Why index investing doesn’t cut it for me

The standard personal finance mantra when in comes to stock market investment is to trickle a small sum regularly into passive index trackers. That will build up a decent lump to retire on over time. Though it seems to be a general consensus, there are critics of this philosophy, such as ERE.

There’s an awful lot to be said for index investing, and if it’s your aim to save a small amount of money every month for 30-40 years to get a decent lump sum to use as a pension, then you’ll be hard pushed to do better.

You are, of course, buying into an assumption that the country hosting most of your investments won’t experience a period of hyperinflation due to political pressures, worldwide resource shortages or peak oil. Think of how different the world looked in the 1960s and 1970s compared to now, and that was a period of relative stability for Western economies ;)

What if the investor doesn’t want a lump sum, but actually wants an income? And what if that investor is older than many in the PF community, at the peak of their earning capacity, and with lower outgoings? I can save at a far higher rate than most index investors in regular employment, but conversely I have far less time to do it. The stress of working in adverse (to me) conditions of the modern workplace will lay me low in years, not decades, so I have different requirements to the typical index investor, and some very different beliefs and expectations about the future than the conventional myth of continuous growth.

In some scenarios I could see the economy growing still, but the share of it as experienced by average workers on middle class incomes to shrink, as capital attracts money and leverages the associated power, polarising our economy more and more towards capital and away from labour. In that sort of world, you want to get an income from money working for you, rather than working for money.

Jacob from ERE boiled it down to the essentials for me. Don’t spend money until it is re-earned. I don’t want a big lump sum, so I don’t give a toss about my net worth. What I want to do is be able to live off re-earned income. Put another way, I want to be able to sit on my big fat lazy ass and be able to watch daytime TV all day. Well, I don’t actually want to watch daytime TV all day as I don’t have a flat screen TV, but I don’t want to have to earn money to be able to live. Having said that, I’m happy to earn money for wants – its earning money for the needs that means your job owns you.

That’s a big ask. If you keep your wits about you, you can realise about 5% ROI on some investment trusts and indeed some stocks these days, which have a track record of paying dividends. So if, now, you were able to live on Ramen and fresh air, get the landlord or mortgage company to stop charging you for a year, and save your entire income for a year, you’d be able to get 1/20th of it, for the rest of your life. Obviously it’s going to take a long way to get to being able to live off that. More realistically, if you could save 50% of your income you would accrue 1/40th of your income every year, so you could slowly build up the 50% you do spend in in about 20 years. ERE has an analysis of this here, and an example here. In the latter, observe that there is a world of difference between saving 80% of your income and 90%.

I haven’t managed 90% in terms of saving to financial investments, though my  savings rate does approach that in terms of total investment including non-financial ones. And no, it’s not a miserable way to live though it does require sacrifices. I have a lot of stored capital in terms of house and stuff, which reduces my outgoings, so most of my outgoings are utilities and things. Obviously I don’t have a flat-screen TV though I have a pretty good 15 year-old stereo. I’ve also got some pretty good camera kit and other hobby stuff from my more profligate and high-spending days. I favoured quality rather than quantity, and sadly I am still the primary limitation in the results I get with anything creative rather than the equipment. Improving my skill and fieldcraft is a lot cheaper that buying the latest and hoping it fixes it all for me.

Nobody said it was going to be easy.This is why people generally don’t take that route, and prefer to look at their net worth and play with compound interest calculators assuming a deferred result after 20 years to make the journey look less daunting and less lonely. I can’t afford that luxury because I need results soon, so I have to look the beast in the eye and face the bugger down, or surrender in the attempt. It’s a funny old game, this conflation of net worth with wealth – give me a decent income over winning the lottery any day.

I have some advantages over many other people – I paid off my house rather than using it to inflate my lifestyle, and I can save at the full ISA allowance rate of £10k a year, though note that only buys me an income of £500 each year :) Which is why I have to save more money in index trackers (!) as pension AVCs to stop the taxman stealing so much of my earnings, which I will spring when I retire as a lump sum, so I can continue this strategy of buying a tax-free income about £500 a year at a time.

So for all those reasons, index tracking doesn’t cut it for me. Though it took me an awful long time to get the subtle distinction, I don’t really care about my net worth. What I care about is having enough income to cover my costs. As soon as I spotted this I switched my investment approach away from an ETF based buy and hold strategy to an income seeking strategy. Stock market investments are poorly suited for selling off itsy-bitsy pieces to produce a steady income.

The reason the standard advice targets growth rather than income is because for most cases the investment horizon is long – several decades. Mine is much shorter, and the usual logic is that people with short time horizons should favour the relative safety of bonds rather than shares. However, I have other accumulated investments that performs the function bonds do in a normal portfolio.

