Tuesday, September 18, 2007

Why I Love Index Investing.

Index investing is the rage these days. Almost every financial guru recommends and encourages index investing – starting with the founder of this concept – Mr. John Boogle – who in turn was the founder of Vanguard. He recently wrote a book on this subject – The Little Book of Investing. Interesting book with lots of facts but one central theme – invest with index funds.

I became a convert to Index investing after I got burned in the dot-com implosion. I was buying technology and internet mutual funds being pushed by my financial analyst and when it was all said and done – I was scratching my head and wondering – there has to be better way. After all rule # 1 is – don’t lose the money and I broke the rule buying actively managed funds that projected exponential returns.

So what is an index fund and why is it a good idea to invest in one. Fundamentally an index fund represents or tracks an index. The most popular one being S&P500, but there are index funds covering all different indexes – S&P100, DJIA, Nasdaq, Wilshire 1000 … All these indexes track performance of a portfolio of stocks. The index funds tied to that index invests in the same stock portfolio using the same weighting and distribution. So in the end your return is the performance of the index. And the index performance is the market performance.

If you trust the market and want to bet on the US or Europe of Emerging markets – you buy index funds. In a nutshell these are the big advantages of buying index funds

  • Cost are low (.04% versus 2-5%) since these are not actively managed funds. And costs can add up. Image getting a 6% rate on your mortgage or an 8% rate. 2% points over 30 years will equal a large interest bill. Similarly each percentage point paid in fees is not working for you and eroding your portfolio value exponentially (remember compounding) over 10, 20 and 30 years.
  • You get the market performance – no more and no less. And the US stock market has returned 10-12% historically. If you don’t want to time the market and chase the next great idea – stick with dull and boring but consistent market return. If you believe in the US market – invest in the market.
  • No reliance on a superstar fund manager to deliver these returns to you. Actively managed mutual funds rely on star managers who are the exception and even they can be wrong. Just look as the recent meltdowns in the various hedge funds – being run by professional money managers who got it wrong.
  • There is no middle man – it’s you and the market. Goes back to cost and transparency. No financial advisors to take a cut, no upfront sales charges, no front-end loads, no back-end loads, recurring fees and clarity on what you are investing in.
  • Buy for the long term - This strategy works when you want to invest for the long term. My preferred approach is average cost investing. Keep buying every month. When prices go up – I buy less – when they go down – I buy more. I don’t time the market – just keep investing for the long term.

  • Explore your options – understand the concepts around actively managed funds and index funds. Index investing is an investing style – if it suits you – go for it.

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