ETFs Compensate for Lack of Knowledge

I have never believed in using ETFs. But when many authors, whose viewpoint and experience I respect, including Warren Buffet, recommend that the average investor would be well-served by using ETFs, there must be a good reason. Since the “debate” hasn’t, and probably won’t be, resolved either for or against passive investing, it makes sense to view each side for its merit.

The case for passive investing can be summed up as follows: it compensates for lack of knowledge. There are other steps that are more important than the investment decision. If you’re not saving any money or making any progress on reducing debt, making great investment decisions won’t make up for those failings. However, making bad investments, where your capital is lost, will cause a permanent setback, whether your plan was on track or not. One way to avoid making bad investments (think: too risky) is to buy a passive investment. Later, after you have developed good habits of saving and reducing debt, you will be able to develop skills in choosing wise investments.

There are a number of reasons that I do not believe in passive investing. The first is that passive investments are almost always based on a market-cap weighted index. A market-cap wieghted index was original intended to represent the aggregrate experience of investors, as a reporting mechanism. It was not intended to perform as an investment and makes no sense from that perspective. It has been shown that an equal-weighted average generally outperforms the index, probably because small-caps tend to perform better over time (with higher risk).

Further, index investing does not decrease the volatility of stock market-based investments. People who have experience owning term deposits will probably be surprised at the fluctuations in the value of the market. For example, the S&P 500 return was negative between 1999 and 2009. People who are comparing their ETF return to the guaranteed interest of a term deposit would hardly be comforted by the idea that their return is the same as that of millions of others (the average).

Finally, an investor may have reasons for investing other than purely for profit. Profit is, of course, the first motive, without which no one would invest. But you may also invest in order to own a portion of companies that you believe in. If are loyal to a bank, a gas station, a grocery store or buy a certain brand of household product, you may want to own a portion of the company and profit from something you believe in. At the same time, it may be easier for you to understand the financial situation (and management’s commentary) of a company that you are familiar with.

A side-benefit of choosing the companies that you invest in, is that you can develop a better understanding of their profitability and outlook. If the market value crashes, you will be more likely to know whether the fall is justified or irrational selling and in a position to make a better informed (usually more profitable) decision. Having an emotional attachment will likely make you slower to sell, which makes it more difficult to sell losers, but easier to ride out the inevitable market crashes.

Buying an ETF is like investing with training wheels. While it’s low-cost and efficient enough for beginners, it’s not fool-proof. As you increase in experience and get the rest of your financial plan in place, you will probably benefit from taking more of an active role in selecting the companies that you choose to own. You will benefit from aligning the types of investments you own (bonds, preferred shares, common shares, trusts) with your goals (growth, income, speculation).