The Beginner’s Guide to Index Investing

The Beginner’s Guide to Index Investing

There’s an overarching investment philosophy that I use myself and that I recommend to anyone who asks me for advice. It’s called index investing, and there are two main reasons I like it so much:

  1. It’s easier to implement than just about any other investment strategy, and
  2. It works better than just about any other investment strategy.

Hard to beat that combo!

Index investing lies at the heart of pretty much everything I believe about investing. And in this post you’ll learn exactly WHY it works so well and HOW to do it yourself.

Here’s what we’re going to cover:

What are index funds?

At its core, index investing is simply an investment strategy that makes use of index funds. So what’s an index fund? Well, I’m glad you asked!

First, an index fund is a type of mutual fund, and a mutual fund is simply a collection of investments (stocks, bonds, real estate, etc.) that you can buy as a package deal. For example, a single mutual fund might own a little bit of stock in many different companies.

Second, an index fund tracks an index, and an index is simply a representation of a part of a market (e.g. the stock market, bond market, real estate market, etc.). For example, one of the most well-known indexes is the S&P 500, which includes the stocks of the 500 largest US companies. There are many different indexes that track many different parts of many different markets.

Finally, index funds stand in contrast to actively managed funds. With an actively managed fund there’s a manager who’s paid to try and pick the best investments to include in the mutual fund. The manager’s goal is to use his or her skill to generate a better return than you could find elsewhere. But an index fund doesn’t try to pick the best investments. Its sole goal is to mimic the return of the part of the market it tracks. This is why index funds are often labeled as “passive”.

To sum it up, index investing is the practice of using mutual funds that passively track indexes rather than trying to beat the market.

With that background, let’s start looking at why index investing is such a powerful strategy.

5 things that determine investment performance

index investing - 5 things that determine investment performance

If you really want to understand WHY index investing works so well, you first have to take a step back and understand WHAT matters when it comes to investing.

What are the factors that influence your investment performance, and therefore need to be considered when evaluating any investment strategy?

Here are the five biggest thing you need to know.

1. Investment returns are largely out of your control

When you invest, you’re doing it because you expect some kind of return, right? If that’s the goal, then it’s important to understand where that return will come from so that you can create a strategy designed to actually capture some of it.

This paper by Roger Ibbotson has all the details, but the upshot is that your investment return is determined by three main factors:

  1. 75% of your return comes from something you have no control over: the overall market return. That is, simply deciding to invest at all exposes you to most of the same big market swings that everyone else experiences.
  2. 15% of your return comes from how much you decide to expose yourself to those market movements. Technically this is called your asset allocation, and we’ll talk about it in more detail below. But essentially you have to decide how much of your money to put in high-risk, high-return investments, and that decision will affect the return you end up receiving.
  3. 10% of your return comes from the specific investment choices you make. That is, the specific mutual funds, ETFs, stocks, bonds, etc. that you decide to use.

This might initially make you feel a little powerless, but you can actually use this information to your advantage.

First, the market will have big swings up and down from time to time. It’s just a fact of life. And when it does, most of the people around you are going to freak out.

When the market is up, people will get greedy and put more of their money into high-risk, high-return investments like the stock market. And when the market is down, people will run for the hills, sell all their stocks, and hide their money under a mattress.

That is exactly the kind of reactionary behavior that gets most investors into a lot of trouble.

But you can know better. Whether your account balance is way up or way down, you can step back and remember that most of that has very little to do with how you have decided to invest. You can keep a level head knowing that you’re neither a genius nor a failure, and you can stick to your plan instead of panicking.

Second, you can take some of the pressure off yourself to get your investment strategy exactly right. While it does matter, and while there are some simple ways to do it well (which we’ll get into below), in the end most of your return is not actually determined by the specific choices you make.

2. Investment return always comes with investment risk

A big part of investing is managing the level of risk you want to take on. But risk is kind of a strange word in the investment world.

When an investment is labeled as “risky”, that simply means that there is uncertainty about the return you’ll get from it.

As an example, stocks are deemed to be risky because you can never be sure what they’ll do. Some years they’re up big. Other years they’re down big. There’s a lot of uncertainty involved.

At the other end of the spectrum is a savings account. Yes, interest rates change over time. But basically you know exactly what will be in your account from day to day. That’s as certain as it gets.

And there are two big points to understand here when it comes to your personal investment strategy.

