From Darkness To Simplicity : The Evolution Of An Index Investor

Index investing is widely accepted to be one of the simplest approaches to investing. But, most investors are more aware of actively managed mutual funds. Also the benefits and essential truths associated with indexing are not widely propagated. Therefore, making the shift to passive investing proves to be quite hard. It therefore requires a significant degree of evolution for an active investor to fully embrace index investing.

The evolution of an active investor investor into an index investor happens in various stages. Each of us may be at a different point in the evolutionary process. But it is certain that any investor can complete the evolutionary process and embrace indexing wholeheartedly. But they must be willing to let go of their biases and put in the time and effort required. Therefore today I am going to talk what it takes to make the transition from being an active investor to an index investor.

In order to be successful as investors, we must first have clarity on three aspects. Firstly the philosophy, or the concepts and basis behind the approach. Secondly, a strategy which we would use to employ our chosen approach to investing in our investment portfolios. And finally discipline, which represents our ability to stick to our chosen approach regardless of external factors and pressures. Achieving a balance between these three aspects within a broader framework of simplicity as shown in the graphic that follows should be the central objective of our investing endeavours.

Darkness

Most first time investors tend to buy investment products based on instinct and hearsay. They may not have knowledge of concepts such as asset allocation and goal based investing. They run a highly cluttered portfolio with exposure to almost every product they are aware of. Such an approach to investing clearly means they create and build assets without a purpose. And this ultimately points towards a clear lack of philosophy, strategy and discipline.

Investors who are slightly more evolved would have a clear understanding of the concepts of asset allocation and goal based investing. Their investment approach is usually built around investing in individual securities and actively managed mutual funds. So these investors would quite clearly have a clear philosophy, strategy and discipline in place. The philosophy behind active management involves picking individual securities based on superior insight so as to beat the return of a specified market benchmark.

But as shown comprehensively by (SPIVA) India reports, active management strategies fail to perform as advertised with any degree of consistency or reliability. Also, any investment strategy that is based on active management places focus on product selection. And this would require a lot of work to be done by the investor in terms of picking the right products for their needs.

It would also involve constantly reviewing the weights of various products in their portfolios. Then there is the need for regular rebalancing. All of this would demand a lot of time, analysis and effort from us as investors. And the majority of us may not be able to do justice to the demands of such strategies. This may make cause us to constantly modify or change our strategies. This implies that we don't maintain discipline. And all of this points to the fact that active management lacks simplicity.

Enlightenment

This leads some investors to realise that the complexity associated with active management ultimately sees their portfolios underperform the market. They therefore realise that simply earning the market return over the long term may be the best option for them. And it is this realisation that helps them evolve and open their eyes to the benefits of index funds.

Complexity

Waking up to the benefits of index investing and actually shifting towards index funds across asset classes are two different ball games. Following index investing as an approach right from the beginning is fairly simple prospect. The real challenge would arise for those of us who have had a portfolio of active funds until now and wish to switch approaches to index investing. In such a case, we must first be willing to make a permanent shift in our mindset.

Most active investors begin making the shift by letting go of most or all of the active funds in their portfolios. They then include a variety of index funds in their portfolios. They include large cap index funds, mid cap index funds, small cap index funds and even factor funds. This again clutters the portfolio and increases complexity. This implies that the shift to the index investing has begun. But is not yet complete.

Simplicity

Completing the shift involves appreciating that index investing is a simple, low cost and low maintenance approach. It ensures that we are likely to have enough money to meet our goals over reasonable periods of time. We must also have the maturity to understand that having enough money for our goals and generating the highest returns don't need to go together. So just a few well managed index funds would be enough for our needs. We must also realise that index funds do not offer downside protection.

In other words, if the benchmark index that our index fund tracks falls by say 15%, the equity component of our portfolios would also fall by 15%. We must remember that index funds are a tool used when following the passive approach of investing. Downside protection in such a case is achieved at portfolio level through the use of asset allocation.

Final Thoughts

All of this points toward the fact that becoming an index investor represents a move to a philosophy that is simple. This can be converted into an easy to follow strategy. And this makes it easier for us to follow the strategy in a disciplined manner. But it also takes maturity and a desire for simplicity to be able to appreciate index investing in the right way. So completing the shift to index investing certainly would not be easy. But it is definitely possible. And it would definitely be worth the effort.