and Alphabet Inc. (Nasdaq: GOOGL) are also in the top 10.

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Together those five stocks would make up a little more than 15% of an S&P 500 fund portfolio.

Now, we can debate the merits of owning those stocks another time, but what's not debatable is that these are not low-risk, high-dividend blue-chip stocks; they are highly volatile tech stocks that are probably riskier than many index owners, who, properly informed and educated on the risks, would be interested in having as a significant part of their portfolio.

In fact, 34% of the index is in technology stocks, and another 14% is in healthcare, so about half of your money is in more volatile sectors of the market.

But because of the presence of actual blue chips, as well as the misconceptions around these big tech stocks, a large number of people who own indexes think owning all 500 stocks in the S&P 500 can - somehow - lessen the risk of stock ownership.

I'm serious: Natixis Global Asset Management surveyed investors last year and found that 60% of investors think owning indexes can help reduce market-related losses.

By that rationale, owning the entire market (magically) makes it possible to (magically) lose less when the market goes down.

That kind of magical thinking is absurd - and it goes a hell of a long way toward explaining why millions of people are doomed to grind out subsistence-level retirements with subpar returns.

Over the past few months, the wild swings in the market have conspired to reveal that the index "emperor" wears no clothes; we've started to see the indexing sales pitch for what it really is...

...a kind of bait and switch.

The Big Index Stocks Are Not What They Appear to Be

There's another "game" going on in this scam - another thing they won't tell you.

Timing matters - big time - when it comes to how much you earn.

The person who retired in 1999 and put their equity allocation in the index has not done that well.

They have averaged about 4% a year and have seen their portfolio decline by 50% or so twice during the two decades. Their $100,000 portfolio is worth less than $220,000 today, provided they had the courage to withstand the maddening volatility they would have experienced.

Someone who started indexing 10 years ago today has a different story to tell. They put their money in when prices had fallen a great deal and have now done very well indeed. Their $100,000 has grown to about $330,000 - about 50% more than the poor guy who owned the index for twice as long.

When it comes to index investing, price matters too. Buying low and selling high works very well; buying high in hopes of selling higher is not as sound a strategy.

And buying high is just about the only choice indexers have open to them right now.

"Owning the Market" Is About as Expensive as It's Ever Been

Before you run out and buy that nice, low-cost, safe index fund, consider that the price-to-earnings (P/E) ratio of the S&P 500 is in the highest 20% of ratios ever measured.

With the P/E ratio at roughly 25, history tells us that today looks a lot more like 1999 than 2009 - and remember what happened to the poor schmuck who bought in in 1999.

Expected returns from this level are somewhere right around 3%. After an extended period of low volatility, we are seeing market volatility increase recently, so it's highly likely you'll experience some truly stomach-churning fluctuations along the way to that whopping 3% return.

It's simply not worth the "grind" when there are so many other opportunities to make the kinds of unreasonably high, 20%-plus returns you need for a comfortable retirement.

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About the Author

Tim Melvin is an unlikely investment expert by any measure. Raised in the "projects" of Baltimore by a single mother, he never attended college and started out as a door-to-door vacuum salesman. But he knew the real money was in the stock market, so he set sights on investing - and by sheer force of determination, he eventually became a financial advisor to millionaires. Today, after 30 years of managing money for some of the wealthiest people in the world, he draws on his experience to help investors find "unreasonably good" bargain stocks, multiply profits, and build their nest eggs. Tim tirelessly works to find overlooked "hidden gems" in the stock market, drawing on the research of legendary investors like Benjamin Graham, Walter Schloss, and Marty Whitman. He has written and lectured extensively on the markets, with work appearing on Benzinga, Real Money, Daily Speculations, and more. He has published several books in the "Little Book of" Investment Series and a "Junior Chamber Course" geared towards young adults that teaches Graham's principles and techniques to a new generation of investors. Today, he serves as the Special Situations Strategist at Money Morning and the editor of Peak Yield Investor.

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