August 23, 2018

ETF Index Error 3: Index-Funds have good stocks

Once more, we let our kids compete in the 100-meter race and measure their times. The Big Kid Index is the average of the 10 tallest children. Our goal is to beat it with our own selection.

The Big Kid Index was formed with the assumption that taller children run faster. Stock index funds use the same approach for securities: They select the biggest of them, under the assumption that they bring good returns – and that they are representative for all stocks (in our example: representative for the running potential of all tall children).

However, selecting children based on their height is not the optimal approach. There are probably better criteria for making the best selection: for instance the body mass index or the children’s eating and sleeping habits. The determination of such criteria is called research. If you do research, you soon discover that selecting the most expensive stocks is not necessarily ideal for the best returns. Choosing stocks by profit or turnover brings better long-term returns on equities than the market capitalization weighting that prevails at ETFs.

When buying ETF, you‘re usually buying the most expensive stocks in the market. Not really a good selection of stocks.

So what it comes down to is not beating the index, but rather understanding it: Does the index even make sense for you as an investor? The fact that it usually contains the most expensive stocks in the market isn’t really an argument for the index, and there are other drawbacks too. But more on that here next week.

ETF Index Error 1 ¦ ETF Index Error 2

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