Just buy the haystack: 3 benefits of index investing
“Don’t look for the needle in the haystack. Just buy the haystack!”
In 1975, the first index fund was created. Nearly 50 years later, index funds have become massively popular, but still there are many people who are unfamiliar with the concept.
An index is a group of stocks that match a certain set of criteria. The most well-known index is the S&P 500, which contains the 500 largest companies in the United States.
Index investing is a passive strategy in which you (or the mutual fund you invest in) buy and hold every single stock in an index of stocks. Rather than searching for the needle in the haystack, index investors choose to buy the entire haystack.
How did index investing begin? And how could it benefit your investing results?
A history lesson
In 1973, Burton Malkiel wrote a book called A Random Walk Down Wall Street, in which he presented academic research showing that the prices of publicly traded stocks fluctuate randomly, making it impossible to outperform market averages. Malkiel illustrated his concept by using a now-famous metaphor: “a blindfolded monkey throwing darts at the newspaper’s financial page could invest just as well as a Wall Street stock analyst.”
With the knowledge that even the well-compensated Wall Street stock pickers couldn’t deliver superior investment returns, John C. Bogle in 1975 started the First Index Investment Trust. Bogle did not attempt to pick the best stocks; instead, he bought a small piece of every company in the S&P 500 index (in essence, the 500 largest companies in the US).
By holding every single stock in the index, Bogle’s fund generated average returns. And since he wasn’t paying stock pickers (or monkeys), he was able to reduce costs, which benefited the investor. Ultimately, average was superior.
Benefits of index funds
Your investments are less expensive
Because index funds don’t employ analysts and stock pickers, they are able to operate at a much lower cost than an actively managed fund. This cost, expressed as an “expense ratio”, directly reduces the value of your investment.
Why would you pay an analyst if he or she can’t invest better than a dart-throwing monkey?
You won’t second-guess your choices
Let’s say you want to invest in an actively managed mutual fund, Fund A. After a year, you review your fund’s performance and find it performed much worse than Fund B. So, you decide to sell Fund A and buy into Fund B. The next year, Fund B does poorly, but Fund C does well. Sell Fund B and buy Fund C. Rinse and repeat.
When you engage in this performance-chasing behavior, you will frequently get burned. Not only will you constantly worry and second-guess your decision, but you may lose a lot of money, as many shareholders in the ARKK fund did.
When you buy an index fund, you expect to get the average, and your expectations are met, year after year. When they first hit the market, index funds were laughed at as un-American; who, in their right mind, would settle for average? When the alternative is a below-average performance (while lining the pockets of a Wall Street analyst), average sounds pretty darn good to me.
You will pay less in taxes
When active mutual fund managers buy and sell stocks, they generate capital gains income. If you are investing outside of a retirement fund, you will be paying taxes on this income.
Index funds rarely buy and sell stocks and are able to keep taxable distributions to a minimum.
Are you an index investor?
It’s not always obvious whether your investments are active or index. If you would like to learn more about your current investments, send me a text or an email using the information in the website footer.
About the Author
Joseph Fowler, CFP® is a financial planner and co-owner of 402 Financial in Lincoln, NE.
402 Financial provides financial planning and investment management services to people approaching or in retirement. Joe always acts as a fiduciary and never takes commissions on product sales.
Click this link to schedule a free consultation with Joe.
