Index Investing 101
But first, for those of you guys who might be hearing about index investing for the first time, let me quickly explain what it is.
If you watch any financial news, you hear reporters talking about how the market is up 50 points. Or down 100 points.
They are referring to what is known as the Index.
The Standard & Poor, S&P 500 is one of the most widely followed indexes in the world. It represents the 500 largest publicly traded companies in the United States.
As of this article, the top companies within this index are Apple, Microsoft and Amazon. Of course, this can and will change. Just 20 years ago, Amazon was still a river in South America.
The Basic concept of index investing is that, since the chances of finding single stocks that outperform the market are very small, you’ll get better results by buying every stock in a given index like the S&P 500.
50 years ago, this would have been almost impossible. You’d need to know all the publicly traded companies in the index and buy them individually.
However, came Mr. Jack Bogle. Mr. Bogle founded Vanguard and gave the individual investor the ability to purchase all the stocks in an index by creating the first index fund in 1976, the Vanguard 500 Index Fund (VFINX).
When he initially created this fund, the idea of index fund was challenged, because it threatened the existing rationale behind paying high fees to Wall Street professionals.
He was ridiculed and laughed at.
But Mr Jack Bogle had the last laugh. Since the formation of the S&P 500 index fund, the fund has returned an average of 11.47% annually while maintaining its low expense to the investors. And Mr. Jack Bogle’s idea has been validated repeatedly.
Now you might be thinking, man this index investing sounds like an amazing deal – why wouldn’t everyone do it?
Let me tell you why.
Why People Believe Index Investing Is Lazy Investing
Regardless of Index Investing’s success record the last 4 decades, many still believe the myth that there is a better way of investing.
They believe that Vanguard and index investing is sound advice, but it’s for the average person who doesn’t want to do the hard work of real investing.
They believe that with a little more effort and the right selection of individual stocks and/or actively managed funds, the studious investor can do better.
I honestly don’t think so.
1 | Hard to Accept “Average”
It’s hard to accept the “average.”
We all believe that we are better than average.
According to recent research, 65% of Americans believe they are above average in intelligence. This isn’t surprising since who would want to believe they are below average?
But, if the belief and reality were true, this statistic wouldn’t make any sense. Only half the people can really be better than average right? We tend to carry over this belief into our investment mindset.
Because to buy the index is to accept the market’s “average” return. Right? I’m not average, so how can I accept “average” returns?
But in this context, the word “average” is quite misunderstood.
It doesn’t mean that index fund returns are at the midpoint. The “average” here means the combined performance of all the publicly traded stocks in an index.
Professional fund managers are measured against this return. Their ultimate goal is to get their actively managed fund to beat the index “average” returns.
However, in a period of 30 years, the index has outperformed 99% of actively managed funds.
This is based on a study presented in the The Journal of Finance. Where of 2,076 actively managed U.S. stock funds, only 0.6% showed any skill at beating the index over a 30 year time period; from 1976 to 2006,
This means that if you were to buy a total stock market index fund like the VTSAX, you’ll likely be in the top 1% performance compared to actively managed funds.
Not bad for being an “average.”
2 | Banks & Financial Media Make You Believe You Can Beat The Market
Big banks and the financial media also play a huge role in perpetuating this myth.
Just turn on any financial news. It’s filled with stories of individuals who have outperformed the index.
These “superstar” investors are the darlings of the financial media.
And the reason is because they sell news.
Who wants to hear about a boring investor who’s consistently growing his or her net worth by index investing.
The media’s primary purpose is to get more viewers through sensational news. Then with these viewers, they can sell advertisement slots to the Big Banks – who in turn want to convert the viewers into customers.
Customers for their lucrative financial products.
And these are quite lucrative indeed. The financial service business is a trillion dollar industry dedicated to selling advice and brokering trades to people who can be persuaded to believe they can outperform the market.
Financial advisors, money managers, mutual funds companies and brokerage companies all want their hand in your pocket.
Make no mistake – the financial news media isn’t providing financial information for your benefit.
Recognize that these are marketing techniques for the Big banks.
Carefully leverage their services for your benefit, but recognize what their ultimate incentives are.
3 | People Underestimate The Hidden Cost Of Active Investing
Another big reason people believe in this myth that index investing is for lazy people, is that we underestimate the hidden costs of active investing.
Paying 1 to 2% to a fund manager or an advisor sounds miniscule.
We pay multiple times that in taxes every year.
However, 1 to 2% annual fee in the investing world can be detrimental to your wealth.
Remember, these fees not only reduce your returns, but also compound over time.
So, if you’re paying an advisor or fund manager a fee of even just 0.50%, that means you are losing 25% of your potential return after 30 years! That’s huge!
Mr Jack Bogle has a saying –
“Fund performance comes and goes. Costs go on forever.”
4 - We Can’t Pick Winning Stocks
Let me tell you some harsh truth you may not want to hear.
I can’t pick winning individual stocks or mutual funds and neither can you.
Nor can the vast majority of people who claim they did or can. If you happen to be one in a billion who can, I’m not sure why you are reading this article. It is ridiculously difficult and having the humility to accept this will be the key to making you rich and wealthy.
I love index investing not because it is simple and straightforward, but because, at the end of the day, it is a much more effective way to invest than the alternative.
Final Words. If you don’t believe this random guy on the internet, at least listen to the some of these wise individuals:
“On average, the average large-stock fund manager produces average returns before fees and below-average returns after fees. So compared with after-fee returns, an index fund is superior.” – Howard Marks
“A low-cost index fund is the most sensible equity investment for the great majority of investors.” – Warren Buffett
“Don’t look for the needle in the haystack. Just buy the haystack!” – Jack Bogle