First, if you want to implement a strategy that reaches for higher returns, you have to accept a lower level of certainty about actually getting those returns.

If someone is telling you about a way to get higher returns without increased risk, then they’re selling you something that doesn’t exist (unless they’re talking about diversification, which I’ll get to below).

Second — and this is a point that’s often overlooked — certainty about returns brings its own set of risks. This is why I say that risk is a strange word when it’s used in the context of investing.

A savings account allows you to be certain of your balance from day to day, but it also introduces the risk that the value of your money will decrease due to inflation.

Over short periods of time this isn’t a big deal. I often encourage my clients to use savings accounts for near-term goals.

But over long periods of time it matters a lot. This is the main reason why people suggest that long-term investors put their money into riskier investments, like the stock market; there’s actually risk on both ends of the spectrum.

Here are the two big takeaways on risk and return:

  1. If you want the possibility of higher returns, you have to accept more uncertainty about whether you’ll get them.
  2. Over the long-term, there actually IS risk involved with even “low risk” investments. Yes, it’s confusing but it’s true.

3. Asset allocation matters

Asset allocation is a term you’ll hear a lot when you read up on investing and, although it sounds fancy and technical, it’s actually a pretty simple idea.

Your asset allocation is simply the way in which you divide your money between different types of investments.

You can think of investing a lot like you think of cars. While there are a TON of different choices out there, each with their own unique set of features and nuances, they can all be grouped into just a few major categories that tell you most of what you need to know.

With cars, we have categories like “sedan”, “minivan”, and “SUV.” Not all cars within each category are exactly the same, but they’re pretty similar along the major characteristics like size, power and gas mileage.

With investments, our categories are things like “stocks”, “bonds”, and “cash.” Just as with cars, not everything within each category is exactly the same. But they share similar characteristics like expected risk and return.

And how much money you decide to put into each major type of investment —  your asset allocation — is the most important part of your investment strategy for two reasons:

  1. Your asset allocation is the single biggest piece of your investment return that you actually have control over; that 15% of your return that’s based on how much money you expose to the overall market movements.
  2. Your asset allocation is also the primary way that you can control risk. A higher allocation to stocks will introduce the possibility for higher returns, but will also expose you to bigger ups and downs along the way. And on the flip side, a higher allocation to bonds will decrease your expected return while increasing your odds of actually receiving that return.

Basically, your asset allocation is one of the few factors that is BOTH directly under your control AND has a significant impact on the return you end up receiving.

4. Diversification is your friend

Up above we talked about a golden rule in investing that’s virtually impossible to break: if you want the possibility of better returns, you have to take on greater risk of not getting them.

This is really the whole point behind the asset allocation decision above. You can put more money into the stock market if you want, and that WILL increase the possibility of getting higher returns. But it also increases the risk that you won’t actually get those returns. So your asset allocation decision is an exercise in deciding how much risk you’re willing to take on in pursuit of higher returns.

But there’s ONE way to decrease your investment risk WITHOUT decreasing your expected return.

It’s called diversification and it can be summed up by the phrase don’t put all your eggs in one basket.

Essentially, diversification is the act of spreading your money out over a lot of different investments so that you never have too much money invested in any one thing.

As an example, instead of trying to pick a few winning stocks and taking on the risk that one wrong pick will leave you with a huge loss, you can diversify by choosing to invest in the entire stock market.

When you own a little bit of every company, no single company can bring you down.

And diversification works for one simple reason: even the professionals aren’t good at picking stocks. Seriously, the best research we have tells us that stock-picking (or bond-picking for that matter) is mostly a matter of blind luck, even among the most highly trained and skilled investors out there.

So if stock-picking doesn’t work, that means that there’s no real reason to expect any particular stock to outperform another. Of course some will actually outperform, but it’s incredibly difficult to know ahead of time which ones will do so.

And if you don’t know which stocks will outperform, that means that all stocks essentially have the same expected return. So whether you invest in a single stock or the entire stock market, your expected return is the same.

BUT the amount of risk you take on varies a lot.

In the most extreme case, investing in the stock of a single company means that your entire investment return is dependent on the fortunes of that one company. That’s a lot of eggs in one basket.

If you instead decide to put your money into an index fund that tracks the entire stock market, no single company has too much importance. You’ve reduced your overall risk by spreading it around and your expected return is still exactly the same.