At the moment I target a yield of 4 to 5% on purchase, which means it costs me 20 to 25 times the annual income I want to buy. So I favour investment trusts, regular dividend payers like National Grid, as opposed to someting like Ishares FTSE100 ETF ISF, which I used to own but at the moment has a yield of just over 3%. I look for investments that have a decent track record of paying steady dividends, which is where the investment trust route is attractive. The downside of this is that getting a passive income that way is a very long, hard slog. To realise an income of about £4000 which covers my static running costs of heat, power, water, council tax, insurance and transport I need a capital sum of at least £80,000 which is a reasonably big ask. Well, it’s a big ask for me, even if it isnt for you, dear reader ;)

This is the antithesis of index investing, as advocated here by the Accumulator and Retirement Investing Today for example, though I’m more than happy to acknowledge Monevator’s excellent tutorials on investment trusts and general philosophy. And a long-dated hat tip to my Dad who disdained unit trusts and favoured investment tru sts more than 20 years ago when he retired. To my eyes an investment trust is an active, not passive, investment. I screen them first starting with the ones in this list (sorry TI, I know your articles aren’t meant to be used that way, I’m happy to take responsibility for my own errors and eat the pain along with the gain). I then look at the yield and the top-held shares in the investment trust, and the charges. Are the shares ones I would buy myself if I were after high-yield?

There’s an oft-repeated saw that you can’t time the market. Neither can I, but I can see a poor offer from Mr Market. An income of 4-5% on the current price I pay, particularly if the income has held over a number of years, is something I can work with. Its presence or absence will show itself a lot quicker than any putative capital growth. I can even eat a drop in capital value – if I buy an income and the income stays about the same, then my purchase is still delivering for me even if my net worth has dropped.

If share prices rise and yields drop, then I find myself priced out of the market – what I am looking for at the moment is a jolly good stock market price crash, perhaps as a result of the PIIGS finally going bankrupt, or the Americans finally looking down like in the cartoons, and finding nothing solid holding up their currency. I expect such opportunities to crop up in the next couple of years while I am working. The early part of 2009 and summer this year were good for me, I could use some more of that.

It has taken time to finesse this and realise that my requirements are very different from most people investing for retirement. Of course I could simply run down my capital, but I still have a fair few of my three-score years and ten to go, so the 5% income return I seek gives me a better long-term sustainable deal, and the value of the underlying securities may even track government-sponsored inflation such as caused by QE, though they won’t hedge inflation due to forthcoming resource shortages.

So although index investing seems to be a great way for most people to go, it isn’t necessarily right for everybody. It favours the young and impecunious, who need the long accumulation period and the effect of compounding. That long accumulation period also amplifies the effect of fees and charges, and tax if applicable. It favours those needing a big lump sum some way into the future.

But for those looking to get out of the rat race sooner rather than later, a different approach may be more rewarding. It is a lack of ongoing income that kills you financially – indeed some older people end up asset-rich and income poor if they are in a big house but short of income. However, it isn’t  just greybeards  that chase income, though most people chase net worth.

I take the view that you need both the capital and income strands and I tend to divide my investments, psychologically, into two classes accordingly.

I like good yield stocks like GSK, BLND, RSA or, yes, NG. Like you, I am not interested in index tracking and for the same reasons, but I tend to avoid ITs too since I feel I can do it myself, although I’m not ruling them out completely as they can give exposure to many smaller companies that might otherwise be too risky for the small investor.

However, I look for capital growth too in a few shares since there is the little matter of the otherwise unused CGT allowance. This strategy, of course, assumes that you have the time and inclination to follow prices regularly.

Finally, yes, bring on the great crash of 2011.

11 Dec 2010, 10:56am
by lostinmidlands


To tell the truth, I don’t think that you have properly addressed or answered the question in the title of this post. And neither does the ERE Jacob in his occasional posts about his investing practice. I acknowledge Jacob’s arguments that DIY investing in individual stocks allows him to save on costs, but his distinction between income (good) and capital growth (bad) is a red herring. It’s the total return that matters, and the rest can be easily handled with a little portfolio management (see below). If Jacob likes analysing individual stocks and has confidence that he knows what he’s doing (I don’t doubt that he does, even if his investment remarks on the blog are far less convincing and rigorous than the rest of his overall ERE philosophy), it’s good for him. But your reliance on investment trusts is unfortunately exposing you to paying higher fees (TER >1%?) that will over time transfer a non-trivial part of your wealth to your investment managers (20-40% over a lifetime of a portfolio?).

How about the following simple plan. While, admittedly, such plans are not always (psychologically) easy to follow, this one minimizes reliance on judgement (i.e., emotions!) and has a lot of built-in automation, which makes it easier to stick to it and to avoid being lured by the latest fashion.

1. Keep a properly diversified low-cost portfolio. Decide what your preferred asset class allocation is and write it down. The exact percentages are not so important, but make a decision once and deviate from it very reluctantly in the future. Monevator has a number of very sensible proposals on both asset class allocation and specific implementation using UK index funds, ETFs, and ITs (if no index funds are available for an asset class). Then stick to your asset class allocation by rebalancing regularly, but not necessarily more often than once or twice a year. Check your notes on what asset allocation you have committed yourself to in order not to be tempted to tinker with it and let emotions wreck your rigorous process. Keep it simple, limit yourself to at most 8-10 asset classes/funds, because there is good evidence that more than that will harm your investment process and results more than benefit it. And keep in mind that the discipline of rebalancing is a free lunch. Over a lifetime of a portfolio (say, 30 years) it will give you 10-40% cumulative overperformance, not bad at all.

