Index Investing

It may surprise you that between 60% and 80% of the managed stock mutual funds underperform the stock market as a whole. This means that if you simply take the "buy the whole stock market" approach to investing, your return on investment will be better than most of the managed funds. With certain caveats, index investing is investing in the whole stock market.

HERE'S HOW IT WORKS

Here's how index investing works. Let's pretend that there are only 100 stocks in the entire US stock market and you can either invest in an actively managed fund or an index fund:

1. The actively managed fund has a fund manager who will try to pick the five or 10 best stocks of the 100.
2. The index fund manager doesn't pick and choose from the 100, but rather buys a small portion of all 100.

The beauty of index investing is in its simplicity. You don't need math skills. You don't have to worry about who your fund manager is. You just buy into the whole market.

BUT WHICH MARKETS?

But how do you find the best index funds? Here are a couple of golden nuggets I have unearthed:

Golden nugget 1:

When investing, don't go for a win. Go for a tie instead. Index investing is an investment strategy that tries to mirror the performance of the stock market, or sector of the market, without any bias to whether a stock is undervalued or overvalued. It is made up of all the stocks within the group, or a sampling of enough stocks that will accurately reflect the group.

Index funds are tied to indexes that adhere to this unbiased view on stocks. Mutual fund manager Peter Lynch states in his book Beating The Street, "Over the last decade, up to 75% of the equity funds have been worse than mediocre, failing to outperform the random baskets of stocks that make up the market indexes, year in and year out."

Golden nugget 2:

If you're trying to get rich with bonds, you are wasting a lot of time. Let's suppose you have $100,000 to invest and your dream is to one day become a millionaire. If you invest your money in bonds, which have traditionally given its investors an annual return of 5%, you will reach your goal in 47 years. If, on the other hand, you buy stocks that traditionally yield an annual return of 11%, you will reach your goal in 22 years: in less than half the time.

The word you will often see trumpeted for a sound investment portfolio is "diversification." Diversifying in stocks is good; that's what index investing is all about. Diversifying with bonds is bad. It's "di-worse-ification." The more bonds you add to your portfolio mix, the worse your returns will be over time. A portfolio divided equally between stocks and bonds would be worth about $643,000 in 22 years, or $357,000 less than the portfolio that consists of only stocks. You can have a healthy, happy, and diversified investment strategy without any bonds. This is where index investing really shines.

When you buy into an index fund, such as one that tracks the Standard & Poor's 500, your investment is spread out over 500 companies in utilities, energy, financial, industrials, durables, staples, services, retail, health, and technology. This weighting over many companies in different market sectors creates its own ballast without hindering performance. It's the smart way to invest.

ADVANTAGES OF INDEX FUNDS

Index funds have several built-in advantages over managed funds. Here are some advantages you will enjoy when you invest in an index fund:

• Diversification — The indexes are made up of hundreds or even thousands of different stocks spread over all the various market sectors. A managed fund is limited to the number of stocks that the investor can reasonably keep track of. More stocks mean a safer investment.
• Free of fund manager error — Stock investment is part science and part art. A fund manager must be able to blend number-crunching skills with a sixth sense about which stocks will be in favor. For every fund manager capable of beating the market, there are three or four who cannot, as evinced by the number of mutual funds underperforming the various stock market indexes. You might get lucky and invest with the manager who will beat the market, but the odds are you will not. Do you really want a one-in-four chance of beating the market?
• Less expensive — Managed funds are more expensive to run than index funds for a couple of reasons. First, the company has to pay someone a handsome salary to pick good stocks. An index fund can use a computer at minimal expense to determine what stocks to purchase and what proportion as money flows in and out of the fund. Second, an index fund delays capital-gains taxes because it generally holds stocks longer than its managed fund counterpart. When a fund manager sells a share of stock that has increased in value, it is said to have realized a capital gain. The capital gains are then distributed to the investors, which are then subject to tax. Because capital gains are taxable, it is financially beneficial to the investors for a mutual fund to hold a stock for as long as possible, thereby delaying the gain and the accompanying tax.

Should you invest over a course of years, your investment journey will be an experience of many different things. The world will change. The market will have its sunny side as well as its rainy one. But when the fog lifts, index investing will still be there. Index investing will stand the test of time because it is built upon timeless investment principles. If you are patient and stay the course, you will be richly rewarded.

— Eric Witkowski

REFERENCES

Lynch, Peter [1994]. Beating The Street, Fireside Books/Simon & Schuster.

S&P 500 Index, 1926­99. SBBI Yearbook, 1999. Rate rounded to the nearest whole percentage.

A FEW INDEX FUNDS

Total Stock Market Index Fund

Large Cap Index Fund

Mid Cap Index Fund

Small Cap Index Fund

Phone: 800 595-9111
Index tracked: Russell 2000Trading symbol: NSIDX
Minimum initial investment: $2,500
Minimum initial investment for an IRA: $500

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