How I learned to Stop Worrying and Love the Index
Shock Market
Here are ten questions. To answer them, think of a range where, if you found out the correct answer fell outside the range, you would be shocked!
What is the current population of the town in which you were born?
How many Grammys has Beyonce been nominated for?
How old was Tu-Pac when he died?
How many countries participated in the first modern Olympics in 1896?
How many teams are in Major League Baseball?
What portion of people in Canada live in cities with over one million people?
How many people voted for Abraham Lincoln in the 1860 presidential election?
What is the height of the St. Louis Arch?
How many of Taylor Swift's songs have topped the Billboard charts?
How much more likely is an adult in the US to die from heart disease than 70 years ago?
I'll wait a moment. The answers are here.
This is how author, poker star and decision expert Annie Duke set up her colleague professor Abraham Wyner's "Shock Test," in her book How to Decide. I changed the questions, in case you’ve read it!
I'm sure that you nailed all your answers. But, most people find about half their answers fall outside their range — half the answers they guess are shockingly wrong.
The exercise highlights three things:
Most people don't know as much as they think.
Most people aren’t great at guessing what they don’t know.
Most people are too confident about things they don’t know — they pick a too narrow range.
Stock Market
What's true for Beyonce's Grammy nominations is also true for stock market returns. Where will returns come from next year? I don't know. Ten years? Also pretty hazy on that.
I have some ideas. I have some past evidence. But the range of possible and likely outcomes is pretty wide. And probably wider than I think.
We can look at the past for guidance, but that doesn't get us too far. Where have returns come from this year?
Current Events
Through the beginning of November, the S&P 500 rose 16%. But all of that came from just seven stocks, all of them tech or tech-forward companies. Excluding those, the S&P 500 rose only slightly. The Russell 2000 of smaller companies fell -2%. Worse still, TLT, an index of US Treasury Bonds, the safest of safe investments, dropped -9%.
Last year, analysts were very confident that the US would face a recession in 2023. It has not. For most companies, performance has wobbled anyway. There are more unprofitable companies in the Russell 2000 today than there were in 2009. You may remember 2009 was not a great year for many companies. So, expectations were wrong about recession, wrong about overall returns, but right that most companies would struggle.
I'm not sure exactly what to make of that pile of information other than being mostly right about companies struggling, but for the wrong reasons and still being wrong about the aggregate outcome — solid economic and market performance — is confusing.
LCM isn't much better at this game. Its answer to many questions about the markets is "I don't know." But that shouldn’t deter investment. A technique that neatly addresses the "I don’t know" challenge is to use indices, but not necessarily for the usual reasons.
The pro-index party-line is that indices help investors diversify. The S&P 500, after all, captures about 500 of the largest US companies. Holding the index will keep you from blowing up from one or two or many bad investment decisions. The S&P often does that job.
Lately, it’s helped investors do another job too. The index has saved investors by keeping them from being sunk by 493 mediocre investment decisions this year and tied them to the good fortunes of just a few.
This isn't that unusual. A few star stocks in the market often make up for a lot of mediocre ones. Ben Carlson summarizes that feat at A Wealth of Common Sense here. What’s new is the degree of concentration.
Ten years ago, the top ten companies in the S&P 500 index made up 18% of the whole. Today, the top three companies make up that same portion. One thing the main index has captured over the last decade has been the consolidation and concentration of returns in a few large tech-y companies.
Not exactly the perfect diversification envisioned in textbooks. But the S&P still achieved those returns and those returns have been a boon to investors.
Mix and Match
Indices are a way to approach that challenge of "I don't know." I don't know which seven stocks will drive all the market performance next year or next decade. I don't know what trading days will matter to performance. I don't know when higher interest rates will drive down returns. I don't know what corporate or geopolitical events will unleash financial chaos…
Indices leave a lot out too, though. LCM spends most of its time uncovering sources of returns very intentionally not captured by indices.
There are loads of things to do on that front that offer a nicely balanced cocktail of (low) risk and reward. But these also tend to be things where LCM has very specific knowledge. For the rest, love the index.
Disclaimer: None of this is investment advice. It's meant to illustrate ways LCM thinks about investing. Things that LCM decides are good investments for LCM and its clients are based on many criteria, not all of which are covered here. Some or all of LCM's ideas may not be suitable for other investors. LCM does not recommend investing either long or short any position mentioned. LCM may own positions in some of the companies mentioned. Some of its ideas will lose money — investing entails risk. See full disclaimer here.