Index funds: The investment answer?

Yesterday, GRS reader Mike Robertson sent me a New York Times article about Gordon Murray, the author of a new book called The Investment Answer.

Mike writes, “I'm at a point in my investing life where I disagree with the guy, but what an interesting, compelling story.” (For reference, last year Mike shared a guest post about direct stock purchase plans.) What is this interesting, compelling story? It's about how Murray, who used to work for Goldman Sachs, Lehman Brothers, and Credit Suisse Fist Boston, has abandoned the prevailing paradigm of active investment management and now, as his dying act, has made it his mission to educate people about the virtue of index funds.

What are Index Funds?
The Investment Answer

Because it's been a long time since I wrote about index funds, let me briefly cover the basics for newcomers. As you probably know, mutual funds are collections of stocks. They're like baskets containing many eggs. If one of the eggs breaks, it may cause a bit of a mess, but there's no reason to panic, because you have lots of other eggs from which to choose. This practice is known as diversification. And contrary to your intuition, owning many stocks instead of one stock not only decreases risk, but also increases returns.

Index funds take diversification to an extreme. Index funds are mutual funds, but instead of owning maybe twenty or fifty stocks, they own the entire market. (Or, if it's an index fund that tracks a specific portion of the market, they own that portion of the market.) For example, an index fund like Vanguard's VFINX, which attempts to track the S&P 500 stock-market index, tries to own the stocks in its target index (the S&P 500, in this case) in the same proportions as they exist in the market.

So what?

Well, because indexed mutual funds base their investments on numbers and not on intuition, they require very little human involvement. Nobody's making the buying decisions. Computers are able to track market movement and then re-balance the fund as needed. This means that index funds have very small expense ratios. That is, they don't cost very much to operate. Over the long term, these low costs mean owners of index funds earn (or keep) more money.

Do index funds always come out ahead in a given year? Not at all. In fact, they're usually in the middle of the pack. By definition, index funds produce an average market return — no more, and no less.

However, over the long term — ten years, or twenty, or thirty — a remarkable thing happens. Index funds float to the top. It turns out that average performance in the short term is actually above average in the long term. Some mutual-fund managers are able to out-perform the stock market for a year or two, but they're not able to do this for a decade. In fact, over long periods of time, actively-managed funds tend to underperform the market.

Part of this is because — Warren Buffett aside — nobody can reliably pick winning stocks year after year. But the biggest reason index funds outperform actively-managed mutual funds over the long term is this: Index funds are cheaper. The average mutual fund has an expense ratio of about 2%. That is, for every $100 you have invested in the Magnificent Brothers' Growth Fund, you're paying a $2 fee every year. Index funds charge just 0.20% (or less!). Over time, this difference is huge.

In fact, over and over, academic studies have shown there are two things that most influence individual investment returns: expense ratios and investor behavior. Keep your expenses low and you're more likely to achieve above-average results. And stop trying to time the market!

Further Reading

But don't take my word for it. If you haven't made the time to read up on index funds, start by reading the New York Times article about Gordon Murray's legacy. Then head to the public library and pick up a book by John Bogle or William Bernstein or Daniel Solin. Or take the time to browse past GRS articles, such as:

I haven't written about investing much lately because my investing habits are boring. I no longer have the urge to beat the market. I don't have to prove I'm better than everyone else. I've read dozens of investment books, many of which come to the same conclusion as The Investment Answer. I'm persuaded. Though I may not write much about investing, I'm doing plenty of it. But all of my money is pumped into index funds. And I never touch them.

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LifeAndMyFinances
LifeAndMyFinances
9 years ago

Index funds appear to be a great option for many individuals.

I’m always interested to learn about a different type of investment. I think one of the most important things to do as an investor is to actually look at your portfolio once in a while. You might contribute to the company 401(k), but if you never look at your progress, the future will be bleak.

The market is dynamic and requires action.

Writer's Coin
Writer's Coin
9 years ago

It irks me that index funds are getting a bad rap because they “haven’t moved in 10 years.” 10 years is hardly long term, and that’s when (like you said) they rise to the top.

