Mental Models 4 Life

When proponents of index investing talk about the benefits of index investing, several things tend to come to the fore:

1. share markets tend to rise over the long term, and dollar-cost averaging is a low-risk strategy to get the market returns;
2. most active fund managers underperform index investing over the medium to long term, after expenses — the cost of index investing, at around 0.15%, is 8-10 times lower than the 1.1-1.5% that active investing funds typically charge.

What is usually not discussed are the reasons behind these two empirical observations. Without understanding what’s behind these empirical observations, how do we really know they will continue, even accepting that they have held true for many decades now?

Here’s my attempt at a simple explanation of the success of the index-investing phenomenon.

The sharemarket can be thought of as a giant conglomerate made up of all the companies listed in the sharemarket. It produces, at a profit, goods and services for the consumption of the worldwide population. As long as the worldwide population is increasing or maintaining its consumption level, the giant conglomerate has a captive customer base. (No single company has a captive customer base quite like this one.) Within the giant conglomerate, there will be internal competition because the ambitious managers within the conglomerate would always be looking to get a bigger slice of the overall pie to increase their own compensation and climb the corporate ladder. Such internal competition leads to productivity gains within the conglomerate over time, reducing the cost of production, which then feeds into a virtuous cycle of increasing the level of consumption by increasing the availability of goods and services to more people in the worldwide population. Such internal competition would also largely be controlled from causing damage to the conglomerate over time, since efficiency gains that benefit only the customers but not the conglomerate would eventually be stopped. All these dynamics mean that an investment in the conglomerate, at a fair price, is a no-lose proposition as long as the worldwide population doesn’t shrink over time. That, I think, is the reason index investing works over the long term.

Now let’s look at why active investing tend to underperform index investing. I think this has something to do with the difficulty of predicting success in complex environments. At a fundamental level, creative destruction is what propels the giant conglomerate that is the sharemarket forward. Companies die and new companies rise to take their place all the time, it’s just hard to know which are the ones that will die and which are the ones that will rise a priori. Active investing is, to a certain degree, about picking the winners from the losers, and that is an increasingly unpredictable game as the consumption level of the worldwide population goes up Maslow’s hierarchy of needs. Index investing side-steps all of these, relying only the existence of winners to profit.

I am sure none of the above thoughts are novel, but I haven’t really seen them spelled out explicitly in my readings. I am still a value investor at heart — I still believe value investing is one of only a few active investing strategies that can outperform market returns — but the above lists the reasons why I adopt a hybrid strategy of splitting my money between value investing and index investing.