Top 5 Reasons Why People Buy Index Funds
November 14, 2011
Ever since the whole idea of “Efficient Market Theory” came into vogue on the investing scene academics and several “experts” have been touting the advantage of index investing. For those of you that aren’t sure of exactly what index investing entails, it is basically a very low-maintenance strategy to guarantee your investments will return the exact average of the overall market. An index of a specific market (you can buy them for just the USA stock market, the Canadian stock market, or the entire world’s markets) automatically purchases a tiny sliver of many companies (if not all of them) within the market it is “tracking.” An index fund never buys more or less of a certain stock in order to increase returns, and is not actively managed like a mutual fund is. It simply seeks to buy a little bit of everything (this is usually accomplished by using a mathematical formula and not human judgement) and return the average of the market. While index investing is a much better approach than the ones some “gurus” advocate for, it still pales in comparison to the power of value-based dividend investing. Here are the top five reasons why people use index funds, and ultimately why they can do better:
1. Efficient Market Theory
The main reason index investing has become so popular is because many investors truly believe the academia-inspired theory that stock markets are perfectly efficient. The theory claims that the rules of supply and demand will dictate that a stock is perfectly valued at any given time. Any information that gives you an edge has already been incorporated into the stock’s price, and there is consequently no advantage to be gained. Of course, by looking at the markets in any given month (especially these last few years) we can see that while markets maybe fairly efficient in the long-term, they can be absolutely illogical and inefficient in the short-term. This creates opportunities for value-based investors.
2. Lack of Time
One practical reason that index investing makes a lot of sense to some people is that it essentially takes no time to do. If you are satisfied with returning exactly the market average in your portfolio (most people actually do much worse than this), then you can blindly set up your discount brokerage and just buy away every month or quarter. When you buy an index there is no research to be done or numbers to be looked at, you are simply buying every stock within a given market, so you are guaranteed to get all the “good ones” and all the “bad ones.” In the end you get the average along with no time commitment. While this is appealing, making a lot more money with a minimal time investment is superior in my opinion.
3. Instant Diversification
If you have ever turned on an investing TV show, or read the odd newspaper column about personal finance, you have no doubt heard the magical term “diversification” used. The idea behind diversification is that if you spread your investment dollars out as much as possible, than you can guarantee you won’t lose big (of course you will never win big either). This is exactly what index funds do. They will take your investment dollars and spread them out across geographical regions and hundreds of industries. This extreme diversification has the benefit of doing exactly what it claims it will do, and that is return the exact average (minus very small fees) of the overall market.
4. Mutual Funds Suck!
Please, please do yourself a huge favour and forget what mutual fund salesmen have pitched you on. Guess how many financial advisors make their money? If you guessed off of mutual fund sale commissions then you’d be correct. Make sure you know how your advisor is compensated so that you are assured of getting non-biased advice. The undeniable truth that has been confirmed by study after study, is that mutual funds and their highly-esteemed management teams cannot beat the market consistently once their high fees are taken into account. In fact, most can’t even beat the market straight up, even before they take their cut. The sheer idiocy of mutual funds and the extremely large amount of money they suck out of your returns (ever see a middle-class fund manager? Me neither) makes index funds look spectacular by comparison. Index fund advocates will say that fees and taxes are the only investment outcomes you can control, and this is why they are so much better than mutual funds. They are definitely 100% right in their comparison with mutual funds, but their overall premise does have some holes in it.
5. They Don’t Know About Value Investing
Ever hear of a guy called Warren Buffett? He is currently the third richest man in the world. Many people think he is some kind of wizard (his nickname is even “The Oracle”). The truth is, that Buffett and his partner Charlie Munger are not wizards, they have simply mastered the execution of an investment strategy known as value-based investing. While attaining Buffett’s level of expertise might be tricky, benefitting from the principles of value-investing is not that difficult, and it is also quite lucrative. Learning how to determine the proper value of a stock may sound intimidating and time-consuming at first, but it doesn’t have to be. The Simply Investing Course teaches you the same value-based approach that has made Buffett rich. It takes you step-by-step through how to confidently determine if a company is overvalued or undervalued at any given time. Once you start investing with this strategy in mind you can eliminate all the “bad companies” that are included in the index, and reap the benefits of having your investment dollars in the right place instead.
At the end of the day, index investing is fine for people who want to put thirty seconds a month into their investment portfolios and get average results. They are definitely superior to mutual funds, and some of the other get rich quick schemes out there; however, if you want to do better than average check out our Simply Investing Course.
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Reader Comments (2)
Kanwal, I enjoyed the post but I wouldn't be so hard on mutual funds. While you and I may be avid students of investing not everyone has the time or interest to do it right. Investing in a well diversified, tax efficient, low cost equity mututal fund is probably the right move for the vast majority of investors who can't or won't read a financial statement or do the kind of research necessary for picking individual stocks.
Hi miltonf, thanks for visiting! Yes, a low cost index fund might be the way to go for some people. However investing on your own is not very difficult nor does it have to be time consuming. Just that tiny bit of effort can result in huge gains over the long-term.