Why does the world want index investors?

I have no financial training or credentials. This article represents my understanding from synthesizing many sources of information, but I am likely misusing terminology, and I may be factually incorrect on some points. Apply this information at your own risk.

Don’t invest in anything you don’t understand.

This is the first rule of investing. In a world where people want your money, it’s a good way to avoid becoming mark, swindled out of your life savings. In other words, it’s important to understand:

  • What your money will be used for
  • Where the new money to pay your return-on-investment will come from
  • What the risks are

If investing for building personal wealth has a second commandment, it is to continually pump excess income into low-cost index funds that track a large chunk of the US stock market. It’s not the purpose of this piece to justify this, but mountains of research indicates that this almost absurdly simple strategy—when executed with discipline and an iron stomach—has historically outperformed pretty much every complex investment strategy implemented by active traders, especially once fees are accounted for 1.

I have found these two pieces of advice to be in conflict. This piece is my attempt to sort this out.

Where is the investment?

The word investing literally means that I take money I don’t need to day and I give it to another entity that needs it today. In return, I expect to eventually have more cash out than I put in, either because they have paid me back or given me a cut of profits. It’s pretty straightforward. The philosophical problem I’ve grappled with is that it’s not obvious how buying an index fund constitutes investment, in this most literal sense.

When you put money into an index fund, that manger of that fund buys shares in every company in the index from the secondary market for stocks—the “stock market”. By secondary market, I mean that the money you put in isn’t going to the companies in the index. It’s going to existing shareholders, who are selling shares that they might have bought from the company. But more likely, the shares have passed through dozens of hands since a person or entity actually provided capital to the company. You know: investment.

This is well and good, but the burning questions in my minds are:

  • Why should this be the gold standard of personal investing?
  • Why does the market reward people so lucratively for not actually investing directly in companies?
  • And furthermore, for not exercising any personal judgment on individual companies whatsoever?

It’s been surprisingly difficult to get a straight answer to these questions. I’ve posed them to people I know who are very sophisticated. I often get answers that are vague or too loaded down with jargon for me to understand. But it’s more than an academic question, because those questions underlie the real questions in my mind:

  • As index funds become more popular, is dumb money (like mine) indiscriminately increasing the demand for shares?
  • Is this just a giant game of hot potato?
  • Will this last until and through my retirement?

A proposed answer

As I’ve been needling and challenging folks to draw out nuance, I’ve continued to do my own reading, and combined all of this with the bits of econ I still remember from my minor. I present my two answers, which feel somewhat satisfying:

  1. Share price extremely important to the executives of every public company, and they will do damn near anything to keep it increasing. It drives their own wealth and the determines the ability of the company to raise capital in the future. So, while they don’t need your money in the form of literal investment, by being a shareholder, you are along for the ride. By being an index fund shareholder, this extends to the massive chunk of American industry on the stock market.
  2. What you are literally investing in is the cash needs of the faceless people or entities who your index fund is buying a share from. Maybe they’re retiring. Maybe they’re buying a house. Maybe there’s a hot deal they want to participate in. Maybe they’ve lost faith in the US stock market and want to hold cash. Maybe they’re starting a business. Who knows. On some level, the stock market is simply serving our economy as a giant pool to park and retrieve cash.

Presumably, the stock market is in a unique position for Answer 2 because whatever the seller is using their cash for, it probably isn’t going too far before passing through the hands of publicly traded companies, helping those companies meet their goals, and increasing demand for their shares.

I guess the brilliance of the whole scheme is that I, as an investor, don’t really need to know who needs my money or how it will eventually help the companies I’m investing in. I can trust in the dollar-based economy to work it out, and I can trust the huge number of active traders on the stock market to determine the value of companies. The lack of specificity of my “lending” of cash to the economy diffuses the risk and increases efficiency, as long as the dollar-based economy remains functional and growing.

The stock market is likely to have crises of confidence and the economy is likely to periodically break down, but historically, things have always recovered and achieved new peaks. Maybe that won’t always be true, but if the trend ends, I’ll probably find myself more concerned with short-term survival than wealth growth.

