Investing 101: An Introduction to Index Funds and Passive Investing
Published on - December 10th, 2008 (by J.D. Roth) This is a guest post from ABCs of Investing, a new site for novice investors. ABCs of Investing offers two short and simple investing posts each week.
Personal finance bloggers are vocal proponents of passive investing in index funds and exchange-traded funds. But not everyone knows much about these, and not a lot of bloggers do a good job of explaining the basics of passive investing. This post is intended to explain the basics — along with the basics of the basics!
I was inspired to write this article because of two separate but identical conversations I recently had with friends. They went something like this:
Friend: What do you invest in?
Me: I do passive investing. You know — investing in index funds and ETFs. ETFs are kind of like index funds.
Friend: I see… [Blank stare.]
Me: Do you know what an index fund is?
Friend: Nope.
Me: It’s a fund that invests in all or most of the stocks of a stock market index and gets a return which is equal to the index return minus a small fee.
Friend: I see… [Blank stare.]
Me: Do you know what a stock market index is?
Friend: Nope.
Me: I see….
With active investing, an investor tries to pick stocks that will outperform other stocks. With passive investing (also known as index investing or “investing in index funds”) an investor simply uses mutual funds to buy all of the stocks in the market. The basic idea is that with greater diversification and lower costs, a passive investor will generally do better than someone who buys actively-managed mutual funds.
Let’s cover some of the basic facts that my friends need to learn in order to understand passive investing.
What is a stock market index?
A stock market index (or just “index”) is a number that refers to the relative value of a group of stocks. As the stocks in this group change value, the index also changes value.
For example, an index might have a value of 1000 points at the beginning of the day. If the stocks in that index rise in value by 1% during the day then the index will be at 1010 points at the end of the day. Does this sounds familiar?
The Dow Jones Industrial Average (commonly just called “the Dow”) and the S&P 500 are two examples of stock market indexes. Most people (including my friends) who think they don’t know what an index is, in fact probably have a reasonably good idea.
What are index funds?
An index fund is a mutual fund that invests in the same stocks that are contained in a stock index, in the same proportion as in the stock index.
Imagine a stock index — let’s call it the ABC Index — that contains two stocks: IBM and Google. Let’s say that the ABC Index is currently made up of 60% Google and 40% IBM. If an index fund is based on the ABC Index, then it too will also invest in Google and IBM — 60% of the index fund will be Google and 40% will be IBM.
These percentages will change as the values of Google and IBM change. If the price of Google stock increases and the price of IBM stock decreases then the index will change so that maybe 65% will be Google and only 35% will be IBM.
The two main arguments in favor of index funds (and passive investing) are:
- Most managed mutual funds can’t beat their index over any length of time, and it is impossible to predict which ones will beat the index in any given time period.
- The significantly lower costs of index funds will ensure that, on average, index fund investors will have better returns than their managed mutual fund counterparts.
If you assume that the average mutual fund will earn the same return as the stock market index minus fees, then an index fund will outperform the average mutual fund because it has lower fees.
As an example, if a managed fund XYZ earns the same 8% return as the S&P 500 in 2009 but it charges a 1% fee, then the XYZ return will be 7%. If the ABC Index fund is based on the S&P 500 and only charges a 0.25% fee then the ABC Index fund return will be 7.75% which is three-quarters of a percent higher than the average managed mutual fund.
Over time, that difference is significant. After 25 years, the investor with the lower fees will have 19% more money invested than the investor paying the higher fees.
Passive investing is easy
If you want to get into passive investing, then I suggest doing some more reading on the topic, as well on possible asset allocations. Some books you might consider include:
- The Little Book of Common Sense Investing by John Bogle
- The Four Pillars of Investing by William Bernstein
- The Smartest Investment Book You’ll Ever Read by Daniel Solin
Regardless of whether you believe that index funds are better than managed funds, it’s certain that passive investing is much easier. You don’t have to analyze mutual funds or stocks — just pick some basic index funds and away you go!
SEARCH FOR RECENT ARTICLES
we find Mr. Bennett acting as if he is an authority
That’s not so.