Long live index funds!

retirebyforty
retirebyforty
9 years ago

I believe every investor should start out with a solid base of index funds. This will give your portfolio an anchor point and once you learn more about investing, it’ll be easy to branch out into other funds and individual stock.

Nicole
Nicole
9 years ago

Preach it, brother!

We’ve also moved FROM individual stocks to indexes over time as we learn more about investing.

Other things to think about:

Fees (some index funds are more expensive than others for the SAME INDEX)
Rebalancing (you can get out of whack if specific indexes do better than others over time if you are diversifying using different indexes)
ETFs (if index funds are not available, these may be a viable alternative)

Chickybeth
Chickybeth
9 years ago

I think you meant that Index funds charge just 0.2%, not mutual funds.

Kevin
Kevin
9 years ago

John Bogle (the founder of Vanguard) wrote a fantastic book on this topic: “The Little Book of Common Sense Investing.” I highly, highly recommend it. The truth is, the entire financial services industry is built upon the idea of convincing people that they can beat the market. And yet, they all take their fees as a percentage of the amount invested, and not as a percentage of your gain (excluding exotic hedge funds unavailable to anyone reading this). Why is that? They sit there, encouraging you to buy and sell stocks, convincing you that you can beat the market, but… Read more »

Paul
Paul
9 years ago

I would also agree with Nicole’s comments and would emphasize the importance of looking further into index ETF’s. Not just as an alternative but possibly as an addition and/or integral part of your portfolio. FYI, institutional index funds inside of qualified plans often have the lowest on-going expenses. For example, VFINX is the S&P 500 for individual Vanguard customers and it has an expense ratio of .18%. VINIX is the Vanguard S&P 500 Institutional Index and it has an expense ratio of .05%. If you can access these instituional index funds without incurring additional plan fees you can cut your… Read more »

First Gen American
First Gen American
9 years ago

I’ve actually been burned by a financial advisor..nothing says incompetent like under performing the market in 2009. That’s pretty hard to do.

I fired him and went to mutual funds. A good chunk is in the S+P 500 vanguard fund and I couldn’t be happier.

Dylan
Dylan
9 years ago

The math is simple. Each index fund produces its market’s return (the average) before fees. Because the cost to participate in indexing is lower, the average dollar that is passively invested via indexing outperforms the average actively managed dollar. Case closed on the “only being average” argument.

By the way, many of the brightest advocates of indexing that I know are Wall Street converts like Gordon Murray. The fact that this fellow is spending his remaining months trying to save investors real money makes him a hero in my book.

Chris Parsons
Chris Parsons
9 years ago

For 95% of the population, index funds are the way to go. However, I chose to invest in individual stocks. Quite simply, I believe that I can do better than an index fund. If in 5 years I look back and that’s not true – then I will gladly change my tune. I wrote a post on why I chose individual stocks rather than index funds here:
http://www.smallbizbigdreams.com/money-finances/why-i-invest-in-individual-stocks-not-indexes/

matt ward
matt ward
9 years ago

One advantage of index ETFs over mutual funds is that in a down market you can sell covered call options on your ETF brining in a nice little extra return – anywhere up to 2% a year.

babysteps
babysteps
9 years ago

I am also an ex-Wall Streeter. Completely agree, over time study after study has shown that index funds produce higher returns with lower volatility (that is, less bouncing around – the statistical measure of risk) than actively managed funds, with lower hassle (not just costs). You don’t even need an advisor, just a low-cost brokerage account and some routines/self-discipline. I agree, it’s best to check your portfolio regularly. One hint: in most cases, it is cheaper to “rebalance” by shifting where you invest new money, not by selling and moving existing holdings. That is, if your target is 40% bonds… Read more »

Dylan
Dylan
9 years ago

“I’ve actually been burned by a financial advisor..nothing says incompetent like under performing the market in 2009. That’s pretty hard to do. I fired him and went to mutual funds. A good chunk is in the S+P 500 vanguard fund and I couldn’t be happier.” The difficulty of outperforming the market has nothing to with state of the market, i.e. a bull or bear market does not change the odds of outperforming. It’s always an equally hard thing to do! I’m a financial advisor and my investment advice will never out perform markets, ever. I say, get as close as… Read more »

Jason Beck
Jason Beck
9 years ago

I try not to comment just to point out typos, but I can’t get past this sentence – “but also to increases returns”

honeybee
honeybee
9 years ago

The Bogleheads’ Guide to Investing is the single best-explained “encyclopedia” of basic investment options that I’ve come across, and they go into great and clearly-explained detail about exactly why Index funds are better for your wealth.

