Updated on 02.18.15

What Is Index Investing and Why Does It Work?

New York Stock Exchange

Even professional Wall Street traders struggle to beat the market. Photo: Brian Glanz

There are an almost infinite number of ways to approach investing, but my personal favorite is called index investing. It’s a simple strategy that can yield remarkable results. I use it myself and it’s the strategy I recommend to clients who come to me for investment advice.

My goal in this post is to explain what index investing is and why it’s effective so that you can decide whether you would like to use it for your own investments.

What Is Index Investing?

At the highest level, there are two different approaches to investing: active and passive.

Active investors try to use their skill to beat the market. Some do it by trying to invest in companies they think have strong long-term growth prospects. Others do it by trying to time the ups and downs of the market, getting in and out at the right moments. And there are plenty of other approaches, all with the goal of either improving returns or reducing risk relative to the market as a whole.

Passive investors look to match the market returns. Instead of trying to pick stocks or time the market, they manage their expected risk and return by dividing their money up between different types of investments. Some money might go into the U.S. stock market, some into international stock markets, and some into the U.S. bond market. How they spread that money around will affect the returns they receive, but with each type of investment they are simply taking the market return rather than looking for an edge.

Index funds are simply mutual funds that attempt to mimic a given market. Continuing with the example just above, there are index funds that mimic the U.S. stock market, international stock markets, and the U.S. bond market. There are actually many more than that tracking many different markets of all shapes and sizes, but each one shares the same basic principle: Its goal is simply to match that particular market’s return.

Index investing is therefore simply the process of using index funds to build a passive investment strategy. Index investors decide which markets they want to invest in, how much of their money to put in each one, and utilize index funds to put that plan in place.

Why Is Index Investing Effective?

Based on the definitions above, it might sound like index investors are “settling” for average returns while better, more skilled investors are out there achieving much better returns.

That couldn’t be further from the truth.

Index investing is an incredibly effective strategy. A 2013 study by Rick Ferri and Alex Benke actually showed that index investing outperformed similar active strategies anywhere from 80-90% of the time. That is, in the vast majority of cases, simply taking the market returns produced better results than trying to beat the market.

But how can that be true? How can such a simple strategy produce such positive results? Let’s look at a few of the biggest reasons.

Active Investing Is Really Difficult

As it turns out, beating the market is actually really hard to do. The truth is that there are millions of people all investing in the same relatively small set of opportunities, and beating the market means you have to have an edge over most of them, including the people who do it for a living.

The numbers show just how difficult it is to do that.

Average investors regularly underperform the stock market by 4-5%, often because of failed attempts to time the market.

But even investment professionals have trouble. Year after year, the majority of professional investors fail to beat the market. And even worse, there’s no consistency to their performance. The ones who outperform one year are no more likely than pure chance to outperform again the next year.

The moral of the story here is this: Most investors, both everyday people and professionals, lose to the market. Therefore, market returns are actually above average.

So index investing, which simply seeks to achieve market returns, is actually more effective than most active management strategies.

Index Investing Is Low-Cost

One of the biggest reasons that index investing is so effective is also one of the simplest: It’s low-cost.

Cost is actually the single best predictor of a mutual fund’s future performance. Better than past returns. Better than the fund manager’s track record. Low costs lead to better returns.

Index funds are often the lowest-cost investments available simply because they don’t require a portfolio manager who needs to be paid. And they also don’t incur all the trading costs, taxes, and other expenses that go into some of the more active strategies.

Index funds have a simple job: track the market. That simplicity keeps costs low, and those low costs are passed on to you in the form of higher returns.

Index Funds Are Diversified

Diversification is one of those fancy investing words, but all it really means it spreading your money out into lots of different types of investments instead of putting all your eggs in just a few baskets.

For example, instead of buying just a few stocks, you can diversify by buying stock in every single company in the US. By doing so, you’ve removed the risk of any single company sinking your investment portfolio.

In fact, diversification is often called the only “free lunch” in investing because it’s the only way to decrease your investment risk without decreasing your expected return. With that kind of benefit, why wouldn’t you take advantage of it?

Because index funds invest in entire markets, they are a great way to get the diversification you’re looking for.

Index Funds Are Consistent

Sticking to your investment plan is one of the five most important things you can do as an investor.

As the markets move up and down, there will always be people around you consumed with either fear or greed. But buying and selling based on those emotions typically doesn’t end well, as we saw with the numbers above. Instead, the best investors stick to their plan no matter what is going on around them.

Index investing makes it relatively easy to stay consistent. When all you’re doing is picking a few different funds to track a few different markets, there simply isn’t all that much to tinker with. And the index funds themselves will keep right on tracking the same markets, so there’s no risk that some manager will suddenly decide to do something different, forcing you to rethink all your investments.

Consistency is key, and index investing makes it easy.

Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents build a better financial future for their families. His free book, The New Family Financial Road Map, guides parents through the most important financial decisions that come with starting a family.

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