The Problem With Index Funds: The Lloyd Christmas Effect

I could sing the praises of index funds and ETFs (especially Vanguard’s) all day long.  It’s hard to beat instant diversification and the dirt-cheap fees that characterize passive management.

But the incredibly simple nature of index investing also happens to be its greatest weakness.

There’s no challenge in searching through potential stocks, trying to pick a winner. The adrenaline rush that you get when you plop down your hard-earned cash on shares of XYZ Widget Company is missing.  The riskier route that is individual stock-picking appeases our ego a lot more than owning a tiny fraction of thousands of different companies.

We can all imagine the guys who stand around at a cocktail party or at the water cooler bragging about their supposedly highflying investments, exaggeration all but guaranteed. Then there others who may not discuss their financial activities much, but sit around at night playing with the technical indicators in their new E-Trade account, wondering what the day-trading baby’s secrets are.

Index investors, on the other hand, could care less about flaunting or attempting to demonstrate financial prowess. Heck, it takes up so little time that they can largely forget about it. While others are talking about making riches in the stock market (I doubt many actually are), or plotting their fail-proof route to investing success, index investors are actually doing it- slowly but surely, without even giving it nearly as much thought.

Over the long haul, index investors are many times more likely to have succeeded in creating wealth than their active-trading buddies, but it’s hard to impress others (or yourself) with a K.I.S.S strategy.  When’s the last time you heard somebody bragging about matching the market?  Probably never.  You might as well brag about being able to read this page.

And this is a problem.

When matching the market is easy as pie, many people will conclude that such a strategy is below them.  I’m guessing this mindset is much more prevalent among people who are well-educated and intelligent, and it gets many of them in trouble.

You surely remember Lloyd Christmas (Jim Carey), the insanely awesome but extremely dim-witted protagonist in Dumb and Dumber. The fact is, Lloyd could probably invest for success if he acknowledged his blatant lack of mental capacity and invested in an index fund or two.  Yes, I’m confident that a man who fell of a jet-way could save up some money, contact a fund company, and become an index investor.

The Lloyd Christmas Effect, as I’ll call it, is the challenge to our ego upon realizing that someone with a ridiculously low IQ could succeed as an index investor. Of course, I’m guessing few people actually make a connection between Dumb and Dumber and investing, but I’m probably far from being the only person to realize how incredibly simple and even thoughtless passive investing can be.

Given that we laugh at the stupidity of Lloyd Christmas, while generally thinking of ourselves as smart individuals, it can be difficult to accept such a simple method as a weapon of choice. Our intelligence is hardly tested, so it seems reasonable to believe that we could do better. And we probably could; I’m not trying to discredit active investing, but instead point out one of the biggest and most common flaws of those who partake in it- overconfidence. It’s not that we aren’t capable of beating the market- it’s that we tremendously underestimate how much consistent effort is required to do so.

If we can accept two facts….

1.) That passive investing is the clear choice for most people.
2.) That even Lloyd Christmas, or the Cavemen from the Geicko commercials, could do it.

…then we’re set.  Humility would do many an investor a lot of good.

There is one thing all index investors can brag about though: beating nearly every mutual fund over time.

Note: Despite the name of this post, this issue isn’t the only problem of index investing. A little while back, I wrote about basically the exact opposite issue.

Why Hasn’t Index Investing Exploded in Popularity?

ETFs have been around for quite some time now, and index funds for even longer. It is now possible for even the smallest investors to own a thoroughly diversified portfolio that tracks the market indices. So why hasn’t the mainstream public swarmed to these investment vehicles?

Sure index investing keeps growing in popularity, but much of this growth is probably accounted for by institutional buyers like life insurance and pension companies. There aren’t many individual investors out there deliberately seeking out these funds and investing their money. Millions even have access to these funds through their employer-sponsored plans, but still don’t make use of them. It’s ridiculously easy to set up a dummy-proof investment strategy all but certain to deliver long-term growth, so it’s unfortunate that so many neglect to do so.

I don’t believe the financial sector in general wants people to realize how simple investing can be, for an obvious reason; their profits largely depend upon making people believe that investing has to be difficult. Several examples:

1.) Financial advisors need people to feel ill-equipped to manage their own investments. The less confident their clients are about their own abilities, the better chance a financial advisor has to profit off of them.

2.) CNBC and all other investing networks and programs need investors to overcomplicate things. Passive index investors don’t waste time watching the garbage on CNBC, waiting to hear about their investments. They’re out doing something more enjoyable.

3.) Online brokerage firms’ profits depend upon getting people to sign up for accounts and squander half their investment capital on transaction costs They love to perpetuate the message that you can only win by ‘taking control of your investments’ by becoming an active trader (I’m thinking about those E-Trade commercials with the day-trading baby).

Td Ameritrade probably hates buy-and-hold customers like myself who only have a handful of transactions a year (I used to do otherwise, but I’m beginning to wise up now). They honestly don’t care too much if their customers succeed; what they want is to rack up as many $10 commissions as they can.

4.) Mutual fund companies need us to believe that their so-called professional management is the ticket to investing success. They love to hype the extraordinary market vision they have as financial gurus. What they don’t tell you is this; almost no mutual funds manage to beat the market consistently for a considerable length of time, especially when expense ratios are figured in.

Don’t get me wrong- mutual funds were without a doubt one of the most incredible financial innovations of the 20th century. They can be a highly useful tool for long-term wealth creation. However, with very few exceptions, they have proved mathematically inferior to passively managed funds.

Scare tactics:

The extremely broad investing field thrives by making it all seem threatening and complicated. The industry spends billions upon billions of dollars each year propagating this message, so of course it’s going to make regular John and Jane investors feel overwhelmed and intimidated.

John and Jane could set up a incredibly easy plan that invests passively in the indices and basically runs on autopilot, saving them money, time, and stress. Instead, it’s more likely that they opt to turn their investment decisions over to a financial advisor who charges $75 commissions or buy a mutual fund with a 2.5% expense ratio (or heaven-forbid trying to become a day-trader in their free time). The sharks in the investment field claim yet another victim…

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