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Index Investing

Why I Believe In Index Investing

“Index Investing” is quite the buzz word right now in the investment world. From blogs all over the internet to Warren Buffet’s annual letter to shareholders, index investing is becoming increasingly popular.

While not a new idea, it has gained traction in large part thanks to Vanguard and the idea of low-cost, passive investments that track the returns of a certain market, or “index”. People everywhere are recognizing the benefits of the low-cost index approach, including myself.

I’ll admit: I am an index investor. I agree with the investment approach; it provides consistently competitive returns and is an easy way to diversify your portfolio at a low-cost.

Really, I view it as the best approach for investors like you and I. It’s an approach that could even help the mega-rich and institutional investors. The key to the index approach lies in its low-cost nature. This article from Vanguard does a good job of explaining the impact that costs have on your investment returns.

Now, let’s get into some details and break down what index investing means and how to implement the approach in your portfolio. Bear with me for a second while it get’s a bit technical.

What is index investing (the technical version)

According to Investopedia, index investing is:

“A form of passive investing that aims to generate the same rate of return as an underlying market index. Investors that use index investing seek to replicate the performance of a specific index – generally an equity or fixed-income index – by investing in an investment vehicle such as index funds or exchange-traded funds that closely track the performance of these indexes.”

Let’s break that down a bit further:

  • Passive Investing: an investment strategy intended to limit the amount of trades (buying/selling). Each trade has a cost, so limiting trades limits the fees associated with the fund. In other words, passive investing is a low-cost approach to investing.
  • Market Index: an aggregate value of stocks and other investment vehicles intended to track market changes over time. For example, the S&P 500 is a combination of the 500 biggest companies in the U.S. and is widely used to gauge overall market performance. Other market indices are the Dow Jones Industrial Average (the “Dow”) and the NASDAQ.
  • Index Fund/Exchange Traded Fund: while technically different, both index funds and exchange traded funds (ETFs) seek to mimic a market index. A S&P 500 index fund or ETF is a bundle of all the stocks in the S&P 500 at a single price. Instead of buying 500 individual stocks, a fund does that for you.

What is index investing (the simple version)

Think of index investing like a shadow – it follows you up, down, left, right and in any direction that you move. In this case, the “you” is the market index that it is tracking.

To invest this way, you buy an index fund that tracks the part of the market you want to invest in. This could be U.S. stocks, developed market stocks or emerging market stocks, bonds, real estate, etc. When you start to review which index fund you want, you’ll come across a lot of options. The simplest way to avoid this information overload is to follow the three-fund investment approach championed by the Bogleheads.

The three-fund approach is a no-hassle investment strategy. It’s a combination of a total US stock market fund, total international stock market fund, and a total bond market index fund. An example, using Vanguard ETFs, would be: VTI, VXUS, and BND. That’s it! Just three funds and you have diversified your portfolio across the entire world.

(Note: those three-letter identifiers in the example are the investment symbol, or ticker. Another example of a stock ticker is APPL, which is the ticker symbol for Apple)

The fintech industry also uses the index investing approach, though they typically invest your money across more than 3 funds. For example, my Betterment account invests across 10 different funds. Some major fintech companies are Betterment, Wealthfront and Personal Capital. I’ll cover the pros and cons of this in another post. The point is, there is more than one approach to index investing.

To summarize index investing in one sentence: Index investing is an investment approach intended to match the returns of the market

Why the hype

The hype lies in the low-cost nature of index investing. Review this chart from the Wall Street Journal:

Cost of Index Investing

(Note: the y-axis values are “basis points”, where 100 basis points = 1%)

Let’s compare two points on that graph. Taking the latest year, actively managed funds cost, on average, 0.9% (or 90 basis points), and index funds cost 0.1%. We’ll use the following criteria for the comparison:

  • Active fund cost: 0.9%
  • Index fund cost: 0.1%
  • Initial investment: $10,000
  • Annual addition: $5,000
  • Investment return: 6.0%
  • Duration: 30 years

Over the course of this investment, the cost of the funds end up being:

  • Active fund: $70,298.79
  • Index fund: $8,492.40

That is a difference of $61,806.39.

That is a major difference! And that difference only gets larger as the investment amount grows.

Why the cost matters

Besides the glaringly obvious example above, cost also factors into the returns you can expect. The higher the cost you have to pay, the lower your return will be. For example, if a fund returns 6% on the year but costs 1% in fees, you’ll only see 5% of those earnings. If that same fund cost 0.1% instead, you’ll see 5.9% of those earnings. That adds up to thousands and thousands of earnings over time.

Don’t be a fool and throw away your hard-earned money like that!

Index vs. active vs. stock picking

Index returns vs. Active returns:

A Morningstar report finds: “…actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons, and experienced higher mortality rates (that is, many are merged or closed).” The same report finds that the culprit of the underpeformance is largely due to the higher cost of active funds.

Index returns vs. Stock picking returns:

When you pick stocks, you are selecting a single stock at a time. When picking an index fund you are picking hundreds, if not thousands, of stocks. The single stock approach carries more risk, but also more reward. (In investing, higher risk = higher return potential, but also higher loss potential).

For example, had you bought Johnson & Johnson (JNJ) 10 years ago on April 13, 2007, your return until now, April 10, 2017, would be 106.55%. You would be feeling very good about that, especially considering the S&P 500 returned 64.01% over that same time frame. However, had you bought General Electric (GE), your return would be -14.35%. Do you see how individual stocks can fluctuate greatly? You wouldn’t bet all you had on something that returned -14% over a 10 year time period. Instead, you’d take a safer bet, while still allowing enough risk to see strong returns on your investment.

That’s where the index fund comes in. Instead of single stocks, you have exposure to thousands. If some are up and some are down, you’ll get the median return. It’s like buying the entire stock market.

In summary

  1. Index investing is a form of passive, low-cost investing that seeks to match market performance.
  2. Index funds cover any and all parts of the market; from broad, all-market coverage to real estate and bonds.
  3. Index funds offer straightforward diversification, finding the right balance between risk and reward.
  4. Their low-cost nature is the not-so-secret sauce to their success. Be sure to understand the cost of any investment you make.

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