The Case for Index Investing

In most endeavors, there are high rewards for taking charge, for working hard, for striving for perfection. “Fortune favors the bold!” Taking a passive approach and relying on others to do your homework is typically a recipe for failure.

Except, it seems, for investing in the stock market.

Index investing is where your goal is not to pick winning stocks and crush your enemies, but rather to passively follow the returns of an index chosen by someone else. Some third party decides what should be in a stock market index (often by taking a section of a market-cap-ranked list), and then you buy an exchange traded fund (ETF) or mutual fund that holds the same securities.

It’s the investing equivalent of dining out and saying, “I’ll have what that guy is having” “But sir, he hasn’t even ordered yet – you don’t know what he’s going to have!” “That’s OK – I don’t care.”

Such a passive approach doesn’t seem like it’d be terribly effective, but index investing has done quite well historically and is now one of the most mainstream approaches to stock market investing.

Why is index investing so great? Let’s count the ways.

You Can Earn (Close to) a Market Return

The stock market has historically been a pretty good place to invest money. The goal of index investing is to earn a “market” return. In fact, it’s tautological – since the market’s return is typically defined by an index’s return, the index IS the market.

A market return is just average performance, which in most fields isn’t too impressive. However, average (over a very long haul) historical U.S. stock market returns of 9-10% p.a. are easily enough to achieve most financial goals. If the market return is enough for you, then set it and forget it.

Plus, even if you desperately want to earn more than an average return, it’s not that easy to do.

Outperforming the Market is Hard

If you think you can beat the market yourself, you have to ask, “Why?” There are a lot of really smart people and teams trying to outperform the market as their full-time jobs, and unless you have a good reason that gives you an edge, you may be disappointed.

If you plan on hiring someone else to help you actively manage your stock investments and beat the market, you have to 1) ask why THEY will outperform and 2) pay them for their efforts. Even if they can manage #1, #2 can bring your net return back down to what you would have made in an index fund (or worse).

Also, here’s a sneaky little secret, learned when I went deep undercover during an internship at a investment management company: some (many?) active managers aren’t really trying to seriously outperform the market. They’re fine mostly mirroring the market, so their investments often closely track whatever index they’re supposedly trying to beat. You get active management fees with index investing returns – good for them, not for you.

There are some people (see Buffett, Warren) who do seem able to outperform the market. However, they typically tend to be whip-smart and devote their entire lives to investing. If you’ve got other stuff to do, you may not be able to replicate their success.

Easy Diversification

Since putting all of one’s eggs in one basket is unwise (in investing and beyond), diversifying your investments is often a good idea.

With a single trade and modest funds, you can become a part owner in 500, 1000, or even more stocks. That’s pretty efficient diversification. And you don’t need to constrain yourself to your shores – you can add diversified foreign exposure through an index fund far easier than through trading individual foreign stocks.

Low Turnover

Index investing has been lauded for low turnover. Yay. While high turnover in a mutual fund in a taxable account can be a drag on your return, that’s less of an issue nowadays with the rise of ETF’s.

Perhaps the best thing about low turnover is simply that it’s not high turnover. Stock market investing is a long-haul, buy-and-hold affair, so I struggle to see a case for rapidly moving in and out of positions (at least for an individual investor). Make your bets, even if they’re passive index ones, and let time do its work.

You Can Target Specific Industries, Countries, or Regions

Index funds have exploded, and there is likely one targeting whatever industry or part of the world you might fancy. I may not know much about individual health care or Russian or African companies, but if I want to make a punt on that specific market, there’s an index fund for that.

However, if you’re not smart enough to pick individual stocks, I’m not sure why you’d suddenly be an expert at picking individual industries, countries, or regions. We’ll go ahead and list this as a further advantage of index funds, but sector investing could drift dangerously close to the active management an index-lover is supposed to eschew.

Low Expenses

Expense ratios matter, especially over time. Every exchange-traded fund and mutual fund has expenses, but an index fund can keep costs very low because they already know what they’re going to buy: the index. An actively managed fund has higher costs (e.g., more staff to research investments) which translate to a higher expense ratio.

Vanguard was the vanguard of index investing and still offers some of the lowest expense ratios in the industry.

Vanguard’s VTI exchange traded fund tracks an index of roughly 100% of the investable U.S. stock market for an annual expense ratio of 4 basis points / 0.04%, or $.40 for every $1,000 invested. That’s pretty cheap.

If you want some global exposure and/or are even lazier, Vanguard’s VT exchange traded fund tracks an index of the entire world stock market (over 7,000 companies) for 11 basis points / 0.11%.

Getting total market exposure and broad diversification for that low of an expense is lovely. While Vanguard is not the only option for index fund investing, you should definitely compare expense ratios of any index fund you’re considering with the Vanguard equivalent.

It’s Easy

Most people don’t get as excited about investing as I do. Being able to “buy the market” and sit back and enjoy the dividends is nice – no worries about monitoring positions.

Because the index will keep updating, you don’t need to do anything. If a company does terribly, they’ll remove it from the index. If a company does great, they’ll add it to it. Certainly, you would do even better if you could sell the stock before it tanks and identify early winners, but you can do OK (aka, “a market return”) with the index itself.

 

Thank You, Captain Obvious

When you sing the praises of index investing, you’re joining a rather large choir.

I get that, and I don’t know that I’ve made any award-winning breakthroughs in today’s effort.

However, I’m not going to stop here. While I love index investing and do some myself, there is also a case to be made for investing in individual stocks. Acknowledging the greatness of index funds will allow a fair consideration of when individual stocks might have an advantage, even (prepare to brace yourself) if you think markets are efficient and you can’t beat the market. So, along with Christmas, you’ve got that to look forward to later this month.

 

If you don’t know much about investing, but you want to play the stock market, index investing may be for you. You won’t outperform the market, but you shouldn’t underperform it by too much either. In most fields, doing average is nothing to get excited about, but in the stock market (at least historically), doing average through index fund investing has done quite well.

 

Do you stick strictly to index funds, or do you live life on the wild side? Let me know in the comments.

 

Picture courtesy of Philip Spanhove

If you’d like a more scholarly (but way more boring) discussion of the case for index fund investing, I’d recommend this piece promoted by Vanguard. Granted, Vanguard has a dog in this fight, but the argument stands on its own merits.

 

2 thoughts on “The Case for Index Investing

  1. My portfolio is almost entirely in very broad index funds. The low cost and simplicity of it all is the main attraction. Every couple months I get excited about buying individual stocks or more targeted funds but I always end up convincing myself the potential for extra return isn’t worth the extra cost/time/taxes/risk/etc.

    The only funds I have outside of my index funds is some money I’ve put into peer-to-peer lending up here in Canada, that’s more play money than anything though.

    • I think broad index funds are generally the way to go exactly because of the low cost and simplicity you cite. I do think there can be advantages to individual stocks, but you can’t get away from the extra time and stress that come from holding individual positions. Thanks for the note!

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