Investing Paradigms
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Indexing and Dollar Cost Averaging
There is a tremendous amount of information available online about investing and optimal investing strategies. For the vast amount of individuals who look at investing as a low priority in terms of time commitment, there is a strategy that is close to optimal. This strategy is called indexing and is often done by employing an approach called dollar cost averaging. This approach is likely to be the best for many individuals, and requires almost no further investing content or knowledge.
The main downside is that you are unlikely to ever get significantly above average returns using this approach. However, you are also unlikely to get below average returns. Additionally, compared with most active investors, you will get better returns over the long run.
Before getting into the strategy there are some basic concepts that should be understood which in turn justify the strategy as a whole.
Inflation
Inflation is something you are likely to see in the news frequently, and more frequently when it is high or rising. While calculating inflation and developing a sophisticated understanding of what it really is can be complicated. The main understanding required for investing is knowing that over time, your savings will be worth less in terms of what those savings can buy and be used for. This effect is a key justification for investing overall, and is also why getting a good return is important. If your return doesn’t beat inflation, you are still losing money over the long run. Below is a table demonstrating the effects of inflation under various time horizons and rates:
As you can see, inflation can have a significant impact on your wealth both in the short term when it is high, and in the long run even regardless of inflation rates. Target inflation in many jurisdictions is 2%, with inflation being slightly higher or lower most of the time. Inflation can, however, grow quite high depending on the circumstances, passing even 10% on occasion.
You can see in the chart that after 40 years even at 2% inflation, you will need more than double the money just to remain at the same value as your original funds. At 30 years of 2% inflation you need close to double the original funds. At higher levels of inflation, you need double your funds in 10 years or less. The important point to take away is that you have to invest, not only to gain wealth over time, but also to avoid losing wealth. Somewhat ironically, often savings accounts or guaranteed accounts with low returns are the riskiest place to put your funds in the long run, as their return may not outstrip inflation.
Interest rates
Interest rates are conventionally what people are willing to pay to have access to funds. Theoretically they are willing to do this because they can do something now that is worth more than what they will have to pay in the future. Ideally this is a business or investing approach that will provide a higher return that the interest payments. Often for individuals this tradeoff is the ability to have or experience something now rather than in the future, with typical examples being the interest on a mortgage or car loan. Interest rates are different for different things based on the risks of making a loan; loans that are not backed by assets are likely to be much riskier and therefore require a higher rate for the loan to be issued. For example, mortgage loans usually have lower interest rates than lines of credit, in large part because the mortgage is backed by the property.
What may be less obvious is that interest rates are also significantly tied to inflation. If inflation is higher, interest rates (for almost everything) are going to be higher. Likewise, if inflation is lower, interest rates are likely to be lower. The typical exception to this is with “fixed” interest rates, which are agreed upon for some time period at the beginning of that time period. Fixed interest rates won’t change with inflation, meaning that having a fixed rate can either be good or bad dependent on if interest rates rise or fall in response to prevailing sentiments about inflation.
Also related is the government overnight rate, which is essentially the rate the government charges to loan funds to financial institutions. The overnight rate can get a little more complex, however this surface level understanding is sufficient for understanding interest rates. Essentially, if the government is charging financial institutions more to borrow money, then interest rates will go up, and if the government is charging less, interest rates will go down. The reasons governments change their rates are varied, but rates are often used as a tool to manage the overall economy, and to manage inflation directly. This creates an interrelationship between interest rates, inflation, and government management approaches.
The interrelationship between interest rates, inflation, government and many other factors make predicting interest rates very difficult, but markets attempt to predict interest rate trends all the time. This is specifically because interest rates have a direct effect on the stock market as well. Specifically, when interests are elevated for longer period of time they will act as a downward pressure on stock market prices. Likewise, lower interest rates will act as an upward pressure on markets.
Trying to predict the direction interest rates will go in the short run is basically impossible as even those in the profession can’t accurately predict interest rate movement in the short run. In the longer run, you can generally expect trending toward an average rate, but it may take significant time before that happens. For example, much of the world was in an extremely low interest rate environment after the Great Recession in 2008 until the post COVID inflation increases in interest rates. That was many years of low interest rates that would have been difficult to predict both in terms of the absolute lows and the duration of the low interest rate environment. (At the same time, you can also see a long term upward trend in the markets over that time period, which is very likely heavily related to the historic long term lows in interest rates).
All the information about interest rates aside, the key point is to understand that interest rates are a response to, and have an interrelationship with, inflation as well as a tool to respond to an environment with persistent inflation, where your funds are worth less over time.
