Why Is Index Investing A “No Brainer”?

For those of you who have read much of my writing on the subject, you’ll recall that I generally recommend working with index investments when we have them available. In this article I will do my best to help you understand some of the reasons why I recommend index investing.

What is Index Investing?

In order to understand why index investing is a good option, I need to explain first what I mean by an index. In general, an index investment is a representative investment covering a market, sector, or asset class. The S&P 500 is an index for example, representing the asset class of the 500 largest publicly-traded companies in the US marketplace. The Vanguard Total Market Index is an index that represents the entire spectrum of domestic (US) publicly-traded companies. There are many other examples, including the Lehman Brothers Aggregate Bond Market Index (all publicly-traded bonds in the US marketplace). The Morgan Stanley Capital International (MSCI) Europe, Australasia, and Far East (EAFE) index represents the entire markets of the following countries: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, The Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Since these indexes represent an entire marketplace, they are often used as the benchmark against which managed (non-index) funds are measured.

There are mutual funds and exchange-traded funds that track these various indexes. If you’ll recall, one of the first tenets of successful investing is to diversify – don’t put all of your eggs in one basket. By investing in one of these indexes, the investor is taking an ownership stake in all of those companies at once. What a great, simple way to diversify!

These indexes do not require a professional manager to oversee them, because they represent an entire marketplace. The makeup of the index only changes by an outside force (S&P replacing one company in the 500 with another, for example). Because of this, there is very little overhead (fees and expenses) to reduce your return within index investing. Also, since we aren’t changing investments by selling a company’s stock that is out of favor and buying one that we think might provide better returns in the future, transaction costs are limited, and excess taxation of capital gains is limited as well.

What Are Managed Investments?

On the other side of the coin from Index Investments is the group of mutual funds called Managed Investments. These are investment vehicles where a manager (or team of managers) chooses a group of companies (stocks or bonds) to invest in. Over time, this group of investments must be monitored to ensure that the individual companies are producing the expected results. If a company appears to be underperformingor has changed intrinsically, that stock is sold and another company is chosen to replace it in the fund. All of this analysis requires lots and lots of research, review, and day-to-day management. That management costs a lot of money – often upwards of 1% of the fund’s holdings each year – as opposed to less than ¼% for many index funds.

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