What Is Index Investing?

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As you learn more about the investment world you hear a lot of people talking about “index investing”, “index funds”, and “passive investing”.

If you aren’t completely sure what they are I’ll explain what makes them different and why they are so important.

Index investing and passive investing fit together very well so you will hear those two words a lot.

Personally I chose to passive index investing as the best way for me to go. When you’re new to investing it can all seem like another language. They are the best choice for investors who don’t know a lot about the stock market though so it’s worth understanding a bit about them. If you’re looking for a simple explanation that shows you what they are and why people keep talking about them, keep reading.

. . .

Have you ever been to a restaurant and felt like you couldn’t decide what to order? This happens to all of us. Investors have the same problem but the risk of making a mistake with their money is far higher. Instead of one bad meal they could lose hundreds of thousands of dollars.

Now imagine that you could order everything on the menu. Sure, a few things just wouldn’t be good. Other dishes would be a lot better than you imagined. If it’s a nice restaurant you would get good quality overall by doing this.

You probably can’t eat everything on the menu at a restaurant. But for investors this idea actually does make sense. That’s really what index investing means. It’s buying everything on the menu instead of trying to figure out the best choice.  If this sounds strange to you, you aren’t alone. With our jobs, houses, cars, and relationships we aren’t used to choosing everything at once and if we did it would only cause more problems.

It actually took a long time for investors to realize they could do this and it wouldn’t end badly. The first research on the idea was done 60 years ago and since then many studies have shown that it works. Even today a lot of people don’t believe the results though.

It’s like saying that flying is safer than driving. It doesn’t sound right at first. When you look at the numbers you have to believe it. But a lot of people are scared of flying anyways.

Index investing evolved out of the mistakes that we made in the past. Together with passive investing it is the best way for an average person to invest and make money without having to be a genius or read thousands of pages of financial reports. Today more and more people are starting to see this.

Why are we investing anyways?

The way you invest depends on what you want. If you want the excitement of winning a bit of money you can always go play blackjack at the casino. If you just want to talk about RRSPs all day… haha I’m kidding, you really want to avoid that as much as possible.

Most investors want one thing: they invest so they can buy future income. If you invest $100 in a company and it pays you back $300, that’s good. The investment that pays you the most over your lifetime is the best. There are thousands of investments that could do this. I invest in the stock market like many other people because it’s easy for anyone to do. That means we buy a small piece of a company (shares) so we are entitled to a portion of its profits.

But even people buying the same investment can do it for different reasons. There are two big ways to invest: short-term speculation and long-term investing.

If you buy shares in Ford because they are $20 today and you think they will be worth $40 next year, that’s short-term speculation. The price of a stock next year depends on popularity and the emotions of other speculators. This is very unpredictable and a lot of people lose money with speculation. But because there is always the chance that you could win big (like a lottery) it’s very exciting.

When someone says the stock market is a casino this is exactly what they are talking about. In the first stock markets 400 years ago there was a lot of speculation and this gave them their reputation as a gamble. The financial crisis in 2008 was caused by speculation too. People knew they were making bad investments but they did it anyways because they thought the price would go up a bit more.

There is another option. If you buy shares of Ford because you think it will make a good profit in the next 20 years and you want to own get a piece of that profit, that’s long-term investing. Big companies can keep making profits for a long time so this is a lot easier to figure out.

In the next 12 months anything from natural disasters to strikes could hit the company but in the next 10 or 20 years they will figure out a way to solve those problems. It’s like your career. One year you could get a surprise promotion. Another year you could get laid off. But over the 40 years that you work you can guess what you’ll be doing and how much you’ll earn.

Business is similar. The surprises are much bigger (even if you get laid off you won’t lose $10 billion!). But they average out if you wait long enough. Speculators are betting on those surprises. Long-term investors are betting on the whole “career” of a business.

Some speculators do well and make it seem easy (even if they just got lucky). Most of them lose it all pretty quickly unless they stop gambling. The long-term investors are the ones who do best. They are also called passive investors because most of the time they aren’t doing anything. They just keep owning the same shares or buying more of the same.

This makes passive investing seem a lot more boring than speculation since you can go for years without making any big decisions. But boring investing is the best way to make money and take less risks. Imagine being trapped in a burning building – you wouldn’t be bored, but you wouldn’t like it either. Speculating is like running around in a burning building trying to find something valuable. Long-term investing is more like building a house yourself and buying one thing at a time to fill it up.

It might not get your heart pumping but would you rather be in your perfect home where you chose everything, or in a building that could collapse on you at any moment? Passive investing is like this. You’re not going to get a big lottery-ticket win next year. But it is a lot simpler and less risky.

An investment story in three acts

There’s still one more question: which stocks should you buy? There are three ways that investors have chosen their stocks. The problems with the first two are what led to index investing. All three are still done today.

At first people just bought shares of a few companies they liked. In 1900 you might see that Standard Oil was making a lot of money and buy some of its shares so they would send you dividends. Back then companies didn’t have to tell investors what they were doing so you would buy the shares and hope for the best.

