By periodically investing in an index fund the know-nothing investors can actually outperform most investment professionals. ~Warren Buffett
WHAT IS AN INDEX FUND?
An index is a measurement of tradable assets such as stocks and bonds. An example of an index is the Dow Jones Industrial Average. The DJIA is a measurement of 30 specific stocks. If someone says, “The Dow is up today,” it means that many or all of those 30 stocks (which include the likes of Disney, Coca Cola, and Apple) have moved to the upside and increased in market value during that particular day's trading session.
An index fund is a type of mutual fund. A mutual fund is a collection of stocks or bonds that are grouped together based on certain characteristics, such as company size or industry type. In the case of an index fund the characteristic is market mimicry. That is to say, an index fund is put together using a specific type of sampling in order to mirror the movements of a particular index as a whole. In other words, if you buy a Dow Jones Index Fund, your returns should coincide exactly with those of the Dow Jones Industrial Average.
Buying shares of an index fund is like accepting defeat and laughing all the way to the bank while doing it. You may have thought that the goal of investing was to beat the market. The truth is, if you can simply be the market that is good enough.
From 1926 to 2018, the S&P 500 index has returned an average of 10 percent annually. So for instance, if you invested $1,000 in an S&P 500 index fund, and just put in $200 a month for 20 years, your $49,000 investment would be worth over $144,000 thanks to the magic of compound interest. You did not have to beat the market to get this massive return; you simply had to mimic it. The index fund is the investment vehicle that allows you to do that.
ALPHA vs. BETA
In stock market terms, an investment’s risk is measured by its beta. The stock market as a whole has a beta of 1. Professional investors and traders are said to be “seeking out alpha.” This means they are looking to beat the market. The alpha is ahead of the beta.
Let us switch from investor vernacular to modern slang, and speak of what it means to be an alpha or a beta, and why you cannot let words or misunderstood ideas get in the way of your financial progress. It is understandably difficult for some novice investors to put aside their internal need/ desire to be the proverbial alpha and take charge of things or take things by force. A deep competitive nature inside leads the alpha to try to win. All it takes to be a successful investor, however, is the simple realization that it is perfectly fine to be the beta (i.e. to move with the market). In the end, by stepping back, you will ultimately win.
What I am talking about here is essentially the story of the tortoise and the hare. Flash and speed are no competition for patience and persistence. In other words, thanks to the invention of the index fund, we do not have to “beat” the market. Simply moving at the same pace as the market will likely get us to our financial goals much quicker. It may seem counterintuitive but being the beta is the ultimate alpha move.
INDEX FUND INVENTION
It is often difficult to convince novice investors of the value of index fund investing. This is perhaps because of its sheer simplicity. Even the inventor of the index fund was not initially convinced that they would work.
Any rudimentary search for the inventor of the index fund will lead you to the investing pioneer Jack Bogle. Bogle created the first index fund in 1976 (known today as the Vanguard 500 Index Fund). Nevertheless Bogle was adamantly against these passive investment vehicles. He even went so far as to say that, “Market averages can be a dangerous instrument for evaluating investment management results.”
A recent post on Get Rich Slowly shines a vivid light on Bogle’s evolution on the idea of index funds. In 1960 -- in an article entitled “The Case for Mutual Fund Management” written under the pseudonym John B. Armstrong -- Bogle argued against the idea that mutual funds could be low-cost, passively managed, and economically viable. Important to note here: at the time, Bogle was in the business of active mutual fund management, so it only seems logical that he would be against the very thing that would undercut his livelihood.
In the 1960’s Bogle was an aggressive investor seeking outsized gains. In other words, he was seeking alpha. Bogle, nevertheless had his index fund “eureka!” moment. In the mid-1970’s, Bogle’s investment strategy changed completely when he realized that actively managed funds underperformed the S&P 500 index. Not only that, the underperformance was weighed down even further by the cost to manage the fund. Thus, the construction of the fund was useless, as was the cost to manage it. By simply doing nothing, one would have done better. What I mean is to say is, just let the market do what it's going to do and in the long run you will be better off just sitting back and enjoying the ride. Trying to beat the market and the cost thereof are all about vanity in both senses of the word: ego and futility.
In 2019, when Jack Bogle passed away, Warren Buffett said, “If a statue is ever erected to honor the person who has done the most for American investors, the hands-down choice should be Jack Bogle.” The invention of the index fund has completely changed the world of investing. Out of the $18 trillion in mutual funds right now, $7 trillion is in passive, low-cost, index funds. Index funds have provided an entryway into the confusing, costly, and overwhelming world of Wall Street for the novice investor.
Not every investor has to be Warren Buffett – a genius stock picker who has returned over 20 percent annually since 1965. Nor do they have to be the prototypical Wall Street trader that you see in the movies, who is the ultra competitive alpha-type looking for quick gains during volatile market swings. It is good enough (and oftentimes better) to be Jack Bogle: the tortoise in the race with a bunch of hares.
Investing is a marathon not a sprint. If you contribute regularly to an index fund over a long period of time, you will remove most of the risk from investing while also (almost certainly) guaranteeing future returns. It is a deceptively simple investment strategy that has been proven to work. As Jack Bogle said, "Don't look for the needle in the haystack just buy the haystack." In other words, you do not have to pick winning stocks to get consistent returns on your investments, you simply need to invest in a low cost index fund and patiently wait as the market trudges ever-upward