The Chorus of Voices for Index Funds

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Having read a small mountain of personal finance and investing books in the last couple of years, I’ve come to realize that there’s some significant overlap in the ideas presented in the books. Spend less than you earn and avoid high-interest debt pop up again and again, but I wanted to look at perhaps the most powerful idea presented across a wide swath of investment books: invest your money in index funds.

I wrote out the case for index funds a while back: they’re easy and don’t require much time investment, they’re very cost efficient, and they outperform virtually all managed mutual funds. However, I wanted to point out that this argument isn’t mine and mine alone – it’s shared by a small army of people who write on investment topics. (In the quotes below, I’ve added my own emphasis.)

For starters, John Bogle, the founder of Vanguard, writes in The Little Book of Common Sense Investing (read my review of the book) on page 200:

Deep down, I remain absolutely confident that the vast majority of American families will be well served by owning their equity holdings in an all-U.S. stock-market index portfolio and holding their bonds in an all-U.S. bond-market index portfolio… The rationale for a 100-percent index fund portfolio remains as solid as a rock. It’s all about common sense.

Burton J. Malkiel, a Princeton professor and a former member of the Council of Economic Advisors, writes in A Random Walk Down Wall Street (read my review) on page 358 of the ninth edition paperback:

For many investors, especially those who prefer an easy, low-risk solution to investing, I recommend bowing to the wisdom of the market and using index funds for the entire investment portfolio. For all investors, however, I recommend that at least a portion of the investment portfolio – especially the retirement portion – be invested in index funds.

Malkiel also writes in The Random Walk Guide to Investing (read my review), paperback edition, page 136:

[Index fund investing] has outperformed all but a tiny handful of the thousands of equity mutual funds that are sold to the public. Let’s list all the advantages of an index fund strategy:
- Index funds simplify investing. You don’t have to choose among the thousands of individual stocks and mutual funds available to the public.
- Index funds are cost-efficient. [Many] have no sales charges and have miniscule expense charges. Moreover, index funds do a minimal amount of trading. Thus, they avoid the very heavy transactions costs of actively managed funds, which tend to turn over their entire portfolio about once a year.
- Index funds regularly produce higher returns for investors than do actively managed funds.
- Index funds are predictable. You know beyond doubt that you will earn the rate of return provided by the stock market. Yes, you will lose money when the market declines, but you will never own the fund that performs several times worse than the market.
- Index funds are tax-efficient. If you do own stocks in taxable accounts (that is, outside your IRA or retirement plan), then you need to invest in index funds that don’t trade from security to security and therefor don’t tend to generate taxable gains.

What about Taylor Larimore, Mel Lindauer, and Michael LeBoeuf, authors of the acclaimed Bogleheads’ Guide to Investing (read my review), on page 78 of the paperback edition?

Index funds outperform approximately 80 percent of all actively managed funds over long periods of time. They do so for one simple reason: rock-bottom costs. In a random market, we don’t know what future returns will be. However, we do know that an investor that keeps his or her costs low will earn a higher return than one who does not. That’s the indexer’s edge. More specifically, here are the cost and other advantages of indexing:

1. There are no sales commissions.
2. Operating expenses are low.
3. Many index funds are tax efficient.
4. You don’t have to hire a money manager.
5. Index funds are highly diversified and less risky.
6. It doesn’t much matter who manages the fund.
7. Style drift and tracking errors aren’t a problem.

William Bernstein, one of the nation’s top financial theorists, writes on page 98 of The Four Pillars of Investing (read my review):

Clearly, the best way to avoid [overpriced and underperforming mutual funds] is to simply keep your expenses to a minimum and buy the whole market with an index fund.

And then on page 102:

Failing to diversify properly is the equivalent of taking [your stock investment's] uncertain return and then going to Las Vegas with it. It’s bad enough that you have to take market risk. Only a fool takes on the additional risk of doing yet more damage by failing to diversify properly with his or her nest egg. Avoid the problem – buy a well-run index fund and own the whole market.