Contrarian
Contrarian
9 years ago

Charles D. Eliss makes a compelling case for index funds in his book “Winning the Losers Game”.

Dan
Dan
9 years ago

I also liked “Winning the Losers Game”!

I also suggest “What Works On Wall Street” — check this out at the library, it isn’t really a book to read but an overview of several hundred investing strategies.

J.D. Roth
J.D. Roth
9 years ago

And I bolded that sentence, too, Jason. How embarrassing is that?! 🙁

Kevin M
Kevin M
9 years ago

Actually, Warren Buffet hasn’t done so well lately.

http://www.businessinsider.com/warren-buffett-has-not-generated-any-alpha-in-10-years-2010-10

I don’t like index funds for a couple reasons:

1) you are guaranteed to hold losers too long
2) when people hear index fund they think “I’m diversified!”, but almost 20% of the VFINX fund linked above is made up of 10 stocks
3) sometimes you can actually get lower expenses buying individual stocks or ETFs

tinyhands
tinyhands
9 years ago

You don’t have to beat the market to be a successful investor. “Beat the market” is one of the biggest scams perpetrated on investors of all time. It’s an easy little phrase to say, so people parrot it like some sort of gospel. It turns investing into a zero-sum GAME, which it most definitely is not. You only HAVE to beat inflation, which is generally pretty easy to do. The other thing you should do is have a plan and follow it. If your plan for retirement includes only having to average 4% growth over 30 years, you’ve got a… Read more »

G
G
9 years ago

J.D. I think you meant to say *index* funds charge 0.2% (or less!) , not *mutual* funds.

Dylan
Dylan
9 years ago

@matt ward: “One advantage of index ETFs over mutual funds is that in a down market you can sell covered call options on your ETF brining in a nice little extra return — anywhere up to 2% a year.” That’s only one side of the coin. Those options may be exercised and you may have to give up stock below market value, or you may only be able to close them out at a loss, either case costing you anywhere up to 2% a year or possibly more. The options market prices itself to eliminate the kind of easy money… Read more »

Dylan
Dylan
9 years ago

“but if he starts talking about beating the market, walk away.”

Unless it in the context of why it’s not even worth trying. 😉

Jenn Hill
Jenn Hill
9 years ago

Note that the book is already sold out on Amazon.com. People are paying attention to these ideas.

Philip
Philip
9 years ago

This is a great topic to be discussing. Just to be upfront, I am an investment advisor. There are many things that I have learned about investments. The first is if it seems to be to-good-to-be-true, then usually it is. People always try to get into and out of investments because they have a feeling, or because of some anecdotal evidence. There is always someone who will do better than the market, but the question is out of the over 65,000 mutual fund available worldwide (see the ICI Fact Book) what are the odds that you will pick the manager… Read more »

Brent
Brent
9 years ago
I’m on the no-brainer plan. Age as percent in Total Bond Index fund, The rest as Stock Index Fund. Reinvest all returns. Sure, I could spend time trying to get ahead, just like that guy who swerves in an out of lanes. But we all sit at the stoplight eventually. Sit back and recognize that an extra .5% return won’t make you any happier than taking that time to head to your nearest park.
Suzanne
Suzanne
9 years ago

After once having to sue a financial planner and then having one that charged big fees while giving little attention to my little portfolio, I now manage everything myself. From the research I have done, I am a believer in Index Funds.

I have two index funds: one for my stocks and one for my bonds. I rebalance every quarter if necessary, and just add to those accounts.

