“Just invest in a global index fund”. I have seen this advice distributed many times across many different platforms. I can certainly see the appeal. It’s simple, it’s easy, and seemingly safe. It allows you to capture the growth of emerging markets without being too exposed to their wild fluctuations. It allows you to, apparently, enjoy the benefits of economic powerhouses without being overly exposed to crashes in those countries. Alluring prospects indeed.
Now, I’m all for passive investing (1), even though it has become disgustingly popular (usually a red flag), but the recommendation of “just invest in a global index fund” is alarmingly naive and potentially dangerous. It neglects inherent issues both with relying on one thing and the problems with using global index funds (GIFs) specifically.
A faulty mirror
If you purchase a GIF you do not receive the exact returns of the markets that the index tracks. Not everyone seems to realise this. This is due to:
- Imperfect tracking. These passive funds are not the actual market. They simply purchase stocks in an attempt to mirror the returns of the markets they represent. Hence, the returns of the index fund will not be the same as the returns of the market, or in this case markets, they track.
- Systematic underperformance. One reason for this is because index funds underperform the markets they mirror. This is a result of costs associated with the inconvenience of liquidating and purchasing stocks when they exit and enter country stock markets.
- Exposure to issuing organisation. If the company doing the tracking goes bust, you will lose some of your investment (bankruptcy risk). This is a pretty unlikely scenario it seems, but it’s a possibility all the same. It makes me nervous relying on the ability of one company not to go bust. Incompetence, principle-agent problems, and risk-miscalculation are global pandemics.
When many invest in a GIF they think they are essentially investing in all the big companies in the world, evenly distributed throughout the world. How could this fail? Betting on a GIF is like betting on the future of humanity. However, in reality, this isn’t really the case. For example, if we look at the Vanguard FTSE Global All Cap Index Fund, we see that the US makes up nearly 60% of the fund. No other country has over a 10% share and only Japan has over a 5% share. In fact, only 9 countries have over a 2% share- and these countries make up over 85% of the fund.
When you invest in a GIF, you’re essentially investing in North America, Western Europe, China and Japan. Doesn’t sound very diverse to me.
The global economy is becoming increasingly interconnected. Global markets are moving more in unison, particularly in turbulent periods. GIFs can give us a false sense of diversification. We think we are protected from a crash in the Chinese markets (they only make up less than 5% of a typical GIF), but these types of events reverberate across the globe. We are not as safe as we think we are.
There are also problems with geographic diversification itself. Assuming you are going to be spending the majority of your life in one country, you need to be exposed to the fortunes of that country. More than a GIF provides, assuming you aren’t a Yank. For example, inflation in Japan could be particularly painful to a Tokyo resident if he has no protection against devaluation of the yen. You want some exposure to your native country (2).
An uncle point is the maximum amount of loss a trader is willing to incur before he exits a position. But this concept can be applied to retail investors too. Most people have some uncle point. If your GIF decreases by 50%, you still in? What about 70%? 90%? Of course, everyone says they would never sell (“Yeah bro, I would just buy more!”). In reality, you might. Most people have some uncle point.
We also know that shit happens. This was discussed extensively in, funnily enough, Shit Happens. Essentially, you never truly know when you will need to liquidate some or all of your investments because something can happen outside of your portfolio that convinces you to sell. You decide to go travelling, move to a different country, your mother becomes seriously ill and needs a costly operation, you wisely decide to make a large donation to Perpetual Prudence, etc.
Combining uncle points with shit happens leads to uncertainty around liquidation conditions. Therefore, holding only an investment with a medium or high degree of fluctuation risk is foolish.
Why GIFs for stocks specifically? I know, I know- stocks have delivered historically outstanding returns (3). There is no guarantee that this will continue. It seems arrogant to assume we know the future. We don’t know that the best performing assets over the next 100 years will be stocks. There are reasons to believe this to be the case, but we don’t know for sure.
“I don’t care about the best returns,”, one might say, “I just want decent returns without losing money”. Don’t we all. You may not lose all your money by investing in a GIF, but you face the significant possibility of losing some of it, especially if you have uncle points. So, by only investing in a GIF, you are exposed to both not making a “decent” return- by being out-performed by other assets- and losing money. Not an exciting prospect for most (aside from those who exhibit financially masochistic tendencies).
Violation of principles
Strategy is derived from principles, not the other way round. Just because something is working for some people, it doesn’t mean you should jump on the bandwagon. Just because an investment is popular, it doesn’t mean you should invest. This helps you to avoid things like losing your money in bubbles. Violation of principles gets you into trouble.
Principles come first. Strategy comes second. I take this opportunity to remind the reader of our Principles of Perpetual Prudence:
- Always think long-term
- Consider risks first
- Try and limit the downside
- Focus on the big picture
Exclusive investment in a GIF as an investment strategy violates 2 of these principles. Firstly, it’s not risk-focused. Although there is some consideration of risk (via diversification), it is not the focus. The strategy is based on the fact that stocks outperform, but we don’t exactly know which ones- so we attempt to buy them all (4). Focusing on returns first is a mistake. Secondly, and similarly, it doesn’t attempt to limit exposure to downsides. Some type of global disaster, be it economic or otherwise, will leave you exposed. A single observation from the left tail will be painful. Very painful. As discussed elsewhere, downside protection is difficult for retail investors, but it can at least be attempted. There is no such attempt in the GIF strategy.
(1) Please don’t see this as an endorsement of active management. It is not. Active shouldn’t be an option for the vast majority of investors (it’s more marketing than performance). More on this in the near future…
(2) This is as much a philosophical point as a financial one. It gives you a tiny sampling of SITG. It adds to a sense of pride/community/attachment to the country you have chosen to reside in. It makes you feel more a part of the place. More involved. A more integral part of the fabric of the country. Ok, getting a little carried away now- but you get the idea!
(3) I am again finding myself banging on about the problems associated with the usage of historical data. This is becoming somewhat of a bête noire for me. See Does The Stock Market Always Go Up? for more details.
(4) Some may argue that they are thinking about risk on geographic diversification grounds. A reasonable argument but one that I reject.