What I know about investing, I learned from my participation with my fellow community members over the first seven years of The Great Safe Withdrawal Rate Debate. I have not studied investing in school. I have not run any big funds. The only “expertise” that I possess is as a journalist. I make an effort to uncover realities and to report on them. What I have done different is to apply a reporters’ skills to the field of investing in the way that many before me have applied them to other fields of human endeavor.
My view is that there is no such thing as “expertise” in InvestoWorld today. Our understanding of the subject matter is too primitive for anyone to be thought of as an “expert” in the way in which we use the word in other areas of life endeavor. I have learned a great deal from many “experts” and I am grateful for what I have learned. But I think that far too many work to give the impression that they know more than they really do. I think that hurts them and the people whom they advise.
The conventional wisdom today is that Passive Investing (sticking to the same stock allocation even when prices change dramatically) makes sense. If saying that evidences “expertise,” I want none of it. The idea does not even make sense. How could price not affect the long-term value proposition?
We all need to get back to the basics if we want to figure out how stock investing really works. We need to stop worrying about who is an expert and who isn’t and direct more effort to figuring out what truly makes sense. Expertise that means something will follow.
I certainly do not describe myself as an “expert.” I say that the “experts” have let us down. I am asking all “experts” to take a step back and reconsider their fundamental premises.
Rob
loading....
Mr. Bennett proves once again (as if that were needed) what an internet crank he is with his assertion:
“My view is that there is no such thing as “expertise” in InvestoWorld today.”
The idea that “Conventional experts” and “traditional education” are somehow beyond useless, and actually corrupting to a search for truth is a common theme for most cranks. Now, I don’t recommend anyone simply follow orthodoxy blindly, but neither do I recommend throwing over logic, common sense, education, reason, and sanity to become a follower of Hocomania. Thankfully, besides Mr. Bennett himself there appears to be only on other adherent to the cult, but no one listens to him either, so not to worry too much.
I will provide two links and allow others to decide for themselves if this character has anything to say worth listening to, for other than comedic value.
How to spot a crank:
http://en.wikipedia.org/wiki/Crank_(person)
From Mr. Bennett’s Website:
http://s162532268.onlinehome.us/Sewer/viewtopic.php?t=1010&sid=7c5c5c08142e18df96f26ccebe69f10b
loading....
Your comments are emotional in nature, Occam.
The biggest problem with Passive Investing is that it blinds us to the emotional aspects of the investing project. It is the emotional aspects that almost always do us in in the long run. My view is that we need to direct more effort to understanding why we become so intensely emotionally attached to our favorite investing strategies.
Rob
loading....
“The biggest problem with Passive Investing…”
Still carrying that ax to grind, eh, Hocus?
loading....
Still carrying that ax to grind, eh, Hocus?
Yes indeed, James.
I believe that the biggest reason why we have suffered this economic crisis is that millions of people who have long had doubts about the Passive Investing concept were cowed into silence during the time when Passive was all the rage. Had those of us in the “opposition party” spoken out more frequently and more strongly, I don’t think that valuations ever would have gone to such insane levels.
There are lots of smart and good people who think Passive Investing makes all the sense in the world. I think of those people as friends because I have learned so much from so many of them. But all my work is aimed at persuading people not to invest passively (and to instead always change their stock allocations in response to big price changes). I like to think that I am the most severe critic of Passive alive today.
Rob
loading....
I have a question about finding suitable index funds. I have a Roth IRA with Fidelity, and after reading about index funds on GRS, I really want to add an index fund to my small portfolio. I currently only have the majority in a target-date retirement fund, with little bits in one stock with personal meaning and two other funds that seemed promising. My overall balance is only about $10k right now, but I plan to contribute the max each year.
My question is- it seems with Fidelity that every index fund I find has a minimum investment of $10k. The only searches I’ve found on Fidelity’s website only show the Fidelity-based offerings, but I suspect there are more I could get there, possibly with lower minimums. Can anyone help me find index funds with a minimum of say $2500 that I can buy through my Fidelity Roth?
loading....