Paul Farrell, a former Morgan Stanley investment banker and financial reporter, writes in The Lazy Person’s Guide to Investing (read my review) on page 111 of the paperback edition:

Of all the predictors, the [Financial Research Corporation] concluded that the expense ratio is the only really reliable one in predicting future performance, because funds with low operating costs “deliver above average future performance across nearly all time periods.”

Conversely, all other predictors turned out to be unreliable – including Morningstar’s famed star ratings and the highly regarded Sharpe Ratio developed by a Nobel laureate in economics.

Bottom line: if you want predictable performance, pick cheap funds. That means no-load index funds. And since Vanguard has the lowest expenses, it should come as no surprise that its funds appear over and over in the lazy portfolios developed by so many independent sources.

The Sharpe Ratio? That refers to William Sharpe, winner of the 1990 Nobel Prize in Economics and professor emeritus at Stanford. In Investors and Markets, he writes on page 146:

An index fund investor can then come very close to achieving the expected utility attainable with large amounts of expensive research and analysis… [the argument that] few of us are as smart as all of us, it is hard to identify them in advance, and they may charge more than they are worth is perhaps the most realistic argument for investing much (if not all) of one’s money in mutual funds.

Even Jim Cramer, who couldn’t possibly be a louder advocate of individual stock investing, says the following in Stay Mad For Life (read my review) on page 87:

Invest in index funds or the lowest-cost mutual funds offered by your 401(k) plan. This is the conventional wisdom on Wall Street, but it’s the advice that most people fail to take. People always want to know which mutual fund will give them the best return, but it turns out that’s a bad question. Even before you add up the fees, actively managed funds fail to beat the market 80 percent to 90 percent of the time. That means that at least in your 401(k), you’re better off investing in an index fund with low costs that simply tries to mimic the performance of the entire market than in a mutual fund that tries to beat the market.

Here’s the scoop in a nutshell, people. If you’re like me and you don’t have hours every week to study individual stocks, but you want to invest in stocks and enjoy some of the tremendous gains you can earn, there is no better option available to you than a low-cost index fund. As of this moment, every single dime (outside of my retirement plan) that I have invested in the stock market is in Vanguard index funds. I’ve watched tons of individual stocks and mutual funds and how they’ve done over the last few years and these guys are all spot on – index funds simply get the job done, easily and effectively.

If you have extra money and want to invest it in the stock market, index funds are the way to go. I got started with Vanguard and they’ve treated me exceptionally well both in investment quality and customer service – I’ve never seen any reason to go anywhere else.

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31 thoughts on “The Chorus of Voices for Index Funds

  1. You just cannot go wrong with an investment in Capitalism and that is what an index fund is. As capitalism does its thing and people make a profit the index fund goes up.

  2. I agree, and as you say, most people ought to apply this even more strictly with their retirement funds, i.e., 401k. Over the long run, mutual funds will likely have higher expenses, and you will be tempted to switch around more often. The majority of the population (and I count myself as one) would be well served at waiting until they can fully fund their retirement accounts each year, and then dabbling with individual stocks with “fun money”.

  3. This article couldn’t have come at a better time. I am very interested in investing in the stock market but I’m a little overwhelmed with the whole process. I’m more of the “easy, low risk investor” and this sounds like a perfect fit. I’ve emailed this to my sister as well who is in the same boat…

  4. I agree with a few of the points above, particularly that of Jim Cramer (surprisingly). If your hands are tied to a set selection of funds within a 401K, you’re probably better off going with the lower cost index fund options.

    Where I differ is that I think there are brilliant mutual fund managers out there who consistently outperform the market indexes. If you can find them, you’ll be well served. In this article – http://20somethingfinance.com/blog/2008/02/03/the-two-best-mutual-funds/ I highlight Ken Heebner, whose CGM Focus fund has beaten the large blend category fund average every year since 2000, by an average of 32.7% annually! If you can find guys who consistently perform like this, going with the market average is not the best path. They are rare, but they are out there. If you can’t find them, go with the index fund.

