Is Indexing Less Risky?

Tom Bradley of Steadyhand Investment Funds wrote an insightful blog post yesterday about a television commercial for ING Direct’s Streetwise Funds. The woman in the ad dismisses active management as “educated guesses” and then asks, “Why take the risk? That’s not you. With the ING Streetwise Funds you don’t guess. You invest in the whole market, which reduces risk because you’re diversified.” Here’s how Bradley responded:

There are lots of issues around active versus index investing, but there’s no issue that actively managed funds are diversified. The reality is, “educated guessers’” portfolios are generally less volatile than indexed ones and have no more risk of long-term capital loss (which is minimal in both cases). To leave the impression that the Streetwise funds are safer than other portfolios is a dangerous and misleading message.

Bradley is absolutely right. There are many reasons why index investing has proven to be a winning strategy, but less risk is not one of them. Some do-it-yourselfers may build poorly diversified portfolios, but retail mutual funds generally don’t make concentrated bets. The long list of poorly performing equity funds in Canada aren’t lousy investments because they’re undiversified or overly risky. The problem is almost always that they’re just too expensive.

Paul Merriman, who also has a lot of investing wisdom to share, recently made a related argument. (Merriman does a regular series of podcasts called Sound Investing, which are available free through  iTunes. I highly recommend them.) He pushed back against the idea that market timing is riskier than a buy-and-hold strategy. This sounds reasonable at first blush, but it cannot be true if risk is defined as exposure to the equity markets.

As Merriman explains, a market timer repeatedly moves money from equities to cash and back again, so they must be out of the market at least some of the time. A buy-and-hold investor, on the other hand, remains fully exposed to market risk at all times. Therefore, she must be taking more risk than the market timer. Most market timers fail to beat the market, but again, it’s not because they take too much risk.

I worry about these misunderstandings, because investors who are new to the Couch Potato strategy may have unrealistic expectations about what it can achieve. Switching from actively managed funds to index funds or ETFs is almost guaranteed to lower your costs. Over the long term, it’s likely to deliver higher returns. But if your portfolio has the same asset allocation it had before you embraced indexing, you haven’t lowered your market risk. Indexing is not inherently safer than active management or market timing.

Even if ING Direct doesn’t understand that, investors should.