While building my portfolio, I could not ignore the wealth that can be built through the use of common stocks in times of prosperity. Yes, the last decade was turbulent, but there have been times when common stocks were an engine for wealth creation. How could I ignore getting a slice of corporate America’s profits? I would surely have to find a way to mitigate the risks, but I knew I wanted some common stocks.
There is an infinite number of ways to approach investing in the stock market. I have come to believe that this is influenced by the myriad of assumptions that investors make to simplify their decision making. I am no exception and I let my assumptions guide how I approach equities.
The first guiding assumption was that net alpha equals zero. This means if I were going to try to pick my own stocks to beat the market, I would be playing a zero sum game. Zero sum games remind me of gambling, and playing against the collective wisdom of a global market is like trying to beat the dealer in a rigged card game. To make matters worse, seeking alpha entails high transaction costs, especially in a taxable account. Does paying fees to participate in a zero sum game sound like investing to you? It smacks of gambling to me, besides there is a simple way around it.
For equity exposure, one can simply buy an equity index with rock bottom expenses. With an equity index, one doesn't pick stocks; the market does all of the work. An index investor pays practically nothing to have every money manager in the market do all the work for them. Money managers sweat, lose sleep, and read annual reports all trying to discover the right price for equities, but with an index you don’t have to pay any of them a dime. One simply pays a small pittance to buy nearly the entire stock market with one click.
This is the power of stock market indexing. Indexers have a joke “You get what you don’t pay for.”
When you buy an index you are essentially saying, "I don't know which mutual fund manager is best, so I am going to have all of them work for me instead." It is inevitable that some managers will do better than the average, and some will do worse.
Why not just pick the best manager then? Why should I settle for "average?" Bill Miller ran the Legg Mason Value Trust successfully for years and he had a 15-year streak of beating the market every year. I'm sure he laughed at indexing. Why should he settle for average when he's extraordinary? Our most recent crisis came entirely unexpected to Mr. Miller. Even if I bought into his fund right at the start of his 15-year out-performance and held until today, I would be lagging the indices because of his recent blow up and the extra fees incurred along the way.
Ultimately, out-performance is a zero sum game. If you observe a coin-flipping competition with thousands of participants, someone could look like a genius by flipping heads fifteen times in a row, but this doesn't change the fundamental nature of the game. In the game of out-performance for every winner there is a loser and we have no reliable way of picking the winners.
What I can rely on with alpha seeking strategies is high fees that eat into my future returns. The average actively managed mutual fund charges around 1.5% per year while most index funds run under 0.2%. Additionally, any of my own stock picking would surely involve commissions, tax inefficiency, and less diversification than an index. The world of investing is very uncertain but fees are one of the few variables I can control with certainty, making it is prudent to keep them as low as possible. An index fund would have to be the way I invested in equities.