For indexing, what is the "market"?

[josstache]

In discussing index investing vs other strategies, the conventional Boglehead/MMM wisdom is that one should generally not attempt to beat the "market."  It is far easier and less likely to lead to underperformance to buy the "market" and get "market" returns.

While this is a fine principle, it becomes problematic when people disagree about what the "market" is.  Does the "market" include commodities, real estate, international equities and debt? In what proportions?  There is also the more fundamental problem that it is only possible to index invest in asset classes that have an index, which means certain asset classes are left out entirely (e.g., Is there an index to invest in privately held companies? By definition I believe it does not exist, though please correct me if I'm wrong.)

What is the "market" for you?  Are you buying the entire market based on such definition?  Do you have a tilt towards US, Canadian,  or Australian assets?  A tilt toward or away from real estate or commodities? If so, how do you justify it as something other than "stock picking"? How do we reconcile the fact that the bond market is much larger than the equity market, while most Boglehead or Mustachian asset allocations favor equities?

I am just beginning investing and am only in stocks and bonds, with the US/international split roughly in proportion with the respective market caps, though not if "international" is broken down on a per-country basis.  I own no real estate, no REITs, no commodities or commodities funds.  Should I be concerned that I don't own the "market"? I don't have a good handle on these questions, but took a leap of faith, in some sense, that it would be better to be in something than leave my money sitting in a bank account.

[FFA]

"Should I be concerned that I don't own the "market"?"

- in my view, no. Personally I think it's more important to be 1) consistent (once you decide on your definition of the market, stick to it no matter what) and 2) aligned with your risk tolerance.

I have seen justifications written for a rational investor to have a home bias (there was a vanguard paper on this). There are certainly valid reasons for it beyond "stock picking". I can't find the link but am sure you can find via search.

Although I do favour index investing, I am not ideologically rigid that everything should be in proportion with respective market caps. For me that doesn't really make sense anyway, but the benefit is the consistency/discipline, which was my point 1) above.

[aj_yooper]

Rick Ferri is a good commentary on using indexes to the market.  Read this and you will get a lot of information:  http://www.rickferri.com/blog/investments/three-simple-index-fund-portfolios/

[innerscorecard]

There's nothing magical about any particular index. But conversely, any good-enough index will be representative enough of ownership of stocks in the economy that differences between them don't matter so much to you in the end, in the long-run. You could argue that a mutual fund that invests in debt (and commodities) as well as equity is in fact more representative, of course.

[skyrefuge]

"Should I be concerned that I don't own the "market"?"

- in my view, no. Personally I think it's more important to be 1) consistent (once you decide on your definition of the market, stick to it no matter what) and 2) aligned with your risk tolerance.

Excellent answer.

I think the order of the investing decisions is important.

The OP implies (and I think many of us think the same way) that the first decision is "I'm going to index", and then the second decision is figuring out what market(s) to index.

But I think the real order is (or should be) to figure out what markets you want to invest in (based on projected risk and return), and then decide how you want to invest in those markets (with the answer to the latter part being "indexing, if available!")

With the latter approach, the questions about home-bias or equity-bias relative to the entire universe of investible assets are easily answerable. And the decisions about what markets to invest in are shown to be unrelated to the decision to index.

Most (all?) actively-managed mutual funds have benchmark markets, just like index funds do. Actively-managed mutual funds existed long before index funds did, so I'm assuming that this relation of actively-managed funds to benchmark markets is not something that was invented only when index funds hit the scene. This lends further support to the "first chose what, then choose how" approach, since presumably Mr. Moneypants from the 1950s was saying "I'd like to invest in the Burmese bond market, and, oh, here's Mr. BurmaBond who promises to help me beat everyone else in that market, so I'll put my money in his fund".

[innerscorecard]

"Should I be concerned that I don't own the "market"?"

- in my view, no. Personally I think it's more important to be 1) consistent (once you decide on your definition of the market, stick to it no matter what) and 2) aligned with your risk tolerance.

Excellent answer.

I think the order of the investing decisions is important.

The OP implies (and I think many of us think the same way) that the first decision is "I'm going to index", and then the second decision is figuring out what market(s) to index.

But I think the real order is (or should be) to figure out what markets you want to invest in (based on projected risk and return), and then decide how you want to invest in those markets (with the answer to the latter part being "indexing, if available!")

With the latter approach, the questions about home-bias or equity-bias relative to the entire universe of investible assets are easily answerable. And the decisions about what markets to invest in are shown to be unrelated to the decision to index.

Most (all?) actively-managed mutual funds have benchmark markets, just like index funds do. Actively-managed mutual funds existed long before index funds did, so I'm assuming that this relation of actively-managed funds to benchmark markets is not something that was invented only when index funds hit the scene. This lends further support to the "first chose what, then choose how" approach, since presumably Mr. Moneypants from the 1950s was saying "I'd like to invest in the Burmese bond market, and, oh, here's Mr. BurmaBond who promises to help me beat everyone else in that market, so I'll put my money in his fund".

Really good post. "Indexing" is a way of doing something (investing in a certain sub-section of the economy) but if you really think about what you are trying to do, isn't as brainless of a decision as some say, unless you're willing to accept a default series of assumptions (which are by no means terrible) (i.e. I want about 1/3 exposure to international equities, 1/3 exposure to US equities, and 1/3 exposure to US debt).

