Passive investing done right: 17.1% annualised returns for 45 years.

Would you like to:

  • Beat the market handsomely and get 17.1% annualised returns?
  • Using broad diversification across 5000 underlying stocks?
  • PASSIVELY: just set it and forget it?

Then read on.

And no: I'm not selling you something. Well, maybe an idea. 

Let me show you this graph:

Blue pill or orange pill?

The blue line is what we normally consider 'The Market' - it is the index of the Wilshire 5000, which covers almost every stock in the US from megacap to microcap. It returned 10.5% in annualised returns in the period 1970 to 2016 which means that $1 invested would turn into $99 - an almost hundredfold increase in wealth. Not bad at all. 

That's a 1970 cup of coffee turning into a 2016 steak dinner - drinks included!

But what about the ORANGE LINE! That's obviously what we want right?

Well, it's actually the exact same 5000 stocks - the Willshire 5000 Equally Weighted Index. Let's take that again: the orange line holds exactly the same assets as the blue line. Same megacaps. Same microcaps. Yet it returned 17.1% annualised in the same period turning $1 into a whopping $1.458.

That's a 1970 cup of coffee turning itself into a 2016 weekend trip at a nice hotel with you and your wife - two steak dinners included.

An explanation is in order:

How do the two indexes differ from each other? Simple: The difference is in how they are weighted. The 'normal' Wilshire 5000 index is market cap weighted just as all other major indexes like the Dow Jones Industrial Average and the S&P 500 (returning 10.3% in the same period btw.). 

Market cap indexes are proportional to the companies or assets that they track, which basically means that largest company will take up more of the index than the second largest which will take up more than the third largest and so on all the way down to the last stock in the index. 

The three largest stocks in teh S&P500 make up more than 10% of index for example:

S&P500 concentration

So while you are technically diversified across 500 companies in the S&P500, you are fairly highly CONCENTRATED on a few of those.

This is really smart if the primary goal of an index is to track how well the stock market is doing - which, naturally, should give more weight to the stocks of bigger companies and less weight to smaller ones. If you are an economist and want to figure out how much money investors as a whole have made on stocks: Market Cap weighted indexes are where you go. 

But it's a stupid way to invest

If you are an investor, however, this is classic herd following: the more something rises, the more you own of it. And the more something falls, the less you own. 

In an equally weighted index (orange line above) you simply buy an equal dollar amount of each stock: Apple takes up 0.02% or 1/5000 of the Willshire 5000 index - just as Nathans Famous Hotdogs (real company - check it out).

So why the big difference in returns? It's a basic value vs. price difference: the market cap weighted index actually PREFER expensive companies - because they are worth more and hence make up more of the index. It also SHUNS cheap companies for the same reason.

Market Cap weighted indexes are, in other words, biased towards size. Which is fine if you use them as a benchmark for overall wealth generation - but palm-to-face stupid if you use them as an overall VEHICLE for wealth generation.

 

WHERE DO I BUY!??

.. I hear you scream. Wait up. You've JUST read this on the internet. Breathe. It's not going anywhere. Let's hear some 'against' arguments:

The biggest is that an equal weighted index is easy to model but hard to replicate in real life: it has to be rebalanced constantly as some stocks rise (you sell those) and others fall (you buy more of those) which costs comission and increases tracking error. Market Cap weighted indexes are more buy-and-hold and only have to be rebalanced when companies enter or exit the index or stocks are retired or issued.

The second against argument is that equal cap weighted indexes are more volatile. They fall farther and rise faster. In the long run this means that you make more money, also relative to the volatility, but it can be problematic if you go all-in just before a major crash. 

Guggenheim has a lot of Equal weighted ETFs here tracking industries (don't do it) and the S&P500 (maybe for you). They don't have the same return as the Wilshire 5000 data, but do check how they drop compared to the market cap weighted indexes and see how you'd feel about that.

It has returned almost +2% compared to the market cap weighted S&P500 after expenses over a 14 year holding period..

Let me know your thoughts or questions in the comments.

Happy weekend!

/Ulrik

 

 

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