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In the footsteps of index investors (part 2)

In this article, we will continue speaking about the new generation of index investors. First let's look into the concept of investment portfolio. It is impossible to imagine a successful financier without it, so that is why we will touch upon the issue of asset allocation in a portfolio when discussing the philosophy of index investing below.

Most investors are familiar with the idea that any investment portfolio contains 50% of securities that are overpriced. Conversely, the other half, as you may have guessed, is undervalued. However, even though they do realize this fact, it is hard for them to determine which half is which. At the same time, this new generation of investors tends to view themselves as clever strategists able to foresee unexpected developments and predict the unpredictable.

In the end, everything has its consequences, and so does self-praise. Many of those investors, encouraged by past achievements, wholeheartedly believe in their future success in the stock market. In fact, the more they believe, the bigger the disappointment when success just does not come at the first, second, third … try. The profit-generating methods that used to work really well in the past may not be as effective in the future.

In The Little Book of Common Sense Investing, John Bogle illustrates this idea with a real-life example. Following the financial bubble that burst on the stock market 16 years ago, value stocks outpaced growth stocks from 2000 to 2005. As a result, even though investors gained a short-term edge, they still lost in the long run. All yields in the portfolio that was based on successful performance in the past grew by a mere 1 or 2 percent of annual return.

The author of this book believes that new index managers are similar to active managers even though they claim prescience and brag about their outstanding instincts. New index investors are confident that their forecasts regarding the stock market are the most reliable and accurate. However, it is actually impossible to predict everything, no matter how hard you try.

Of course, it all may change in the future. There are more and more signs that confirm upcoming shifts in the world of investments. Numerous paradigms emerged and evolved over time, yet none lasted for long. To prove this fact, John Bogle cites “concept” stocks in the 1960s and the “Nifty Fifty” era of the 1970s. These were the fifty most popular stocks in the United States that guaranteed investors high and stable revenues. The price-to-earnings ratio was higher than broad market averages. These stocks came and went with the winds of time. In late 1990s, the same thing happened to shares of high-tech companies. It is hard to escape a conclusion that an intelligent investor should not expect each new paradigm to sustain itself over the longer run.

The best thing you can do is to keep the motto “look before you leap” in mind when making crucial investment choices. However, there is still a chance that the new so-called paradigm of fundamental indexing may pay off with significant returns. John Bogle recommends that both aspiring and seasoned traders should not implicitly trust those who promise enormous returns on a scale that used to be out of reach when it comes to traditional index funds. The author quotes William Sharpe, Professor of Finance at Stanford University and Nobel Laureate in Economics, who said, “New paradigms come and go. Betting against the market (and spending a considerable amount of money to do so) is indeed likely to be a hazardous undertaking.”

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