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A Bet On Humanity: Why Index Investing Works (In Simple Terms)

Reading Time: 13 minutes

No matter if you’ve only just started investing or have been in this game for a long time, we’re all investing in the hopes of growing our wealth – to more money back than what we put into it. However, if you’re like me, there will be times when you ask yourself “How does this all work?” and “Why do share prices go up and down?” and, especially in our FIRE community, “Why do prominent people in the community advocate Index investing? Why does the stock market go up over time?”

These are great questions, they are also questions I ask myself when I was starting to get my feet wet.

When I first started investing, it all just seems random and super risky. This lack of understanding caused me to be uncertain, fearful and it ultimately delayed my start on building my wealth.

Now that I have gained more knowledge and experience, I want to detail out what I am beginning to understand intuitively in the hopes that it can also help you gain the confidence that you need to continue on this path.

This will also help me solidify my own understanding – the best way to learn something is to explain it, right?

So let’s get into it, I’ll start from the very basic concepts and then reason it up logically and walk you through to the more complex topics. In the end, you should have much better clarity on how and why Index investing works.

Ready? Here we go!

Buying shares of a company allow us to own a piece of a living, breathing business

You own a part of this (All image credits go to Giphy)

Sometimes people forget this. A share of a company isn’t just a piece of paper. It represents your ownership of a company and all the value that comes with it.

Companies own assets, employ people, and produce products and services to sell to customers. Businesses generate real, tangible value in the marketplace – whether it be local or international.

With a share of a company, you are a part-owner of all this. There is intrinsic value in the shares that represent all of the company’s current and future assets and income that the business will generate.

This is what gives shares their value. Yes, some companies pay dividends to its shareholders, which is valuable, but that’s not the only reason why they are valuable.

As the business grows and performs well (barring any share dilution), the shares should be worth more as the underlying value (assets and income) increases.

Companies compete with other companies in the market and better companies become more valuable

Companies don’t operate in a vacuum. They compete against other companies that are also out there trying to make money producing similar products and services.

So whichever company we choose to invest in must fight for survival against companies that other people invested in.

Customers of these companies vote with their wallet to determine which product or services better fits their needs.

Companies that are able to understand customer needs and cater to them while managing their costs well will create better products and services and prosper. They will capture a larger share of the market, make more revenue, have more opportunities. Companies that cannot will lose out and slowly stagnate and die.

This brings us to the next point.

In order to compete well, companies must invest in great people

Companies can’t produce great products and services without employing the best and brightest people to work for them.

People create new ideas, new products, come up with new ways to do things more efficiently. In order for businesses to survive, they must continue to invest in human capital. That’s why the biggest companies today boast about hiring only the best of the best.

Model employees

In turn, as shareholders of these companies, you have these amazing people working for you – all working hard to ensure that their company is the best at what it does. Most of these people are way smarter and work way harder than I do – as they are working hard (in aggregate) to make the company – and thus us shareholders – richer.

I mean, who wouldn’t want people like Elon Musk or Tim Cook working to make us richer?

Great companies prosper and bad companies die out

However, given the fierce competition, some companies will win and some companies will lose.

If a company cannot compete in the market. Either their competitors produce better products or customers no longer want what they produce. They will slowly die and fade away. Their value can go to zero – despite having smart people working for them.

On the other hand, companies that are able to understand the market and able to provide products and services that meets their customers’ needs will likely prosper and do well – giving them a leg up in continuing to invest in future products and services. This should increase the value of the business and the value of their shares.

This should mean that we should be golden if we just pick the best companies and ride off into the sunset as they generate more and more value, growing more and more quickly and make their investors filthy rich right?

Well, not so much.

Great companies aren’t guaranteed to remain great forever

History is filled with stories of once-great companies that fell from their dominant position and even some that went bankrupt – losing all of their value and shut down. Why?

There are several ways that great companies can fail. Here are some examples:

  1. Competition: Other companies who produce your product or service better, cheaper or more efficiently than you do. Think BlackBerry, Nokia and Microsoft. These guys were dominant in the smartphone market before Apple and Google came along with iOS and Android. They simply could not imagine better phones their their own products until another company stuck one in their face. Even then they were slow to realise that their days were numbered.
  2. Market Shifts: Changes in the costs of components, raw materials or supporting commodities which affects the overall costs of ownership or cost of operating of a company’s products and services could shift the entire market in favor of your competitor’s products. Think American car manufacturers like Ford and GM. When the oil prices rose, American consumers shifted to buying a more fuel efficient and cheaper cars from Japan and thus significantly reduced the American car manufacturer’s market dominance. They’ve yet to recover from this.
  3. Disruptive innovation: New products and services that appear which makes their current offerings irrelevant. Think Kodak and Fuji – once great companies that produces film and film technologies for cameras – with the advent of digital cameras, their products were no longer needed.