Compounding
Compounding is the key to generating long term wealth. Every wealth generating investing strategy is focused on the long term compounding rate of investments. The compound rate can be thought of as an interest rate, or more precisely the rate of return, on an investment. The higher the rate the higher the long run returns. More specifically, with regards to inflation and interest rates, the higher the return beyond the inflation rate the higher returns. Note that if your compounding rate is lower than inflation rates then your actual return will be negative.
In general, compounding can be thought of as returns on returns. In any given time period (with annual time periods being the most common reference, summarized as annual returns) an investment will generate a return. You then take the initial investment and add the return so that your new total invested amount is the original investment plus the gains on the investment. You get a return on the initial investment plus the gains, to provide even higher gains. That is compound interest. Over time this can have extreme results.
With compounding, individuals usually dramatically underestimate the amount of returns this can generate over long period of time. There are different reasons for this, in short because humans are not predisposed to think about things with a compounding mindset.
For various reasons most human thinking is quite short term, and compounding typically takes place over long period of time.
The math behind compounding is counterintuitive in terms of magnitude of effect, the long tail results behind hyperbolic in nature.
Most challenging for most people is that typically when starting out on an investing and compounding journey the returns are small in absolute terms, and in relative terms to other typical income sources. Thinking that somehow compounding will amount to anything significant enough to warrant attention and effort can be difficult.
Another element of compounding is that while an initial invested amount typically forms a base, quite often more amounts are invested over time, sometimes on a periodic basis, such as monthly or annually. These additional amounts, particularly during the early periods of a compounding investment timeframe, are often key elements of the total returns in terms of the final amount of funds available. This can be thought of as returns on returns plus additional incremental investment. Depending on the amounts involved this can supercharge an overall compounding strategy.
Following are several examples to attempt to overcome the natural human bias around compounding. A variety of return rates and time periods are used to illustrate the different aspects of compounding. In particular small changes to total time, return rates, and further amounts invested will have dramatic effects on total returns.
For the following scenarios, if you are new to learning about compounding, try to guess what you think the total funds available will be after each scenario below, before you review the outputs. In all probability you will be wildly wrong if you have not considered this before.
Now here it is with the total funds available at the end of the time period. Note that this is calculated using monthly compounding, which provides a slightly better result than annual compounding. Actual compounding frequency for investing could be monthly, quarterly, annual or other time period based on the type of investment, ongoing contributions, and the frequency of any payments from that investment. If you want to see the difference between compounding periods, as well as input different numbers to see different results, you can go to Compound Interest Calculator | Investor.gov – which is a U.S. government compounding interest calculator. There are a variety of other compound interest calculators available online.
As you can see, compounding can deliver some absolutely wild returns over time. One trend you should see is the longer compounding runs, the more impressive the results. 5% or 10% are used as rates in many of the prior examples. Reasonable investing strategies will return somewhere between 5% and 10% over the long run depending on the strategy. 15% or 20% are very high returns overall, particularly in the long run. While a very skilled investor might be able to return 15% over the long run, returns exceeding 20% long run returns are very rare and only achieved by some of the best investors of all time. These higher returns are included primarily to demonstrate the effect that small differences in rate of return can have on long run returns.
If you have never examined compounding previously, it is likely that some of the returns were very surprising. Overall the key points about compounding are:
Compound for as long as possible (start early);
Get as high a rate of return as you reliably can (pick the right investment strategy); and
Make ongoing contributions in as large amount as you can manage (which are more important earlier on)
These factors together, when focused on will provide a great total return.
Indexing
The actual implementation of an indexing strategy is very simple: when making an investment buy a market index fund. A market index fund is a fund that buys all of the stocks within an index, often based on the proportion of each stock’s weight within the index. When buying a fund like this, you are essentially purchasing all of the stocks in the index according to the fund’s weighting scheme. While an index can be of any type and variety, the most common thought of when considering this strategy is the S&P 500 Index. This is a list (index) of the 500 largest companies on the U.S. stock exchange. Purchasing this type of index provides wide diversification across many industries with some of the largest typically being viewed as more stable and higher quality companies than many others in the market. Also, because there is no active management by the company managing the fund, the costs associated with operating the fund are very low, leading to low costs overall.
Indexing achieves great diversification, factoring out industry and individual company risk, while by definition when buying a market index fund, providing returns that match the market’s overall returns. Given that the majority of individual investors and fund managers have great difficulty beating the market return in the long run, this strategy will tend to outperform the vast majority of market participants. It also requires very little thinking and time commitment as well as very little ongoing attention. For these reasons indexing has become a very popular approach to investing.
