Q & A about indexing

Aren’t you condemning yourself to average performance if you buy an index fund?

No! It is true that your index fund will very closely match the index — the average it’s tied to. But the index fund will match that average without spending investors’ money trying to beat the average. The lower costs that come from not hiring analysts to try to beat the market will add to your net return. This is why it’s said that index funds give you “average performance at below-average costs.” That adds up to better than average growth of your investment over the long haul.

Why can’t I just pick an above-average conventional mutual fund and beat the market that way?

You can try. But a conventional mutual fund that has returned more than the market has no guarantee of being able to do that in the future. “Past performance does not guarantee future results”: you’ve read it in the advertising, now believe it! Still, if you want to go pick a conventional mutual fund in hopes of beating the market, understand that your chances of success in most years is below 50 percent.

My neighbor invests in individual stocks and does better than the market. Why shouldn’t I?

By all means, give it a try if you’d like. Still, you should first be aware of two facts:

  1. Many people who say they beat the market didn’t actually beat the market. There are some famous instances of highly touted investors (the little old ladies’ investment club known as the Beardstown Ladies, for example) whose investments did not beat the market return, once the numbers were properly calculated.
  2. People tend to brag about their successes and omit mention of their failures. If your neighbor has two investments and one returns 40 percent while the other loses 40 percent, which do you think you’ll hear about? Don’t get spooked if you’re only getting half of that supposed 40 percent return over the same time period with your index fund! Your neighbor’s total portfolio could have returned zero.

I believe that stocks are often overvalued or undervalued. Can’t I make money buying the undervalued ones and selling the overvalued ones?

Sure! If you have that ability, go for it! However, there are very few people who do — but many who think they do.

For a minute, though, think about all the investors out there doing research, listening to tips, playing hunches . . . together they will achieve the market average. Some will do better, some will do worse, and some may even make a fortune. But on average they will achieve the market average! And they’ll do that at higher trading costs than with index funds.

Some people think that the argument for indexing depends on markets being efficient, rational and perfect. There is one line of reasoning like that leading to index funds. But even in markets driven by fad and fashion, an index fund gives you an average return at below-average costs.

How about the work ethic? If I work hard identifying good investments — rather than just sitting back and holding an index fund — shouldn’t I be rewarded for that?

Ideally, you should. But that’s not the way the world works. There is no agency or authority that insures you’ll get good investment returns for your hard work trying to find good stocks. Remember, to beat the market by buying good undervalued stocks, you have to do two things:

  1. Find companies whose value will increase because of fundamentals or other factors driving their stock up, and
  2. Find and buy those stocks before everyone else catches on.

You see, it’s not enough to find good stocks. Pfizer may be a wonderfully run company — but that won’t make its stock go up if everyone already knows what’s good about Pfizer and has bought it on that basis. Really big stock returns usually come about because of surprises, and by definition you can’t predict when and where a surprise will occur.

Aren’t index funds bad to hold when the market goes down? Then isn’t it better to have active control over your stock, or at least a mutual fund manager that will minimize the losses?

The main disadvantage to index funds in a down market is the flip side of their advantage in an up market: They don’t hold much cash. They stay as fully invested as they can. That means that in an up market, you don’t have some of your fund money sitting in lazy cash accounts. It also means that in a down market, you don’t have the buffering effect of cash accounts. (Cash doesn’t go down when the market falls!)

But it’s easy enough to overcome this “problem.” If you want protection against a downturn, keep in cash some of the money you’d otherwise invest in the market. That way you’ll know how conservative you’re being by holding specific amounts of cash. (There have been some cases when mutual fund managers made big bets by holding unusually large, or small, amounts of cash. Some of these bets paid off and others failed spectacularly. You don’t really want a mutual fund manager to make such bets with your cash. If you want more cash, do it yourself! That way, the money you think you have in stocks — via index funds — will actually be in stocks.)

[Note: Holding “cash” also means holding cash equivalents like money market funds. You don’t have to take $100 bills out of the bank and hide them in your mattress to hold “cash” against a market downturn!]

Keep in mind another point. In a down market, everybody’s out there trying to find a way to pick stocks that will fall less than the market. On average, they won’t succeed. On average, the market will fall by the average amount. Holding an index fund you’ll take that average hit with below-average trading costs. The typical investor in individual stocks will take that average hit with above-average trading costs!

Do you follow your own advice to buy and hold index funds, rather than trading individual stocks or trading in and out of mutual funds?

Yes! With my new investment money, I buy and hold index funds only. (In those few cases when I can’t get index funds — such as some of my retirement funds — I get the closest thing I can to index funds.) Even though my work and family relationships have occasionally given me ideas about stocks that might outperform the market, I maintain a strict discipline of not buying individual stocks. (Some of those stock ideas, I now know, would have worked out and some would not have.)

How do I actually get started investing in index funds?

I’ll tell you, but first understand (standard disclaimer): This information is free and I’m not your financial adviser. I’m not getting paid by any of the investment companies. Before you invest in any fund, read the prospectus carefully. Understand that mutual funds can gain or lose value and there is no assurance that you will get your original investment back. Don’t trust anyone who claims that any investment is a “sure thing”!

So here are some links to get you started — my two favorite investment companies:

The Vanguard Group