Given all the above possibilities, you can see why it’s more likely than not that great companies of today will NOT be great companies of tomorrow. There are so many pitfalls and competitive pressure that, often, people running great companies get blind-sided by changes in the marketplace that could end their dominant status.

It’s going to be very difficult to predict which companies will do well and which will do badly in the future and shift your investment strategy in time to take advantage of it. Most experts in the field would not have predicted the downfall of all the companies mentioned above at the time.

Well, if we can’t predict the ones that will do well, all we have to do is avoid the obvious duds right? If we just buy companies that are not bad, then we should be golden? There’s a problem with that too.

Bad companies don’t always remain bad and could become a massive turn around story

Given all the things that could happen to kill off a company, at any given time, companies going through a bad phase could look like a horrible investment. However, this does not mean that the company would not be able to take drastic measures that end up turning it around.

Take a company like Apple. Before the iPod, iPhone and iPad the company was struggling. Most pundits at the time Steve Jobs made his return to the company was predicting that the company would never create great products again and go bankrupt within a year or two. However, they were all wrong and today Apple is one of the most valuable companies in the world. If you had believed the pundits, you’d have missed out on the astronomical growth that the company has made in the last 2 decades.

Similarly, Amazon is a trillion dollar company today, but experts predicted that the company will never make a profit and will go the way of Pets.com when the dotcom bubble burst in 2001.

However, predicting which horrible company will be the next unicorn is fraught with danger.

It’s not possible to predict which company will make the kinds of astronomical returns

We also have to remember that for every Apple, Amazon, Google and Facebook there are hundreds and thousands of MySpace, Excite.com, Webvan, Pets.com, Theranos, the list goes on.

Are Beyond Meat and Incredible Burger worth their valuations or will they dominate the meatless meat market?

Is WeWork going to turn around their current IPO troubles and make it huge or will they be killed by Regus and other incumbent office space sharing companies?

Will Uber and Lyft finally find a way to profitability and take over traditional taxis or will Google’s driverless car kill off the need for their services all-together?

Is Tesla going to achieve their goals of getting everybody to buy their electric cars or will other car makers be able to also produce attractive electric cars that can outcompete theirs. It’s also possible that oil prices drop low enough such that it’s cheaper to buy traditional gas vehicles. Only time will tell.

Unfortunately we’re not Dr. Strange

Any pundits that claim to know are either delusional or are lying through their teeth. They are at best an educated guess and at worst a gamble.

Remember, it’s a competitive market. If a company slips up, the competition is there to exploit it. This brings us to the next point.

Picking individual companies is a fool’s errand

It’s not possible to know, long term, which companies will be successful and which will fail. Regulations change, companies must adapt, competitors enter the market, new technologies could threaten to make the company obsolete. Companies either adapt, improve or die.

Given all the above, in order to be successful in investing in individual companies we would need to do a lot of things right:

  1. Buy a good company at the right time, at the time when it’s struggling but is about to take off.
  2. Sell the company at the right time, when the company is doing well but is about to screw up.

You’d have to be right both times and be pretty lucky to be able to make the timing just right. Often, when the price drops you’ll never know if it will ever come back up again. Or if the company is doing well, that something won’t cause the price to drop before you have the chance to sell it.

Like picking a number on the roulette table

If you made a mistake, that could wipe out all of your returns or worse. So what can we do?

Just buy them all – own all the companies!

Wait what?

OK listen. Remember that roulette table?

What if I told you that there’s a roulette table that has a 1 in 37 odds of winning if you bet on a single number but would pay out 5% of your bets each time that you bet on the entire table? You’d choose the sure 5% return right?

Well the stock market is sort of like this weird roulette table. Let me explain.

The market is self-cleansing

Bad companies can only lose a maximum of 100% of their value – they go to 0 and go bankrupt and gets removed from the market.

However, when companies do well, there is no limit in how much upside there is. They could grow 100%, 500%, 1,000% or, like Apple, Amazon and Google, more than 10,000%.

As bad companies go bankrupt and gets removed from the market, new companies enter and great companies grow to multiple times their value. This creates an upward bias to the market over the long term.

“But hang on!” you might say, “If I own all the companies and they are all competing in the market, isn’t that a zero-sum game? Won’t that mean there will be a net 0 in gain overall?”

Great question! There’s a reason why our global markets is NOT a zero-sum game: “Productivity Growth.”

The driver of wealth creation: “Productivity Growth”

Imagine if we own 2 companies. First, a company that produces screws and sell the screws to the second company. The second company uses the screws to build machines that can produce screws and sells that machine to the first company. In this scenario, it seems like overall, our wealth won’t increase as the net gain is 0.

Now imagine that the company that produces the machine to manufacture screw invented a new way to build the machine that requires less time to build and less labour. This means that the machine can be produced at half the cost. The company can now make double the profits.