Dollar cost averaging
Dollar cost averaging is an approach to investing that seeks to avoid the potential risks of entering the market at any specific time while simultaneously taking advantage of market lows to some extent. Underlying this is the idea that timing the market is impossible and that attempting to do so generally leads to lower long run returns. The approach is simple, as it is just the constant periodic purchasing of an investment over time, typically with the same amount of funds each period. A typical example for an individual would be making an investment every month or every pay period into a pre-determined investment, with a pre-determined amount, regardless of current market conditions, news headlines, pricing points or any other factors. This has an advantage of not requiring much thought to complete and is straightforward to implement on an ongoing basis, in many cases being an automated process that can be set up with the appropriate financial institution.
The market price of an investment will be constantly changing, going up and down over time in response to various market conditions, while a dollar cost averaging approach is followed. Investing the same amount of funds each period will result in a different amount of stock being purchased (as the stock price changes over time). When prices are high, a smaller amount of the investment will be purchased with the same amount of funds, and when the prices are low, a larger amount of the investment will be purchased. This results in buying low and selling high when considering the total amount of the underlying investment that will be purchased over time. As the stock price increases, the relative average cost of the investment will decrease over time, leading to the name Dollar Cost Averaging.
Putting it all together
Keeping in mind the effects of inflation and interest rates, combining indexing and dollar cost averaging leads to a great investing strategy for many individuals. Through buying an index fund on a regular basis an individual achieves wide diversification and keeps costs low. This can typically be done using an automated approach, eliminating attention and action required to follow the strategy. This also generates returns that surpass the majority of market participants. When followed with modest funds, given enough time, this will lead to very satisfying outcomes through compounding.
Another key advantage of this approach is that it helps to manage investor psychology. Investor psychology can and does dramatically affect long run returns. With this strategy being automatable and being simple to follow consistently, the opportunities to make a mistake due to investor psychology are more limited. They can still happen when large market swings lead to fear of loss, fear of missing out by not investing more, or when markets go flat for extended periods and low gains relative to specific stocks or industries lead to a desire to change approaches. However as minimal interactions are required to follow the strategy, there is limited room for investor psychology to take over. This is particularly an advantage in comparison to most other investing strategies where clear, unemotional, thinking is key.
Average market returns over long time periods are around 10%, depending on time period selected. Through an indexing strategy, over time returns can look like those in the below table, which in many cases is quite appealing to most investors:
This strategy is not without risk and downsides. However every strategy will have risks downsides and in terms of magnitude of risks this is probably one of the least risky, with the least amount of downsides.
One of the main downsides is that by definition it will not achieve a market beating return in the long run. It will only provide the average market return. For some investors this is not appealing, but it should be noted that an average market return does surpass the return of the majority of market participants in the long run.
A hidden risk is that indexing can become overly focused on a sector leading to hidden sector risk. For example the S&P 500 index is heavily weighted to large tech companies in ways that may not be obvious. If that sector performs poorly, the indexing strategy in that case will also be negatively impacted to a more limited degree. Likewise, depending on the index, many indexes are more weighted to specific industries, which happens frequently outside of the U.S. where many economies are not as diverse and by extension the national stock markets do not carry the same diversity as the S&P 500 index. If it is difficult to obtain an index fund in a sufficiently diverse market such as the U.S., then sufficient diversification may not be achieved, in turn increasing the risk of this approach.
Additionally, the market as a whole can go flat for many years in a row, and there have been ten (and more depending on where you select the start and end) year periods in the past where no real gains were made in a market. Indexing in those periods would be challenging as it would feel like running in place (however sticking with the approach would be key as the following period is very likely to make up for the stagnate time period). In stagnate periods, an alternate strategy might be preferrable, as components of the market and not the market as a whole could be performing well.
Finally, there is a notion that indexing might be in or headed towards a bubble, where so many investors are following the strategy that it leads to a gross overvaluation of the index as a whole. Given its general appeal there are many investors who choose to follow this strategy, so this concern is worth noting. However, it is more than likely that if there is a bubble effect it is so far off that it could be multiple decades in the future, limiting the extent to which it should be considered at this time. Because indexing deals with the market a whole, very large numbers (think many trillions) are required for there to be a move this toward bubble territory. Additionally, as more investors move toward indexing, it does make other strategies, such as stock picking based on long term business expectations, more attractive as there are likely to be more opportunities in the market due to increase numbers of passive index investors. This in turn can have a significant balancing effect on indexing in the long run as if other strategies demonstrating superior returns on occasion will pull some investors away from indexing.