Why Not Put Your Money Into Index Funds?

Interesting question came my way from reader Scott:

….But Tim, wouldn’t most investors be better off simply owning index funds instead of trying to pick successful companies themselves?

Scott, I like that question because it cuts to the premise of the site—I write articles for everyday investors, and it is fair to wonder whether it’s all a waste of time and whether low-cost index funds should be pursued.

First of all, I’d like to start by observing the great overlap that exists between the two strategies. If you look at an S&P 500 Index Fund, what are going to be some of the large holdings? ExxonMobil, General Electric, Procter & Gamble, and Johnson & Johnson.

What are the stocks I talk about buying individually? ExxonMobil, General Electric, Procter & Gamble, and Johnson & Johnson. There is a huge overlap between the companies I mention approvingly here, and the companies that pay a critical role in an index such as the S&P 500. That part of the argument is pedantic—okay, I might think that a portfolio should have 3-4% General Electric in it, whereas an investor in an index fund that tracks the S&P 500 Index will end up having $2 out of every $100 invested going into General Electric. That hardly calls for the neener-neener “This strategy is better than that strategy” when we are in agreement on the ingredients but in disagreement on the dosage.

Really, the problem I am trying to solve is this: History has shown that holding a basket of stocks for the long term is the greatest way to get rich in a passive way. If you don’t believe me, google the detailed and well-documented Ibottson & Associates studies that point out how holding stocks absolutely trounce the results you could get from holding bonds, gold, or real estate over the long term.

But it is a strategy that does come with significant strings attached if you are not prepared. Every generation, you will statistically face a drop in the 40-60% range. Every three or four years, you will be looking at a price drop in the 15-25% range. Really, the problem I am trying to help you solve is this: We can see this vehicle (stocks) that deliver returns in the range of 10% annually over long periods of time, but we have to deal with periodic drops of 25-60% or so over the course of a lifetime, and what is the best way to avoid being one of those guys that sets aside $100,000 to invest and then ends up selling a few years later at $65,000?

My answer is this: Understand that the business that exists is something altogether separate from the stock price. If you could gather 100 intelligent people in the financial industry together, and you asked them the question, “Will Coca-Cola, Colgate-Palmolive, Nestle, Johnson & Johnson, and Procter & Gamble still be profitable ten years from now?”—they would all answer that question with an emphatic yes. That’s what I’m trying to get you to do here—focus emphatically on the businesses that will still be profitable over the long-term, and then don’t overpay for the stock (although, if I had to choose, I’d rather overpay for an excellent company that get a “great deal” on a company that could be flirting with bankruptcy five years down the road).

That’s why I often talk about starting a portfolio with beverage and food stocks. Companies like Kraft, Pepsi, Coca-Cola, General Mills, and Dr. Pepper operate with very understandable business models. You can see the dividends marching upward over the decades, sometimes exceptionally so. When the price of the stock of one of those businesses fall by 30% or whatever, it’s easy to walk into Wal-Mart and take a look at the soda aisle. You can see all those different products—Coca-Cola, Diet Coke, Fanta, Sprite, Dasani, VitaminWater, Powerade—that all go towards Coca-Cola’s coffers. The tangibility of that experience, plus the cash you receive, makes it easier to hold than something like an index fund, which for someone like me is more of an abstraction.

The other reason, which I was just touching upon, is this—cash flow. There’s a reason why people tell their kids things like, “Whatever you do, don’t sell that Altria or Philip Morris stock. There’s a reason why companies like AT&T and Conoco Philips are the last stocks to go during lean times.” What does lean times necessarily indicate? Lack of cash. People tend to sell stocks when they have (hopefully temporary) cash flow problems. If Google falls 40%, it’s understandable why someone might get bothered and let the stock go. But if you got 800 shares of Conoco Phillips sending you $584 every ninety days, you’re going to be hesitant to let something sending you $2,300+ per year escape from your life.

From 1928 until 2003, guess which stock that existed over the full course of that time frame had the lowest turnover? It was the old Philip Morris, which now exists in the form of Altria, Philip Morris International, Kraft, and Mondelez. People are reluctant to part with an asset that keeps dispensing cash quarter after quarter, year after year. I usually write about income investing from the point of view that it makes reaching your goals easier to pursue because you don’t have to relinquish owner in order to have money come your way to do something, but there’s a flip side of the coin as well: you are deterred from ever wanting to sell.

Do you think people that own Altria, Reynolds, GlaxoSmithKline, AT&T, Conoco, Royal Dutch Shell, or Total SA rapidly trade in and out of the stock because it goes up 10%, down 15%, or whatever? No, because it’s a lot easier to think like a business owner when you are regularly receiving cash profits that the business makes. It makes the whole experience more tangible. Suddenly, everything becomes real. Index funds have a hard time of doing that.