  5. I’m a fan of Jim Cramer’s. I watch his show and read his books. I don’t take a full dose of his advice cause I’m just not that smart, but I love his analysis of markets and how they work. But he is dead on accurate when he says that if you don’t have the time to do proper homework on individual stocks then you should go with index funds. He even says that this is the correct choice for the majority of investors. It’s clear he has a good deal of respect for John Bogle. But Cramer says if you don’t have time to listen to all the conference calls and read all the quarterly and annual reports for ALL of your stocks then you should simply stick with index funds – to me this is the ultimate plug for indexing – Cramer is very pro-stocks, but he admits it isnt’ for everyone.

  6. It’s like the chorus of voices that says that real estate always goes up. Hey wait!

    Whenever there is a chorus (herd), one strictly depends on demographics to make it work. Now, is there an increasing or decreasing number of investors. If one doesn’t know the answer to this …

  7. I agree about index funds. I am solely invested in them except for my one share of Berkshire Hathaway. For the people out there who think they are too boring of that say, “I want to be a stock picker” I understand, but index funds are the perfect way to START INVESTING. When you are beginning to read and consider putting money into the stock market you could be nervous and not sure what to pick. Totally normal. But if it takes you one to two years to finally get comfortable, you’re losing time. Index funds are the perfect “intro to investing” if you want to get started right away. Later on you can always have some “mad money” to pick stocks and see how well you can do. Even Peter Lynch is all about that strategy.

  8. Several of the quotes say that index funds are the best choice for “a majority of” or “almost all” investors. Do they specify the exceptions, or can you think of any situations in which index funds might not be the best choice?

  9. One thing to remember though, and this is clearly outlined by the fine people at fool.com, is that index funds are not for short term investing, whereas stock picking could be. In other words, if you put your money in Index funds, equate it to value investing, and let your money sit for at least 5 years. If not you might get sea sick from the ups and downs of the market. If you put 1000 dollars in an index fund, and needed to take that money out in 6 months, it may very well have gone down to 800, because of a bear market.

    So just make sure you know what timeframe you are working in.

    Alex

  10. Agreed. I’m 100% index funds right now. SP500 in my IRA and a russell 2000 small cap fund for the long term. I’m using etrade’s index funds. If I recall correctly, they had the lowest costs of them all at the time I bought in.

    Index funds just make the most sense in the long run. I’m perfectly happy with market returns.

  11. The thing that bothers me most is that when a crowd all says the same thing, many times it isn’t right. I personally avoid herd mentality.

    Everyone needs to keep in mind that the markets (and by default index funds) have, at certain times in history, had very long down trends or sideways moves. Many professionals believe we are entering one of those trends.

    That’s why I invest in individual stocks and ETF’s. I don’t just buy stocks, I buy businesses afther thorough research. And don’t tell me you don’t have time. We’re talking about your financial future.

  12. Ron:
    Would that mean for a guy like me (30 yrs old, and just starting to get into investing) this would be a great time to get into index funds? If in fact we are in for a long downward trend, by the time I am ready to start withdrawing, hopefully the market will be strong once again.

  13. I think we all agree with you Ron, but the average person is scared of stocks as it is, and it’s why index funds are so often recommended. It’s like getting people to contribute an extra 2% to their 401(k) when so many aren’t even signed up yet, you know?

  14. I work in the mutual fund industy (no, I don’t sell funds, I’m a back-office number cruncher and make no claims of being a financial advisor), and I’m a big believer in index funds. But making the decision to use index funds is just the first step. The next question is “What index funds should I invest in?” There are literally hundreds of index funds out there. Vanguard Funds offers over two dozen. Everyone immediately thinks of an S&P 500 Index fund, which may not be a bad place to start, but even with index funds, you ultimately need to invest in a diversified mix.

    IMHO, a well allocated portfolio of index fund investments can get you through those “long down trends or sideways moves” that Ron@TheWisdomJournal mentioned above. And regarding the “herd mentality”, although index funds may be commonly recommended, most of investors apparently are not following this advice. There is over $10 TRILLION invested in mutual funds and the majority of that is going into ACTIVELY managed funds, not passive index funds.

    When it comes to index fund suggestions, a few of my personal favorites come from Paul Farrell, who tracks a number of “lazy portfolios” made of index funds on Marketwatch.com and Paul Merriman’s recommendations on FundAdvice.com. FundAdvice also has some fantastic articles and tons of stats, which is great for number-crunchers like me!

