Overcoming Fear And Placing Bets On The US Stock Market
We love passive total market index funds, but it was a book on value investing that convinced our family to stop stuffing dollars in our mattress and put them to work in the market.
I’m not a financial advisor, and most importantly, I’m not your financial advisor. This article is about investing and is for your entertainment. Please do your own research and due diligence before putting your hard earned money to work in an investment.
I was happy to see the 17-year-old pull one of my personal finance books off the shelf to read recently.
Though I have a lot of great books on investing, he picked Invested by Danielle and Phil Town. Phil and Danielle have a popular podcast by the same name in which Phil (a hedge fund manager) teaches his daughter, Danielle, how to invest.
Invested is a terrific book for the beginning investor, and a great first book for my son to read. This isn’t a “VTSAX and chill” book like the very excellent The Simple Path to Wealth by J.L. Collins - another book I own and regularly give out to young people.
Invested focuses on buying and selling shares of individual companies using the investing philosophy of Charlie Munger and Warren Buffet. “Buy great companies at a fair price.”
But it’s more than just the nuts and bolts of discounted cash flows and company valuations. The book brings us gently into the psychology of investing.
Danielle was afraid to invest, just wanting to just stuff money in a mattress and never think about it. She didn’t understand inflation, and she didn’t understand the power of compounding.
Neither did I, and this book helped me overcome my own fear of putting money to work in the market.
From individual stocks to index funds
Because I first learned from a book on value investing, I began by buying and selling individual stocks. I spent hours analyzing quarterly reports, earnings, debt, cash flow and forecasts to properly value a company.
Are sales growing? Are margins expanding? Are earnings growing? How will they expand? What might go wrong? Is this company cheap or expensive?
These days, I’d rather spend my time traveling and going on hikes, so I buy index funds instead.
If you don’t want to spend hours upon hours reading annual reports of individual businesses (and their competitors), then you should probably buy index funds too.
I’d never buy shares of an individual company without fully understanding it. For me, index funds are no different. I wanted to understand a bit deeper what’s going on here.
Index funds - my wonky, overly nuanced, and very imperfect understanding.
I just bought 100 shares of the Vanguard Total Stock Market Index (VTSAX). What exactly do I own?
Glossy Brochure: “Congratulations! In buying VTSAX, you now own a tiny piece of every company in the US stock market.”
The real answer is: No, you don’t.
VTSAX is a passively managed fund that follows the CRSP US Total Market Index, which currently (as of this writing) tracks about 3,500 of the more than 6,000 companies traded on the NYSE and NASDAQ exchanges.
Why only 3,500 companies?
When creating the index, the Center for Research in Security Prices (aka CRSP) filters some companies out.
No International companies because… it’s a US Total Market Index. You can invest in a Total World mutual fund, but that’s a different index.
No Ultra-micro companies (<$10M) because even though Aerotyne Industries is a cutting edge high-tech company out of the mid-west, awaiting imminent approval on the next generation of radar detectors, they are just too small (extra points if you get this reference).
No Companies with dismal trading volume because they aren’t very liquid to buy and sell.
And no Special Purpose Acquisition Companies (SPACs) because they suck.
There are a few other criteria, but we’re moving on.
Ok, but what exactly is the ‘Index’ - like what does that even mean?
Simple explanation? It’s just a list of investible companies, sorted and weighted by their market capitalization. This means that really big companies like Apple (AAPL) are a larger percentage of the index than smaller companies like Apple Hospitality (APLE).
A company’s market capitalization (or “market cap”) is its number of outstanding shares multiplied by the share price.
Below is a chart showing the top 10 companies in the total market index by index weight - again, as of this writing. Ten years ago, this list would have looked very different.
Theoretically, this means that if you own $100 worth of an index fund tracking the CRSP US Total Market index, then you effectively own $6.21 worth of Apple stock, $5.19 worth of Microsoft stock, $4.67 worth of NVIDIA stock, and so on.
You said VTSAX is a passively managed fund. What does that mean?
To explain, let’s examine what happened with the GameStop short squeeze in 2021. But first - a quick note on what the GameStop short squeeze was:
“The GameStop short squeeze in 2021 saw the stock’s price skyrocket from a low of around $17 to a high of over $480, driven by retail investors coordinated through online forums like Reddit’s WallStreetBets, causing substantial losses for hedge funds with short positions.” - Allen’s unpaid, and oft abused, AI assistant
Ok, so GameStop shot from $17 to $480, and VTSAX owns GameStop, and we own VTSAX. So all good, right? Cha-Ching! Order the Lambo!
Not so fast.
Remember what we said about market-cap weighted indexes? Well, GameStop is a small company, and therefore, would have represented just a tiny fraction of VTSAX holdings at that time.
If you had $1M invested in VTSAX, you likely owned somewhere around $25 worth of GameStop before the short squeeze happened. Even if VTSAX had managed to shed GameStop shares at their height (Narrator: They didn’t.), it would have maybe resulted in around $500 in value back to you, or a swanky meal and a good bottle of wine.
Ok but that’s still a swanky meal and a wine from a bottle rather than the box I usually drink. Why didn’t Vanguard look at that price jump and say “Hey, I’m going to sell this stock because it has really taken off”?
This is a passive fund. There is no stock picking going on.
The fund would not have looked at GameStop through the prism of whether it is under-valued or over-valued.
There is no one in an index fund saying “Look! GameStop is way up! Sell Mortimer! Sell!”
So what’s the point of passive funds if they can’t take profits? How do they even go up?
Well, there’s a lot of tailwinds for US stocks in general. Here is Allen-speculation as to why a passive index fund like VTSAX might go up (in the long run).
A bet on a total market fund is a bet on the US economy - if US companies are making money and their earnings are growing, then active traders push the share prices upward. The US remains a very friendly place for talent, innovation, and growth.
There are cash inflows to the market from every day workers (via their retirement plans), pension funds (both in the US and abroad), individual and institutional investors, etc. Therefore, there are baked in increases in demand for shares of US companies.
Companies are buying back their own stock to take it off the market. This rewards shareholders by increasing earnings per share and drives the stock price higher. Therefore, there are baked in decreases in supply of shares of US companies.
Inflation naturally drives up the prices of goods and services provided by the companies you own. When prices go up, eventually so do earnings. If you don’t own shares of companies, you are likely just experiencing the downside of inflation - an increase in the prices of goods and services you consume.
My investing mindset
I sometimes hear cynics refer to the stock market as a casino. There are certainly individual stocks and high-risk funds out there that can make it seem that way.
My value investing roots ground me in the idea that I’m not just gambling mindlessly on cryptic symbols.
Through index funds, I own a fraction of actual companies, with actual cashflows, and loads of employees who work hard to make my stake in the US economy more valuable every day.
A bet, not a gamble.
It is said that gambling is a wager placed on events without any sense of the outcome, while a bet is placed on an event of which the outcome is influenced by the skill and performance of the participants.
I don’t like to gamble, but I do place bets on the skill and performance of US companies.
Good read !