[hodedofome]

Yeah I think it's funny that Jack Bogle would tell us that we can't predict anything and the market is smarter than us and active management is silly (my interpretation), while making a giant macro bet that US stocks will be the best place to be for all of our portfolios. If the market was truly smarter, we'd all be in roughly 57/43 worldwide bond/stock portfolios. Any deviation outside of that is active management.

How many on this forum are true passive investors? I'd bet about none.

[Le Barbu]

For me, comparing yourself to "the market" doesnt mean the whole investment world. You first have to decide wich part of the investing world you wanna beat. If you decide to "index" with a good* low cost funds/ets, you will get the market return minus fees and +/- tracking error*. My goal is to get about the average market return of Canada, US and Int. stocks, (market return via index etfs) and then "beat" anyone with about the same AA or diversification but with high management fees (2% more). My average MER is 0.09% and 4-5 buying orders/year...

*good mean small tracking error year after year

[josstache]

I guess my ultimate issue is, in deciding what asset classes to invest in and in what proportions, you're engaged in large scale "stock picking."  While it is far more diversified than the actual stock pickers, you're still choosing to invest in one thing and not another, perhaps based on a view that you expect that thing to outperform the other.  But isn't the tenet of index investing that we cannot know what thing will outperform the other?  If that is so, we should be exposing ourselves to as many asset classes as possible to be maximally diversified.

To keep it simple, in deciding between stocks and bonds, people with a long-term outlook recommend a heavy stock allocation, because in the past stocks have outperformed bonds (on a risk-adjusted basis? I assume so), and thus they believe stocks will outperform bonds in the future.  At the same time, we are all aware that past performance is not an indicator of future results.  Is there a fundamental reason stocks should outperform bonds on a risk-adjusted basis?  Are stock indexers exposing themselves to a massive black swan risk that could blow up the stock markets in their country/ies of choice, or globally?

[brooklynguy]

At the same time, we are all aware that past performance is not an indicator of future results.

Past performance is an indicator of future results, but it does not guarantee future results. 

But past performance is an indicator of future results not merely because the occurrence of the performance in the past makes it inherently more likely to happen again in the future.  Instead, past performance is an indicator of future performance because the same factors that caused the past performance are likely to cause the future performance.  Said another way, past performance does not cause future performance but is probably correlated with future performance.

It's a safe bet that the sun will rise again tomorrow morning.  The sun's uninterrupted track record of rising each and every morning in the past is a good indicator that it will do so again tomorrow.  But the reason we know with reasonable certainty that the sun will rise again tomorrow is not merely because we know that it happened every previous day, but because we know that the same physical forces that caused it to rise every previous day will continue to operate tomorrow.

Now, I'm not suggesting that the performance of the stock and bond markets can be predicted in the same way as the trajectory of the sun across the sky.  But the same economic forces that caused stock returns to outpace bond returns over extended periods in the past will continue to operate in the future.  Because stocks represent the residual interest in a company's capital structure (i.e., after all payments to bondholders and other creditors have been made, everything leftover belongs to the equityholders), stock returns can be expected to outpace bond returns over sufficiently long time periods for as long as earnings potential continues to exist and the relevant macroeconomic forces continue to operate as usual.

[dmn]

While it is far more diversified than the actual stock pickers, you're still choosing to invest in one thing and not another, perhaps based on a view that you expect that thing to outperform the other.
[...]
To keep it simple, in deciding between stocks and bonds, people with a long-term outlook recommend a heavy stock allocation, because in the past stocks have outperformed bonds (on a risk-adjusted basis? I assume so)

The part you are missing is that people have different risk tolerances, due to different circumstances and goals in their lives. For this reason, different people's "risk-adjustments" of the returns can be very different.

For example, some home bias is justified because foreign assets have extra currency risk. For this reason, your domestic assets are safer for you, so to you their risk-adjusted returns seem higher and you overweight them. People from other countries find your domestic assets more risky, because to them they contain currency risk, so they underweight them.

Overweighting stocks for MMMers is similar. MMM people generally invest their own money over long periods of time, so short-term volatility is no risk to them, especially in the accumulation phase. For institutional investors like insurance companies, who invest money borrowed from their customers, a short-term drop can be terminal: if their assets depreciate temporarily, they are often forced to liquidate them in order to not lose the money entrusted to them, so they cannot stay invested throughout a crash. For such investors, short-term volatility is a huge risk, and they want to underweight stocks.

Bonds, on the other hand, are valuable to institutional investors like banks. In Europe, for example, banks can invest in bonds with huge leverage, as they are officially "riskless" so that banks need no equity to invest in them. It's like free arbitrage, they borrow money at almost 0% interest from the ECB and lend it out at 1% to some government. The risk-adjusted return on bonds, using huge leverage, is therefore quite good. For an individual Mustachian, who cannot get such cheap leverage and who invests his own money, the prospects of getting 1% nominal return on his investments are much less appealing. So while banks rationally overweight bonds, Mustachians underweight them.

In all these examples, the prices might accurately reflect "average risk adjusted-prices" for the average market participant, but as every market participant is different, everyone reasonably uses different risk-adjustments for their own investment decisions, based on their individual risk profile.

[arebelspy]

Joshua Kennon had a good article recently about what "market" (or index or benchmark) you are comparing to, and if it's appropriate to use that one.

http://www.joshuakennon.com/thoughts-stock-market-benchmarks-update-5-year-investment-returns/