There seems to be many... MANY "fads" or whatever you'd like to call them out there. Growth stocks, tulip bulbs, dividend investing, diversified portfolio theory, value investing and... index funds.
Some of these things are not like the others. Let's take them apart and look at what they mean.
Growth stocks are stocks of companies expected to grow faster than their economic sector will in aggregate. Investors looking at growth stocks are interesting in the price-to-earnings ratio of the stock (P/E, which is calculated just like it's written). Because the stocks are expected to grow faster than their sectors, investors think the stocks hold a lot of future value relative to the companies' current earnings and are willing to pay a lot more for the stock relative to its earnings. Facebook, for example, is expected to have a lot of future growth by investors, so it's
currently trading at a P/E of 102.3. In other words, investors are so sure that Facebook is going to grow faster than most stocks that they are willing to buy $102.3 of stock for every $1 of earnings.
Value investing is the opposite of that. Value investors seek stocks with low expectations of growth, and therefore low P/E ratios. Cisco, which makes the networking equipment that runs datacenters, office complexes, and much of the internet, is
currently trading at a P/E of 12.06. To get $1 of Cisco's earnings, investors are only willing to buy $12.06 of the company because they believe it is well established in the market and its prospects for future growth are much worse than Facebook's. (I don't know where the P/E cut-off is for value investors, but in general you'll see long-established companies like Cisco that aren't expected to grow extremely quickly).
To beat the market growth investing, your company's earnings would have to grow even faster than the market expects it to, so the real value of the stock when you purchased it was actually higher than the price you paid for it. To beat the market by value investing, your company's earnings would have to grow less slowly than the market expected it to when you purchased it, so the real value of the stock at the time of purchase was actually higher than the price you paid for it. In both cases, the same thing would have to happen: the market would have to have set too low a P/E ratio at the time of your purchase, and expected too little earnings for your company. Whether or not they know it, people who say they can beat the market with either technique are really saying that they are smarter than the market at predicting the future earnings of companies.
I am not extremely familiar with
Dividend investing, but
from what I can tell the way to make money in dividend investing is to buy shares cheaply and sit on them for such a long time that the ratio of the dividends far into the future to price now is better than the yield that would have been received investing by another technique. To follow the article's example, if you bought Coke in 1988, your dividend in 2011 was a 33% yield on your 1988 money. After you discount that based on getting the dividend in 2011 and having bought the stock in 1988, as a dividend investor you would be hoping that you could still beat the return you'd get by investing that same $5.69 with another method in 1988. Again, you'd be hoping that the stock was somehow undervalued when you purchased it and that the market didn't know how valuable it would be to own Coke stock. Otherwise, you wouldn't make any money.
Tulip bulbs are used by
Burton Malkiel's readers among others to illustrate market irrationality and bubbles. Seeing something less recent makes the economic behaviors more obvious, because you don't start bringing in non-economic values as easily as you would if we were talking about the subprime bust (Americans deserve single-family detached homes, it's the American Dream) or the dotcom boom (but at the time, it looked like the internet had limitless potential). Don't buy tulip bulbs at inflated prices. ;)
Modern portfolio theory holds that the optimal ratio of risk to reward is earned by holding assets in several different asset classes. You will get a greater reward for a given amount of risk by holding stocks, bonds, and real estate than you would by holding stocks alone, for example.
Finally,
index fund investing holds that the market is efficient. (If you want to be technical, it really only requires that there are no inefficiencies in the market that can be exploited for less than the cost of making the trades to do so. As you note, the trading costs themselves are significant.) Index fund investors believe that they are not smarter than the highly intelligent, highly trained financial analysts that work for institutional investors. These analysts and institutional investors drive the price changes in the stock market because they do almost all of the trading by volume. If you don't have any reason to believe that you are smarter than they are, then you don't have any reason to believe that you can know which stocks are undervalued, and thus your best option is to hold funds tracking entire sectors of portions of the market. You mitigate your risk drastically by only holding individual stocks, and you do as well as the market as a whole, instead of haphazardly selected portions of the market.
