Investing-Index Fund Investing

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Index Fund Investing

You may have questions about index funds. We are going to start with a few definitions:

  • Asset Class Investing: Stocks are an asset class. Bonds are an asset class. Large capitalization stocks are an asset class. Indexes track the performance of broad or narrow asset classes
  • Indexing: The practice of owning a representative number of securities (stocks or bonds), in the same ratios as the target index.
  • Index: The S&P 500 is an index of 500 large capitalization U.S. stocks (representative collection). S&P publishes the index so you can track the performance of large capitalization stocks. 
  • Index Fund: Offered by a mutual fund family (Vanguard, Fidelity). The fund buys all of the securities, or a representative sample, of an index (S&P 500)
  • Market Performance: When you invest in index funds your goal is to match the performance of an asset class. You are not trying to "beat the performance of asset class" - often referred to as "beat the market"

Brief History

Burton Malkiel published A Random Walk Down Wall Street in 1973. His book documented the widely accepted fact that most mutual funds did not beat the performance of their respective benchmarks (indexes). He questioned paying premium fees for inferior performance. To this day, actively managed mutual funds have trouble outperforming benchmarks after all fees and transaction charges are deducted. 

Vanguard launched the first index fund in 1976. Index funds took off in the 1980s. According to Kiplinger, there are more than 1,700 index funds to choose from. 

Passive Management

Actively managed mutual funds try to beat the market to justify the higher fees that they charge for their services. They also take additional risk in their quest for superior performance. They hope higher returns will more than offset increased risk and expense.

Index funds are referred to as passive management because investors are not trying to beat the market. Their goal is to match the performance of the market. As Burton Malkiel documented, these investors do not believe advisors and money managers can beat the market, net of expenses, over longer time periods. So why try? Use a passive approach for less risk and expense.

Reduced Risk

Beating the market requires a higher exposure to financial risk. The risk occurs when you try to beat the market and you fail. You make less in rising markets and you lose more in falling markets. Your exposure to investment risk declines substantially when you are no longer trying to beat the market. You have eliminated the risk of being wrong. You are taking market risk, but not the added risk of trying to produce superior results.

Low Cost

Most index funds charge substantially lower fees than actively managed mutual funds. That's because index funds are run by computer programs. The mutual fund company does not need expensive Chief Investment Officers, analysts, or portfolio managers to conduct research, build portfolios, and make buy/sell decisions.

Paladin says.....

You can invest in actively managed mutuals that are supposed to outperform market indexes or you can use index funds to invest in the indices. A high percentage of investors, in particular institutional investors, do both. That might invest 50% of their assets in index funds and 50% with active managers. 

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