What if the machine is also more efficient in producing screws so the screw manufacturing company can produce screws twice as fast with the same effort or materials?

Now you can see that our total value produced by the 2 companies has increased without any change in the number of participants. This is Productivity Growth.

This is how innovation and technological progress inject value into the system.

Hundreds of years ago, most humans around the world must spend their time growing and producing food in order to have enough food to eat. However, as we made innovation around agriculture, we got more productive.

Today only a small fraction of the world’s population needs to work in order to produce enough food to feed the entire world. Machinery and automation allows humans to get more done for less labour.

Imagine doing that by hand

This makes food cheaper, more accessible and frees up time for the population to work on and create other products and services.

The total value of the system increases in this manner in all industries over time. As time progresses, we as a species and as a market becomes more efficient – creating more value with the same effort – which leads to the total value of the whole system to increase.

Companies which created the innovations captures much of the gain

This brings us back to which companies succeed. Often companies which were able to innovate and find newer, more efficient, more effective ways to provide products and services get to capture the majority of the value of that innovation and is often able to take that lead to snowball and become dominant in the market – that is, until the next innovation comes around.

Again, it’s not possible to know which company will create the innovation and that the innovation will actually make a difference. The only way to optimally capture all of the countless attempts of innovation and creation of Productivity Growth in the market, is to own as many and all of the companies available.

What if we buy just the S&P 500 or only American companies? Surely that’s enough?

Sure, that’s definitely not a horrible choice. America, after World War II, has gone through a phrase of unrivaled growth and has become the biggest economy in the world. Their companies have built up a mountain of innovation, patents, brands and trademarks that gives them an edge over their competition – an edge that is likely to continue far into the future.

Given that a large number of these companies are also multinational – has business operations in other countries – is there still a need to buy shares of non-American companies?

Well, I think so. Yes, America may be the dominant economy and American companies may be the dominant players now, but they are not guaranteed to remain dominant forever. Who’s to say that America will not run into the same economic stagnation similar to Japan? Who’s to say that China won’t overtake America in innovation and technology?

Remember, it’s not possible to predict the future nor where the next massive growth opportunity will arise, so our investment strategy should take this into account. It makes sense to allocate our investments based on the likelihood of growth, likelihood of innovation, likelihood of value creation.

This is why my portfolio does not only hold American companies but also companies from the developed countries as well as developing countries.

Still, despite diversification and holding as many companies as we can to capture the value-creation and the means of production, it does not mean that our investments will always go up.

There will still be bubbles, crashes and recessions!

Don’t say I didn’t warn you

This is another important item to understand.

Even though we own every stock in the market to capture the productivity growth, it’s not going to always be roses and rainbows. There will always be price fluctuations – massive bubbles when prices are sky-high and major crashes – in the short term. Why?

Because – counter to what economists would like us to believe – the market is inefficient.

Prices of shares in the stock market is determined by the people buying and selling those shares within the market. This means it is still possible that over-optimism, market euphoria and hype can increase share prices beyond the true value of the underlying company.

In good times, wealth flows freely and people are optimistic about the future – people end up paying more for shares thinking that the only way to go is up. However, eventually people will wake up when prices reach a point in which it’s no longer justifiable and people get afraid that nobody will buy the shares from them at the existing price. When fear sets in, people start selling shares for lower in order to off-load them before prices tank, causing the prices to start dropping. Once this happens, it could snowball and prices dive much further than they should.

However, eventually prices will revert back to at least the book value of the business. Over the short term, the stock market will oscillate between boom and bust cycles but over longer time frames, the market will reflect the growth in productivity of the human race or – in the case of country-specific or market-specific indexes – the growth in productivity of the country or market that the index represents.

So how optimistic are you about humanity and innovation?

So should we invest in index funds? Well, after reading my explanations above, I hope that it’s clearer why the question can be rephrased as “Do you believe that us as a human race will continue to make technological progress in the long term?”

For me, this is really easy, the answer is an undeniable “YES” and that investing in public companies is a way to capture the value of that progress.

If that was not true – if the world is going to end and devolve into hunter-gatherer society or a world war will wipe us all out – then investing would be the last thing to worry about anyway.

Conclusion

I hope the above made sense to you! Obviously this is a massive oversimplification of the complexity of the stock market and economics, but I hope it helps give you a better understanding of why Index Investing makes sense – at least in my head.

If you want to learn more about economics and how the economy works, I found this video from Ray Dalio on just that topic really great so you should definitely check it out (if you have 30 minutes):

I’d love to continue discussion and elaborate on any of the points mentioned above so do leave your questions and comments below or drop me an email or tweet at me @firepathlion.

If you’re new to investing, I’d like to know whether this helped you get your head around the concept a little bit better and how I could improve this post.

Until next time!

FPL

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