The other bonus of index funds is that their
expense ratios are extraordinarily low. If you look at what it would cost you in trading fees to diversify your portfolio that thoroughly, we're taking way, way more than the .1-.3% typical of index funds (see
VTSMX, Vanguard's total stock market index, for one example of this low expense ratio). Remember how big institutional investors do most of the volume in the stock market? That means that most of the change in the stock market is due to them, and that the market's performance is very similar to the average performance of funds managed by these big institutional investors. So if your typical mutual fund or other investment instrument will perform about like the market does, minus a .8% expense ratio, why wouldn't you just take market performance minus a .1-.3% expense ratio? And remember, just like picking stocks, you have no way of knowing which mutual funds will outperform the market and which will underperform the market. If it were possible for you to know how mutual funds can make themselves succeed, wouldn't it be possible for financial analysts to know how to make mutual funds succeed? If the market gives us 4% next year, wouldn't you rather have 3.85% returns than one of the returns falling on a bell curve from the negatives to 5%, centered at 3.2%? Most people choosing the second option lose.
there is a big catch... When investing you must "have the patience of a nesting hen" and "not squander long-term returns by incurring frequent trading commissions or excessive management fees". So I'm also happy to pick something, and let it grow over 10-20+ years making sure I don't waiver (which is apparently the hardest thing to do).
Now riddle me this: If all previous methods of making money seem to be "fads" in hindsight... and you have to be patient and wait 10-20+ years to get proper results... how can you tell (with enough time to save your money) that ANY current investment strategy will work?
Every time you change your asset allocation, there are three things you have to consider. First, there are the trading costs themselves, which can be significant. Second there are the tax implications, which can be to your advantage or disadvantage. Finally, there's the fact that individual investors tend to get out of the market when it's low and get into the market when it's high, timing the market in reverse to guarantee that they'll do poorly. If you're buying more stock because prices are up or selling your stock because it's gone down, you're doing it wrong. The advice to stay patient like a nesting hen aims to prevent people from incurring these three costs.
Even IF (say for arguments sake) Index Funds are the best thing to invest in right now... it demands a very long term tenure. Even IF "Idea XYZ Investing" comes along 10 years from now and it is wayyyy better than Index Funds... I can't switch over as I might not have been "in the game" for long enough for the index funds to do it's thing!
There is nothing magical about being in the game for a long time with one strategy. Your total investment return over a period is simply each day's investment return multiplied together (we want to express a 4% gain as 1.04 here and not 4% for this to work), times your original principal (Bad Money Advice
explains this better than I can)... after 9 years and 364 days, your overall investment performance is only going to be different by one day from your performance at 10 years, and only two days different from your performance at 10 years and 1 day. The only thing that's important about sitting on your investments is that you avoid the costs I detailed above when they're unnecessary, because they can seriously eat your performance.
I get the feeling that investing (even the buy and hold ones) is an evolutionary thing. Yes Index Funds might be perfect "now"... but in 10 years who knows? The core principle of them is that "the market always goes up" which, whilst true, there are 2 things:
1. Thou shalt know that past performance is no guarantee of future results - how do we all say this and then just ignore it???
2. The last 100+ years performance was built on fossil fuels. That growth is very suspect to me (although if there's no 0 growth then there should be 0 inflation too right?)
Let's get philosophical. Money is an exchange medium for value. The stock market's job is to take capital from capital holders and put it to work producing things of economic value-- things worth money to consumers or other businesses. The last 100 years' performance was built on this, not on fossil fuels. In the last 100 years, we've had countless innovations in agriculture, medicine, warfare, finance and governance, philanthropy, electronics, academia, entertainment and every other part of the economy imaginable. If you bought into the market in 1912, you'd be profiting from all of that innovation because your capital would have helped the innovators produce value. In 2112, your capital will have been a part of all of the innovation that has happened in the century since, producing value for consumers and businesses. That's no different and not dependent on fossil fuels (which we're not running out of
just yet).
And as a side note, inflation also depends on liquidity, which is how easily money can get around. If there's a lot of money to borrow, there's more 'supply' of money even if the same (see the
Khan academy episode on fractional reserve banking for a crystal-clear explanation of this.)