So to recap:

  • What your money will be used for — the general wants and needs of previous investors
  • Where the new money to pay your return-on-investment will come from — the increased valuations of companies, driven by the spending and further investment of
  • What the risks are — permanent breakdown or devaluation of the dollar-based economy 2

I hope this doesn’t sound too convincing, because I’m still not totally satisfied with this reasoning. But it’s a lot better than where I was before I started asking questions, and I hope I continue to get a better grip on these questions.

If you are an expert in this topic, I would love to hear more perspectives.

1 See, for example, the Buffet Bet.

2 There are also risks inherent to the instrument of an index fund, risks of the dominance of indexing strategies, and risks of the companies that offer them, for argument’s sake, I’m not getting into it.

Mission accomplished (Our financial planning voyage — Part 3)

As has happened before in this process, after making a bunch of progress, I dropped the ball for a couple months. I don’t recommend doing that. It’s tough getting the momentum back. But if you’re like me and you’re allergic to just finishing things, all you can do is pick yourself up and gin up the motivation to get things moving forward again.

Continue reading “Mission accomplished (Our financial planning voyage — Part 3)”

Property taxes, who knew?

Going into buying a home, I had to wrap my head around a lot of things. There was finding the home itself, then the whole process of negotiating the offer, the mortgage, and then all the thoughts of what you want to do when you actually move in. A big part of the financial aspect of the purchase and mortgage is projecting your monthly payments. Property taxes are a significant part of this.

The thing is, even once you pay your mortgage down, you’ll still be paying those property taxes in perpetuity. In a state with high property taxes like New Jersey, it’s a sizable percentage of what you might pay in rent some other places. I was aware of property taxes. I assumed they’d be predictable and logical. Boy was I wrong.

Disclaimer: Per usual, I have to make clear that I am (obviously) not an expert on this topic. This piece reflects my growth from zero understanding, and hopefully underscores that you should get professional advice as you make your own financial decisions. Comments and corrections are very welcome!

Continue reading “Property taxes, who knew?”

The List (Our financial planning voyage — Part 2)

I’ve made a ton of progress since the last check in. All of the work of piecing together our complete financial picture and researching the fundamentals of financial planning culminated in one long checklist of todos to actually begin to build out our plan. What follows is a version of our punchlist.

Continue reading “The List (Our financial planning voyage — Part 2)”

Financial plan update

So here’s where I tell you that I’ve already piloted our financial plan to it’s final state, but just forgot to write about it.

Just kidding.

In reality, shortly after I wrote the last post, I ran out of steam. I haven’t read my books yet, and I just this week started picking up where I left off, very much still in the exploratory part of the process. That said, I still think I’ve learned some good stuff.

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Our financial planning voyage — Part 1

Much like my mortgage shopping voyage, I’m starting from scratch-ish trying to make a financial plan, and I’m hoping to share what I learn in the process, and hopefully other folks can use this as a shortcut to the jump-off point for their own exploration. To begin with, I think my family is in pretty decent financial shape, so this voyage won’t be relatable to everyone. Probably young families blessed with good income. But if you’re in a similar boat, I hope this helps you out.

Continue reading “Our financial planning voyage — Part 1”

Notes on mortgage shopping

I was meaning to post this a while ago, but these are the notes I took when I was shopping for a mortgage and closing the purchase of our first house. It was quite a process. As a first-time borrower, I felt like I was at constant risk of these expert lenders taking advantage of my naiveté, especially given all the stories from mortgage crisis. So, I spent a lot of time reading and double-checking. I try here to lay out what I took away from the process, without biasing it toward any decisions my wife and I made pertaining to our own situation.

Disclaimer: These are the notes of one person (me) who has bought exactly one home with exactly one mortgage. I am not an expert. I have no qualifications. I’m just a dude. This might be useful as a starting point, but I highly suggest you do your own research and confirm your conclusions with advice from an expert you trust.

Continue reading “Notes on mortgage shopping”