That’s the power of diversification. Reduced risk without reduced return. It’s the only way to get that combo.

5. You get what you don’t pay for

John Bogle, Vanguard’s founder, is famous for saying that when it comes to investing, you get what you don’t pay for.

It’s a little counterintuitive, because with most things we’re used to having to pay a higher price for higher quality. But that just doesn’t hold up when it comes to investing.

In fact, research has found that cost is the single best predictor of an investment’s future return. The less an investment costs, the more likely it is to produce a positive return.

And this is actually great news! Because while there are about a million parts of the investment process that you have no power over — what the markets are doing, inflation, interest rates, etc. — cost is something that you CAN directly control.

By minimizing the cost of your investments, you maximize your odds of getting superior returns.

Why index investing works

index investing - why index investing works

Whew! That was a lot of background info. Thanks for sticking with me.

But now that you’re armed with all of that information about what actually matters in investing, we’re ready to answer the question of WHY index investing works better than just about everything else.

Let’s get to it!

Active investing doesn’t work

Remember above when we said that 75% of your return comes from the markets as a whole (which is out of your control), 15% of your return comes from your asset allocation, and 10% of your return comes from the actual investment decisions you make?

Well that final 10% is what’s called your active management, since that’s the part where you’re trying to choose the best investments possible.

Here’s the problem with that 10%: all of the data we have says that even the experts are bad at picking the investments that will perform best. We mentioned this up above in the section on diversification, but the research can basically be summed up in two points:

  1. Year after year, across all different markets and sub-markets, the majority of professional investors UNDERPERFORM the index they’re measured against. That is, they lose to the market.
  2. The professionals who outperform over one period are less likely than chance to outperform again over the next period. This makes it almost impossible to tell which professionals are actually good and which are just lucky.

And this has two big implications for you as an individual investor:

  1. Any attempt to beat the market is much more likely to fail than to succeed.
  2. If you want to fully capture the return of a given market, finding a way to mimic that market as closely as possible is going to be the most efficient way to do it (since that would remove all active management, which again is more likely to be harmful than anything else).

Which brings us to…

Index funds mimic the market

If you want to mimic a market, an index fund is the best way to do it; because that’s exactly what it’s designed to do.

A good, low-cost index fund will come as close as possible to giving you the full return of whatever market you want to invest in.

Index funds maintain a consistent style

We said above that your asset allocation is one of the most important investment decisions you will make. But deciding is only the first step. Once you know what you want your asset allocation to be, you have to choose the specific investments that get you to that asset allocation.

If you’re using mutual funds or ETFs, which most people do, that means that you need to know exactly what each fund you choose actually invests in. Otherwise, it’s impossible to know whether you’re hitting your target asset allocation.

One of the really nice things about an index fund is that you KNOW what it’s going to invest in. An index fund tracking the US stock market isn’t suddenly going to start including international stocks as well. If an index fund fits your asset allocation when you choose it, it’s going to continue to fit your asset allocation unless YOU decide you want something different.

On the other hand, one problem with actively managed funds is that the manager can change his or her strategy at any time. Those changes force you to re-evaluate how the fund fits within your asset allocation and may force you to choose a different fund.

Not only does that put more work on your plate, but changing funds could cost you money in the form of taxes and trading fees.

So the consistency of an index fund makes your job a lot easier and potentially saves you a lot of money.

Index funds make diversification easy

If you own an index fund that mimics the entire stock market, you’re diversified within stocks. If you add another on that mimics the entire bond market, now you’re diversified within bonds too. And you’re also diversified across two different types of markets.

See how easy that was!

Now, I will say that a lot of actively managed funds are diversified as well. For example, most actively managed stock funds hold enough stocks that they aren’t too sensitive to the downfalls of any particular company.

But there are a few reasons why this is less beneficial with an active fund than an index fund:

  1.  Active funds usually cost more — which, as we know, is not good.
  2. Active funds have less consistency (see above), so you can’t always be sure that you’ll have the same level of diversification from one year to the next.
  3. As Warren Buffett would tell you, if you REALLY wanted to pay someone for their stock-picking skill you would actually want them to be UN-diversified. You’d want them to put all their money into their best ideas, because if they were truly skilled then that would be the best way to get the highest returns

So if you want the free lunch of diversification, index funds are the best way to get it.

Index funds are low cost (at least the good ones are)

There ARE some bad, high-cost index funds out there. You need to watch out for them.

