How I learned to hate stock indices
Also published on Al-Ahram Weekly & Arab Finance
The first stock trade I made was buying Nike shares online in the late 1990s. Back then, I was still new to investing and was not aware of all the available options. To me, stock indices were simply indicators of market performance on any given day. Little did I know about index funds, which are mutual funds or exchange-traded funds (ETFs) designed to mirror the performance of a market index such as the S&P 500 in the US.
Investing in index funds or ETFs involves adopting a passive investment strategy, in which investors bet on the overall market performance rather than the performance of individual stocks. This is in contrast to an active approach to investing where investors bet on a selected group of stocks believing that they will outperform the market index.
One way to implement this active approach is through value investing, which is predicated on buying undervalued stocks based on fundamental analysis. Value investing centers around being right when the majority is wrong, necessitating a contrarian perspective. Consequently, relying solely on stocks within a particular market index is not always the most effective approach.
Initially, stock indices were not meant to select the best investment opportunities in the market. Active investing was considered the more promising way to make money by outperforming those very stock indices. However, it was found that the majority of professional fund managers failed to beat stock indices consistently, if at all. This lent itself to making index investing the preferred option.
However, I beg to differ from this view. While index investing may save investors the trouble of selecting individual stocks that they believe are undervalued and will outperform the market index, it is worth questioning whether the chosen market index is truly the best available option. Each index has its own methodology, often focusing on trading liquidity and market capitalization rather than intrinsic value. Consequently, while professional fund managers may struggle to outperform their benchmarks, it is possible that the benchmarks themselves are inadequate.
Ultimately, investors want to make money. However, if their primary goal is to beat stock indices, they are likely to end up losing it. Stock indices experience both positive and negative years. Even if investors manage to lose less than a stock index in a particular year, it still constitutes a loss. Thus, adopting an absolute-return approach could potentially lead to outperforming stock indices significantly.
Had I held on to my Nike shares for the past 24 years, I would have generated a cumulative total return in excess of 2,700%, dwarfing the S&P 500’s 265%. That’s more than 10 times the market index performance. On a compounded basis, this is an annual total return of 14.5% vs. the S&P 500’s 5.5%.
And this is how I learned to hate stock indices.
This article was also published on ArabFinance.com. Another version was published in Al-Ahram Weekly online and its print edition on Thursday, 22 June 2023. Please click here for the Arabic translation.
Al-Ahram Weekly dated Thursday, 24 August 2023 (Page 4)