Why Does Everyone Preach About Index Funds? What They Are And Why They’re Good – From The Very Beginning

yepA reader asked me recently why so many people write glowingly about index funds. I even do this – in fact, all of my investment money is currently in index funds. What are they, and what’s the big deal behind them?

I’m going to try to summarize a lot of economic theory in a way that as many people as possible can understand. To do that, I’m going to generalize in some places and not be exactly precise. You can jump in with commentary if you wish, but keep that in mind when you do.

Let’s start at the very beginning. When you go to work, you’re paid a certain amount of money. The reason that an employer does that is because they believe the work you do provides more value to the business than the wage they pay you. Otherwise, they would either pay you less or give the work to another worker. It’s for this reason that bosses hem and haw about giving people raises.

If you work for a large company, there are a lot of people working there, and theoretically all of them are providing more value each day than they’re getting paid. This is how a business builds itself up and turns a profit. In a nutshell, an average business should always be growing in value because of the efforts of the people working there.

Overall, though, all of the workers at all of the businesses in America are producing more valuable work than they’re getting paid. This is called productivity, and the productivity numbers for the United States indicate that it’s a very productive nation, indeed – the workers of the United States as a whole, from the CEOs to the janitor, produce more value than they’re getting paid.

Where does all of that extra value go? That value is the value of the businesses themselves, and for publicly traded companies, that’s reflected in the values of their stocks. Stocks are just a representation of the business, after all.

Let’s summarize: people are paid to work because they add more value to the business than they are paid. So, in the natural state, over time the value of a business should go up. If a stock represents a small piece of a company, then the value of that stock should go up.

As we all know, sometimes bad management or other issues causes the effort of lots of employees to go to waste. Take Enron, for example – that’s an example of how management can fail, but these failures are relatively rare and it’s very hard to predict them. Lots of things can cause a stock to fall temporarily or permanently, but the continued effort of all of the people involved means the natural state for a business is to increase in value, and thus for its stock to go up.

Now, let’s say you have the money to invest in the stock of one company. A lot of people invest this way by choosing individual stocks to invest in. That one company might be a really good one and skyrocket. It might also just be an average company and just do average. It might also be another Enron and just completely fall apart.

Obviously, you want that high-riser, but what you really want is to avoid that Enron. If the stock you happened to buy is another Enron, your money is gone. This is a very big risk with individual stock investing – if you buy a lemon, your money goes poof.

Now, as I mentioned above, the average company’s stock should go up in value because of the contribution of the work of all of the employees. Over the long haul, that has always been true. There are more good companies out there than bad. The average stock over a long period should go up, but not all stocks do.

One way of getting around that risk is to buy a lot of stocks, often called a portfolio. If the average stock goes up, but not all stocks do, if you own a big handful of stocks, a few will likely be bad, but there will be enough good ones that your overall money should increase in value. But there’s still a risk – let’s say you make three or four unfortunate choices out of ten? It happens very easily.

You want to keep minimizing that risk of bad stocks, so you keep buying more and more and more individual stocks. Eventually, you just buy everything that meets a certain set of criteria – say, all of the stocks on the New York Stock Exchange with a value of more than $100 million. This way, you own all of the companies and the idea that all of the workers in America as a whole are producing positive value is working for you. You’ll own a few lemons, but you’ll also own a few home runs, too, and you’ll own all of the average stocks that are going up over time because of the contributions of their workers that we talked about at the start.

That strategy is called indexing, and you can buy them in the form of index funds. An index fund is exactly what I described above: they define some rule or set of rules, then just buy the stocks that follow that rule. Because it’s so easy to do this, the companies that run index funds generally don’t charge very much in fees for doing this for you.

It’s popular because it’s very easy and it works. Instead of worrying about a lot of investment choices, you just pick an index fund or two and simply put money in them until you need it. The companies that offer them don’t charge much at all for the service of doing this, either.

Why don’t people do this all the time if it makes such sense? Many investors want to trust a human with their money, not a rule or a philosophy. They like to put money in a mutual fund that is managed by a person or a team of people – these people spend their time looking at stocks and making active choices about which individual stocks to invest in.

That philosophy sounds very nice – and there are a lot of people who do that because they trust fund managers to make good choices. There are just a couple problems: humans are fallible and imperfect, and these personally-managed funds are laden with fees to pay the people to manage the fund. While you have the positive of human intuition, you have the negatives of human fallibility and the large fees.

In a nutshell, people get very excited about index funds because they’re very easy to invest in and they naturally minimize your risk. They take maximum advantage of the fact that no matter what business you work in, when you go to work you contribute value to that company. While it’s not the be-all end-all of investment strategies (you can’t have huge gains, for example), it is very strong because it minimizes the risk of investing in stocks without giving up some very strong gains.