Michael James wrote an post explaining why he invests in index ETFs and not individual stocks, stating that it is about knowing his personal limitations:
After reflection, I’m convinced that my choice to invest passively in index ETFs is fundamentally a statement about my own limitations.
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This brings me to my next limitation: I don’t believe that I can figure out which money managers will outperform.
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As you might guess at this point, I have a third limitation. I don’t believe that I can figure out which advisors can pick winning money managers.
Knowing your own limitations as an investor is a very important skill, and Michael explains why he thinks he can’t outperform the index, nor can he choose money managers (or financial advisers that recommend such managers), so therefore he sticks to index ETFs.
This leads me to my next logical question: What makes him think that investing in an index is going to provide a superior risk/reward than holding cash inside a GIC? Other than pointing to a chart with some very long-term x-axis (30 years or greater), it is not clear to me why equity indexes should outperform cash.
Also, assuming that investing in “the index” is superior, what index should you choose to invest in? The TSX 60? S&P 500? Some midcap or smallcap index? Or a smattering of all of them?
One flaw most people have in the marketplace is the implicit assumption that stocks, as a whole, will outperform alternative investment classes (bonds, cash, commodities, etc.) over the long run. We could continue our historic 9%-a-year nominal climb up in the major indexes, or we could enter into a period of decline (e.g. Russia’s stock market in 1900 was the third largest market in the world by capitalization, and we all know what happened there), and we would not know either way at present which will be the case.
The only way an investor can outperform in the marketplace is by selecting investments that are trading below fair value. If an investor cannot explain why an index is undervalued when they purchase it, I would not automatically assume that the index would be outperforming alternative decisions at the time of investment.
An investor completely unwilling to dabble in equity risk (including preferred shares) would have a morally consistent argument by opting for the 100% GIC-only strategy. You can usually get higher returns with GICs than most bank debentures.
As I have said to some other relatives that have come to me seeking investment opinion, “Making 2% a year is a lot better than losing 10%.” Usually it takes such a loss before people realize the impact of such a statement.