But the best index funds are extremely low cost. And it makes sense, because they’re not paying anyone to try and beat the market. It’s simply easier and less costly to mimic the market than to try and beat it.

And since cost is the single best predictor of future returns, this is a pretty nice little feature to have.

It’s easier to know a good index fund from a bad one

A good index fund is simply one that tracks its index well. Basically, you want the fund to deliver the full return of the market it tracks, less any fees.

As an example, let’s say that the stock market as a whole returns 10% for the year and you’re looking at an index fund that costs 0.2% per year to own. In an ideal world, the return for that index fund would be 9.8% for the year. You got the 10% return of the stock market, less the 0.2% fee.

If the index fund’s actual return was significantly higher or lower than 9.8%, you should question whether it’s actually doing a good job of tracking its index. If not, then it’s probably not a good fund to own because you can’t be exactly sure of what you’re getting.

The point here is that it’s a pretty simple process to determine whether an index fund is “good”. It largely comes down to cost, as a lower cost index fund will naturally be able to give you more of the total return than a higher cost index fund tracking the same index. But regardless, it’s just a matter of looking at the numbers.

This is in direct contrast to actively managed funds. While there are definitely good funds and good managers out there, there’s almost no way to know whether you’ve picked one of the few good ones or one of the many bad ones. Like we said above, you’re better off flipping a coin when trying to pick an active fund than you are looking at past performance.

I would much rather be able to know for sure that I’ve picked a good fund.

Index investing actually works

All of the factors above are important, but none of them would matter if we couldn’t show that index investing actually works in real life.

We’ve already talked about the fact that active managers lose to the indexes. But the problem with that research is that no one can actually invest directly in an index. They have to invest in a mutual fund that tracks the index. So while that research shows us that active investing doesn’t work well, it doesn’t show us that the alternative DOES.

Luckily, we have some recent research that solves that problem.

You can read the details here, but in 2013 Rick Ferri and Alex Benke showed that someone who had invested in just a few simple, real-life index funds over the past 16 years would have gotten better returns than over 80% of other investors. And that was the low end. In some cases, index investing outperformed over 90% of the time with certain strategies.

This research was incredibly important because it showed that index investing was more than just a theory. It was something that could actually be applied in real life by real people to get better results with less effort.

It’s hard to argue with that.

It’s simply easier

The big downside of index investing — if you could even call it that — is that you remove the possibility of crazy-high investment returns. You aren’t going to get Warren Buffett results by investing in index funds.

But, if you pick a solid index investment strategy and stick with it, you will guarantee yourself two things:

  1. You WILL get market returns. Over the past 100+ years, those returns have been really good. There’s really no NEED to do better.
  2. You will get them with minimal effort. Most of those people who lose to index funds in the studies we talked about above spend a lot of time and effort trying to do better. And they fail. Why would you put all of that effort into something that’s likely to fail when there’s an alternative that’s not only better but easier?

Two variations on index investing (and the one I like better)

So, it’s plain and simple; index investing works.

But people love to tinker, and over the years they’ve come up with different ways to actually implement an index investing strategy.

As of now there are two basic approaches, both of which can be done well.

The most basic type is what I’ll call total market index investing. Basically, if you want to invest in US stocks, you would pick an index fund that represents the entire US stock market. Same for bonds, international stocks, and anything else you might choose to invest in.

The alternative is commonly called a slice and dice approach. There are a million different ways to do it, but basically it’s an effort to split each market up into different sub-markets, each with different risk/return expectations, and to invest in those sub-markets instead of the whole thing. A simple example would be splitting US stocks in big, medium and small companies.

When it’s done right, there is some really good evidence behind certain slice and dice approaches. I wouldn’t argue with someone who knew what they were doing and wanted to go that route.

But when it’s not done right, it really just becomes another form of active investing where people are trying to guess which part of the market will perform best.

Personally, I prefer a total market approach for a few reasons:

  1. It’s easier for people to understand, which means they’re more likely to stick with it.
  2. It’s simpler to implement and maintain and it still gets great results. Might there be something better? Maybe, maybe not. But do you really need something better to reach your goals? And if not, why introduce unnecessary complexity?
  3. The more you slice and dice, the less sure you can be of getting market returns. You introduce more uncertainty than what already naturally exists in the markets.

There’s no right answer here. In the end you should go with whichever approach feels right to you and that you can stick with.