2. If your portfolio is in the accumulation phase (i.e., your wage income exceeds your expenses), then use your current savings (both from wage and investment income) to rebalance the portfolio by buying asset classes that have recently underperformed.

3. If you are in the distribution phase of the portfolio (i.e., your expenses exceed your wage income), then you need to be slightly more nuanced. Add a sizeable cash (or near-cash) buffer to your portfolio that should be worth between 1 and 3 years of your expenses. Rebalance your portfolio once a year. First, replenish the cash buffer from the accrued investment income. If the cash buffer overflows (>3 years of expenses) then rebalance the rest of your portfolio by reinvesting the excess cash in the asset classes that have recently underperformed. If the cash buffer is too small (<1 year of expenses) then rebalance the portfolio by selling an appropriate amount of the asset classes that have recently overperformed.

Just make sure that you don't draw from your portfolio too aggressively in the distribution phase. A good rule of thumb is to keep the withdrawal rate below 4%, even better to stay on the safe side and keep it below 3%, and if you need considerably more than that, buy an annuity! The Oblivious Investor is arguing very clearly and convincingly why annuities are a worthwhile option to consider if your "lump sum" is not big enough for comfort.

And at the same time, diversify further. Buy a farm. But you're already doing that ;)

[...] Why index investing doesn’t cut it for me – Simple Living in Suffolk [...]

Yes spot on this post really hit home with me. Income is so important when you retire early. I tried the index tracker investing and it was crap for me, totally the wrong investment vehicle for my needs. At the time I was very green (although I’m still not too clever now) and I pulled money out of an ISA for gods sake on the advice of an in house FI with a large high street bank and put it in an index tracker! It didnt end well.

Anyway long story but everything is in bonds now which pay me a modest income that I can actually live off. I do need to get my appetite back for a bit of risk though and income producing dividends seem attractive, although dealing with the stock market really stresses me out:)

But index investing like you say is for people with a long term investment horizon before retirement. Short term it strikes me that with index investing you are along for the ride, the ups and the downs, what if you need your money on a down, this is something that people tend to overlook IMHO.

[...] Index Investing Posted on December 11, 2010 by daibo Here‘s a good post from Simple Living in Suffolk about why Index Investing may not be a great [...]

Hi ermine

If you’re chasing yield then the HYP boards over at http://www.fool.co.uk could be of interest to you.

As you mention this strategy is very different to what I have implemented which in its current guise has (I believe) a good chance of returning 4.2% over inflation in the long run.

Cheers
RIT

Index investing means owning the crap stocks along with the good stocks or buying/selling stocks at the wrong time.

– Why would you continue to own BP when the dividend is being cut?
– Why would you want to buy MMM while it’s yield is <3%?
– Why would you want to sell when the market is at its lowest? Yet that's what happens to an index fund when the investors suffer a liquidity crisis and redeem their index fund shares at the low point.

Thanks all for lots of thought-provoking insights here – sufficient that I’ll have to take some time out to ponder. One think that I clearly failed to give background is I’m a little bit atypical in that:

I don’t have to worry too much about a 40 year investment period. I will be getting towards the end of my life if I’m lucky there, though my grandmothers would have had nearly another decade in them at the corresponding age so maybe I do have to worry a bit longer temr :)

My shares portfolio value is small, because my main pension vehicle is a DB pension, and of my residual investment capital half is outside the financial system as I don’t trust it. Hence the modest £4k income I can expect from this depleted residual amount.

I’m a rotten individual stock picker, I proved it in the 2000s, I proved it again around 2005, though I have done okay with very small stakes post 2008. Hence I’m prepared to eat the IT management costs, instead of the dealing fees on smallish (sub-5k) stakes in companies and the appalling incompetence fees of hiring myself as stock picker ;)

@lostinmidlands, can’t fault the strategy if I had 30 years, but I need to secure an income over the next two years, to bridge the gap to drawing my pension in about 5 years. I could simply run down the cash capital to zero for about three years, in which case I have enough now. I’m trying to shoot for a permanent increase in my income to add to other sources, and the increase I’m looking for would cover my basic costs, which I’ve driven down hard. So I’m looking to have my cake and eat it, though I have to save about 20 times the incremental annual income I want. So I have a accumulation phase of about two years (plus two in the past), and ideally a distribution phase of 40 years. That doesn’t favour a accumulation/distribution model. Unless account is taken of the fact that over the last 30 years I suppose I’ve been accumulating house equity, toys, tools and stuff, some of which drastically reduces my running costs.

[...] at RIT’s carefully honed asset allocation, and pondering some of the comments on my post on why passive investing isn’t for me, I figured I might as well consider my own [...]

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