  15. And they make a fantastic investment for your children – you can start with small investments, use dollar cost averaging and give them a solid portfolio to last their whole lives.

    I read an Australian book (great basic read) and uses just the principles of Index funds and compounding over time to invest a dollar a day for your children from birth (or whenever the idea strikes you!)….author Ashley Ormond, “How to give your kids $1 million each!”, publisher Wright books. Uses Australian laws/tax etc but the principle remains the same whatever the landscape.

    Index funds are just gathering momentum in Australia – we are buying our first large parcel shortly.

    Yay Trent on your fabulous news – just wonderful. If you are after ideas to stockpile entries, I would love to read more on giving children moneysense and providing them with marketing immunity and using different vehicles to save for children’s education. One other area we are finding a stretch is looking after older dependant relatives – as parents age and need care etc at home, with family or somewhere else – how to think about these costs.

    Hope your new lifestyle is everything you dreamt it would be. I’m of the school that socialisation for very young children is a cruel marketing ploy to get women back out into the workforce earlier – brain and ego development is such that they don’t really want to or need to ‘engage’ with other children until they are fourish onwards. Their little worlds necessarily start and stop with themselves. Next time you are at the daycare centre, maybe have a look at just how many of the children are actually interacting WITH each other rather than sitting in a small group doing their OWN thing. Too soon they will be at school every day, there are only a few handfuls of precious months before that happens, make the most of it now that you can is my advice.

    Lorraine

  16. This is from my earlier post:

    Index funds are not well diversified — especially the Vanguard 500 because it is weighted by large caps and high P/E stocks. If you want to lose money over the next 10-20 years, put everything you have in these funds. This advice seems to be a common myth that is extremely prevalent amongst the PF blog crowd and is quite disturbing. It would be nice to think that thought about investing is not necessary and mindlessly investing in an index fund is a panacea. I would advise that people do a bit more research into investing and balance the advice that Trent provides by also reading books by John Mauldin and Ed Easterling who provide a different perspective.

  17. Ron, I agree that researching and investing in individual companies is better than index funds – for me. However, for most people index funds are a better choice. It is not just a question of free time. Researching a company (and its industry) and evaluating it versus its peers, interpreting its financial statements, etc., is well beyond the average person’s abilities.

  18. Someone asked earlier about what index funds to choose? Start by looking at Vanguard. Fidelity is also another good choice.

    If you are afraid of the S&P 500 index fund there are other domestic funds that focus on the entire domestic market and total world funds (domestic and international markets). You can’t get much more diversified than that. I disagree with the person who said that the large blue chippers that make up the S&P 500 will be going down over the next 20 years. The dividends alone will make them outperform smaller companies in a recession.

  19. Souhail Karam and Stanley Carvalho
    Former Federal Reserve Chairman Alan Greenspan
    I have taken a little to reread with my comments.

    “In the short term, free floating… will not fully dissipate inflationary pressure, although it would significantly do so,” Greenspan told an investment conference in Jeddah.

    Still, “Gulf governments should consider the implication of such a move in the long term,” Greenspan said of the idea of floating their currencies.
    Mr. Alan Greenspan is a soaked in economy of the West where this has failed. Dr. Bernanke is trying to balance the budget that was left in shambles. Alan and Bernanke have the two roads totally separate. One is micro the other is macro economist. There is vast difference in the two cannon of economy. Alan as son as he left the office started writing a book Greenspan, A., The Age of Turbulence, 2007. AMERICA’s elder statesman of finance, Alan Greenspan, has shaken the White House by declaring that the prime motive for the war in Iraq was oil. He currently works as a private advisor, making speeches and providing consulting for firms through his company, Greenspan Associates LLC. monetary policy, and viewed by others as overly supportive of the policies of President George W. Bush, as well as for policies seen as leading to a housing bubble.
    Now with this trying to sell the book for cash and his talk of oil after he left the office is worth thinking about. Many economists and politicians wave a magic wand to us then when their time is up, we are holding an empty bag.
    The Lies of Alan Greenspan http://www.thenation.com/blogs/notion?pid=233482
    Until now. The economic consequences of his rule are accumulating and even the dullest financial reporters are stumbling on crumbs of truth about Greenspan’s legendary reign. It sowed profound and dangerous imbalances in the US economy. That’s what happens when government power tips the balance in favor of capital over labor, favoring super-rich over middle class and poor, then holds it there for nearly a generation.
    He is in the Middle East
    I thank you
    Firozali A. Mulla MBA PhD
    P.O.Box 6044
    Dar-Es-Salaam
    Tanzania
    East Africa