But if you’re unsure, start with a total market strategy. It’s the one I use personally, it’s the easiest to implement, and it’s just as likely to outperform as the slice and dice approach.

What are the arguments against index investing?

index investing - arguments against index investing

Not everyone is a fan of index investing. Here the most common arguments against index investing that I’ve heard over the years, along with my response to each of them.

Index investing is lazy

Because index funds are “passive”, and because you’re supposed to hold onto the same funds through the ups and downs of the market, some people label index investing as lazy.

The truth is that there’s a TON of academic research backing it up. A lot of really smart people have spent a lot of time and energy studying this stuff and found index investing to be incredibly successful.

If it’s lazy to take all of the best objective research we have and apply it in a way that gets top-notch results with minimal effort, well then I guess I misunderstand the definition of the word.

Index investing will only get you average returns

I love this one. People always say things like, “well sure, if you just want average returns then index investing is okay, I guess.”

Really? Average returns? What about the research showing that index investing beats active investing over 80% of the time? Winning 80% of the time is average?

PUH-LEASE!!!!

But the market is about to [rally/crash]! I really think you need to [get in/get out]!!!

Everyone has an opinion about what the market is about to do. A lot of those opinions can sound really convincing. Sometimes, it’s honestly hard to argue with the logic.

But here’s the thing: What evidence do you have that the person giving you this opinion has consistently been right in the past? Do you know about all of their opinions, including the ones that didn’t work out? Are you able to track how they’ve performed over time? Is their opinion founded on decades of research that’s also been proven in the real world?

Anyone can have an opinion, and some people are really good at making them sound convincing.

But again, the cold hard numbers we actually have say that those opinions aren’t likely to be worth much.

This guy has a great track record!

It’s tempting to trust your money with the guy who’s recently produced great returns. All I’ll say is that you should look back at the data showing that past performance is less useful than a coin flip in predicting future performance.

What someone has done in the past has almost no bearing on what they’ll do going forward.

I like to be more in control of my money

A lot of people say they pick their own stocks because they like to be in control of their money. They say that no one has a stronger interest in their money than them, so why not take charge and pick their own investments?

Honestly, I get that sentiment. And actually, to a large extent I feel the same way. I have a pretty strong interest in seeing my own investments perform well, which is exactly why I choose to go with the approach that all the research has shown is most likely to make that happen: index investing.

But if you really want to try picking stocks, by all means give it a shot. Just go in with your eyes wide open to the probabilities.

Not all index funds are good

This is true. There are plenty of bad index funds. Some are high cost, some track too small a segment of the market, and some don’t track their index well at all.

Simply being an index fund isn’t enough.

The catch is that it’s pretty easy to identify a good index fund. It’s low-cost, tracks it’s index closely, and represents a large piece of a major market.

So, no, please don’t blindly go around picking index funds. There are plenty of bad apples out there. But since the good apples are pretty easy to find, the fact that bad ones exist doesn’t mean the strategy itself is faulty.

Index investing is boring

I actually have no rebuttal for this one. It is pretty boring. But are you investing because you want excitement or because you want results?

I know my answer.

Are you still on the fence?

I know I’m not going to convince everyone that index investing is the way to go. And that’s fine, because the most important thing you can do is to find a strategy you believe in and stick with it, no matter what that strategy is.

But before you decide to choose any particular investment strategy, I would encourage you to ask yourself one simple question:

“How confident am I that this strategy is good enough to get me to my personal goals?”

I like index investing because I know it works. I really can’t say that about any other investment strategy.

How to start index investing

index investing - how to start index investing

Okay, so you’re convinced! Index investing is the strategy for you. You’re ready to get started and you’d like to know how to do it the right way.

For complete guidance, I highly recommend the guide Investing Made Simple. It walks you step-by-step through every important investment decision, showing you exactly how to implement a personal investment plan that works.

But if you’re looking for cliffs notes version, you can start with this post: The Only 7 Investment Decisions That Matter.

Either way, the most important thing you can do is start. Your savings rate matters much more than the investments you choose anyways, so there’s no real harm in giving it a shot and learning from your mistakes along the way.

And remember, the proof is in the numbers. Index investing works and it’s supposed to be simple. You don’t need to overthink it or worry that you should be “doing more” with your investments.

Get started, trust it, and stick with it. Your future self will thank you.

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