Thoughts on Index Investing

From: Vitaliy Katsenelson, CFA from his most recent client newsletter, excerpted and used with permission.

“Over the last fifteen years, index investing has turned into a religion that promises never-ending returns from stocks, no matter how expensive the stock market might be. “Buy the dip” and “never sell” have become this religion’s commandments. This faith has received endless reinforcement from stock market appreciation… so far.

Of course, as stock market growth outpaces earnings growth, these dollars invested in stocks buy less and less. But inflows never end. In their defense, investors typically keep doing what worked for them. Most are given a menu of index funds they can buy in their 401k. They check off the box, and then billions of dollars buy the index every month, with no research and no attention paid to how much these dollars buy per unit of earnings and cash flows. The longer this cycle lasts, the higher stocks will climb the cliff from which they will eventually fall.

This is where things get nuanced, and this is where risk becomes volatility, because in the case of downside volatility (nobody looks at price appreciation as risk) there may be a semi-permanent loss of capital – losses or near-zero returns for a decade or two.

“The market” is a somewhat nebulous entity to wrap your hands around. Instead, consider Microsoft, Qualcomm, or Wal-Mart. It took them a decade or longer to return to their 1999 levels. A decade is forever in the stock market, especially when you’re losing money.  Only a few investors who bought them in 1999 held on through 10–15 years of negative or no returns before things turned around.  This is why I am so glad we don’t own the market.”

From another source:

Here are some of the largest stock market crashes since 1900, based on their peak-to-trough declines:

1. 1929 Crash and Great Depression:This crash saw a staggering 79% decline. It took approximately 25 years to recover.
2. 2000 Lost Decade (Dot-Com Bust & Global Financial Crisis):This period experienced a 54% decline. 9 years to recover.
3. Inflation, Vietnam, and Watergate:This period saw a 51.9% decline beginning in 1973 and recovery July 1980. 7 years to recover.
4. WWI & Influenza:1912-1925 saw a 51% decline and 13 years to recover.
5. Dot-Com Bubble Burst:A 49% decline. 7 years to recover.
6. 2000 Dot-Com Crash:2000 to 2008 a 34% decline. Immediately followed by 2008 recession Mortgage collapse, so depending on how you look at this… 13 years?
7. 1987 Stock Market Crash (Black Monday): Dow Jones Industrial Average plummet by 22.6%. Recovery took about 2 years.

Per AI source, on average, we are looking at 57% declines and recovery periods lasting 11 years.

11 years is an eternity when you are investing.