  20. I have to agree with Ron and Early Retirement Extreme (even though his website is self-indulgent schlok). Index funds and housing have been where the herd has parked their money for the past couple decades now. How’s that working out now?

    In the financial world, you can bet that once the herd starts doing something, it’s time to bet against it. Housing reached a peak last year or so, and has a lot further to fall. Index funds are just a representation of the overall market, and it’s going to take a pounding for the next few years. You are better off putting your money into an inverse fund (goes up when the market goes down) for a while.

    To the guy that listens to Jim Cramer: You are better off putting your money in a big pile and setting it on fire instead of listening to that guy. At least that way you would be warm for a while. Go look at Cramer’s “Stock Picks for a New Millenium” back in 2/29/2000:

    724 Solutions – SVNX
    Ariba – ARBA
    Digital Island – ISLD
    Exodus – EXDS
    InfoSpace.com INSP
    Inktomi – INKT
    Mercury Interactive – MERQ
    Sonera – SNRA
    VeriSign – VRSN
    Veritas Software – VRTS

    Most of those companies are bankrupt, and if you bought them, you would have about a 98% loss today. The only reason I would listen to Jim Cramer is to hear what NOT to do.

  21. You said: “…there is no better option available to you than a low-cost index fund.”

    I disagree. In many cases you can accomplish exactly the same thing with an even lower-cost ETF. So, there may be a better option than a low-cost index fund. To some degree it depends on your individual circumstances.

  22. “Another situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.”

    W. E. Buffett – 1993

  23. I have most of my portfolio in index funds – 90% in stock index funds, about 5% in bond indexes, and I use another 5% to pick stocks. I do it just for enjoyment, and pick relatively safe large caps that pay a dividend, typically (plus usually one or two tech stocks). Owning individual stocks is enjoyable intellectually, in my opinion, and you can really increase your returns by putting some of your money in individual stocks. For one, you aren’t going to see an index fund double in even its best year – but I have seen individual stocks do this on multiple occassions. I agree, however, that index funds are a very safe, easy, and tax efficient investment.

  24. Index fund are a godsend for the masses who don’t want to bother (or can’t) manage their own funds. It should be the first place new investors put their money.

    Best Wishes,
    D4L

  25. I agree about not listening to Jim Cramer – he has been an example of someone who is consistently wrong and won’t shut up for a long time.

    He’s even quoted in the Intelligent Investor (Graham) as one of the guys in the late 90s saying that tech stocks were the only ones that were relevant and guys like Buffet were past their prime. I have found his advice to consistently lag the market and sound like a recycled version of whatever the most traders are currently saying.

  26. To Ron at the “wisdomjournal” (that’s a bad hyperlink, btw): If given a choice of listening to anyone on the planet about investing, then I would put Warren Buffet on the very top of my list. Warren Buffet’s quote, above, is giving advice to _inexperienced_ investors. Buffet is probably the most experienced investor bar none. He is an expert in analyzing the financial information of companies and has made billions of dollars buying them (whole companies, not shares of their stock). If someone does not have the same time and expertise, which is most of us, then buying mutual funds is the right way to go. In short, your comment seems to intend to disparage Warren Buffet, but it only makes you look very foolish and very ignorant.

  27. I am a private investor based in the United Kingdom. I focus on seed capital, early-stage, start-up, ventures, LLC and all round completion and expansion of investment projects that need funding. I am interested to invest in your company on a long-term business relationship. If this is alright with you kindly get back to me with more details about your company. Dr. Frank Morgan.(Individual/Angel investor)

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