Mike Piper
Mike Piper
9 years ago

A short book with a lightbulb on the cover promoting the use of index funds? I suspect I’ll like it! 😀

Duke Matlock
Duke Matlock
9 years ago

My two problems with index funds.

1) They are passive. I know people who got severely burned in the 2007-09 bear from complacent investing.

2) When I buy an index fund, I’m tied to every stock in the index. If I only would consider 50 of the 500 suitable for further review, why would I want an index fund.

Separately, the srticle slants perception by stating 2% for fees. If they shop around, investors can easily get far lower fees.

Kent @ The Financial Philosopher
Kent @ The Financial Philosopher
9 years ago

Passive investing is an important topic to revisit on a regular basis. Great job, JD! I’m a CFP(R) and fee-only investment advisor. Since I started my own business four years ago, I’ve been shifting clients to index funds and ETFs. My reasoning is that the greatest determinants of a given portfolio’s performance are asset allocation and expenses. Even the greatest investments, combined with poor allocation and high expenses, will lose to a well-diversified portfolio of index funds. The talk about a “lost decade” and “buy and hold is dead” is media noise directed at the one-fund strategy. A passive strategy,… Read more »

Everyday Tips
Everyday Tips
9 years ago

I love index funds. I have lost money in individual stocks, and I just sleep better at night knowing I am spreading the risk around.

RW Cook
RW Cook
9 years ago

Yep love index funds. When folks talk about the market doing nothing for 10 years they are usually talking about the SP 500. But if you’ve diversified into non-correlating Indexes such as REITs and assorted bond funds you’ve made out okay the last 10 years.

Aside from Bogle, Bernstein (highly recommended)and Zweig, here’s another resource for the uninitiated…
http://www.marketwatch.com/lazyportfolio

RW Cook
RW Cook
9 years ago

Brent’s analogy of the driver swerving in and out of traffic to get ahead is BRILLIANT.

A great explanation for risk and return

Mom of five
Mom of five
9 years ago

Our retirement dollars are mostly in index funds and bonds. We have just recently begun investing non-retirement dollars in ETF’s (Agricultural and Oil). I’m glad to see them mentioned here. At this point, they’re a very small part of our non-retirement savings(less than 2 percent), but I’m not completely sure I understand them and would really appreciate an in depth discussion. I just figured they’re a good hedge against inflation.

Philip
Philip
9 years ago

Mom of five — I am glad you asked for clarification about commodity based ETF’s. As I mentioned before, you definitely need to know what you own and why you own it. Commodities are perceived as an effective hedge for inflation because their returns are positively correlated with inflation. Basically that means commodity prices, like oil and gold, typically move in the same direction at the same time. BUT, commodity prices are much more volatile than stocks are. Unlike stocks, commodities do not generate any future earnings or create business value. So, it is a type of speculation of where… Read more »

honeybee
honeybee
9 years ago

Another typo… Credit Suisse “First” Boston (yeah, I know, sorry also to be a pain)

Walter
Walter
9 years ago

I prefer mutual funds that are income funds: that is, funds that pay a monthly dividend. These tend to be fairly heavily weighted in bonds and therefore tend not to increase or decrease in value as quickly as more heavily stock weighted funds. The added benefit is that you can truly take advantage of dollar-cost averaging if those dividends are reinvested. Of course, I still have SP500 and Russell 2000 index funds, but as more of side dishes than the main course.

Sun
Sun
9 years ago

When google employees became millionaires, all the financial experts told them to invest in index funds. I think industry specific “index” funds is like picking individual stocks.

John G.
John G.
9 years ago

buy-and-hold is outdated though. You can use an index fund to ride the ups for a few years, but long-term, that is not great.

For example, if you invested in SPX in 1999, you would have a few years of up and a few years of down. If you blindly stayed in the whole time, you would just now be breaking even again:

http://www.ritholtz.com/blog/2010/12/buy-hold-vs-trend/

Lamont Bradley
Lamont Bradley
6 years ago

Great read! I love to browse your blog in that little free time I get.

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