Speculation was very common back then. Irving Fisher was a well-known speculator in the 1920s. He was a Yale finance professor who made millions from inventions and made bets in the stock market to earn more. Unfortunately he lost it all in 1929 and spent the rest of his life with debts he could never repay.

Others just bought up shares and kept them for a long time. The “Coca-Cola Millionaires” are families that picked up shares in Coke a hundred years ago and just kept making more and more money through the years. Many fortunes have been lost by selling those shares 50 years too early! A farmer who bought one share of Coke in 1919 and left it to their great-grandchildren could have an estate worth millions of dollars today because of the profits the company made.

That’s what long-term passive investing is all about. But not every company is a Coke. It takes a lot of work to decide which companies will can well over the next 10, 20, or 100 years. And if you’re just buying a few stocks it still takes some luck. Kodak seemed like a good company when people hadn’t heard of digital cameras.

It takes time to do all that research. You probably don’t want to spend every weekend reading annual reports and going through detailed accounting notes to understand a business. But once someone figures out a few good companies they can invest a lot of money in those stocks.

. . .

This was the start of the second act and the modern mutual fund. The manager of the fund has one job: to do the research on a lot of stocks and figure out which ones have the best chance of making money. The customers send their money to the fund manager who invests it in the chosen stocks. The manager only has to do the research once and the customers don’t have to do any research. The manager takes a bit of the money every year as a fee and it works out for everyone.

There is one problem though. Soon after this started there were hundreds of mutual funds. Today there are thousands. Now you have to choose the best mutual fund instead of the best stock. Like with stocks a few mutual funds were really terrible and lost money for their customers, a lot did ok, and a few were really great.

It seems like the best managers would get most of the customers and everyone would be happy. But even the best investments might look like they’re losing money for 3 years, 5 years, or longer before they turn around. This is very common.

If you’re trying to figure out if the mutual fund manager who has your money is good at her job, what are the chances you will wait that long? Maybe they made a good decision and they just need more time. Or maybe they will keep losing money.

Because of this investors had to forget about long-term results and start making changes every few years, every year, or even every month. Mutual fund customers started to move their money from one fund to another as soon as things changed. But a fund manager’s luck can change quickly.

Even though the decision seems right, the customers take their money out of a fund that is about to do well (but was unlucky for a while) and move it to a fund that is about to do badly (but got lucky for a bit). This is so hard to figure out that most mutual fund customers actually do move their money to a different fund when they would have done better by doing nothing. It’s not because they are dumb. We just don’t know the future.

The fund managers realized that they needed to get the customers to come to them. Most customers take their money out of the funds that have done the worst recently and put it into the funds that have done the best recently. If Susan and Johnathan are both managing funds, and Susan is getting better results, it’s very easy for all the customers to move to Susan’s fund and put Jonathan out of business. Because of this customers watch closely and try to figure out which manager is best. The managers came up with two ways to take advantage of this.

Some of them decided to start speculating. It is risky but if they get lucky then they look really smart and they can get a lot of new customers. If they lose money they can just move on to start another fund. They aren’t the ones losing their life savings, the customers are. This is like breaking all the rules at your job in hopes of getting a promotion because it worked out. Even if it starts off well, something usually goes wrong. Many of these funds start losing money after they get a lot of new customers.

Other managers decided not to take any risks. Instead of just buying a few stocks they bought hundreds. Then if one of the stocks had a bad year it wouldn’t make a difference to them. That way their results are just average and they aren’t really doing worse than other funds. They might not get the most customers but they won’t go out of business by doing this. This is like doing the minimum work you need to at your job so you don’t get fired. You might not get a lot of promotions but you can always tell your boss that someone else is doing worse.

So mutual funds were a good idea at first but it turned out that a lot of managers take big gambles or just get paid a lot and avoid making decisions. And the millions of dollars that the managers get paid comes from the customers’ money.

Because of the way mutual funds work, the managers and the customers both speculate a lot and change their mind often even though they know it’s bad for them. But there’s a third option, right? Aren’t there some managers who do good work and don’t take big risks?

. . .

After the 1950s a few researchers at universities decided to study this. They knew a few mutual funds had done well without taking those risks. If a smart fund manager could pick good stocks a smart professor could pick good fund managers, right?

What they discovered was so surprising that even today a lot of people don’t believe it even after hundreds of studies that back it up.

There were a few fund managers who were honest and dedicated. And there were a few funds that did really well in the past, either because of hard work or luck. But no matter how good a manager seemed the researchers just couldn’t predict which ones would do best in the future.

If you invested money in a brilliant manager, another one who had just done well last year, one who just bought hundreds of stocks to avoid risk, and even a manager who had lost money last year, it turned out that all four had the same chances of doing well with the money you had invested.

This is so hard to believe because it goes against everything we know. At your job you wouldn’t expect that your worst co-worker will start doing great work next year and the smartest, hardest-working person in the office will get fired. But with fund managers this is exactly what happened again and again.

The researchers realized that just like playing roulette at a casino, they couldn’t predict which fund managers would win the competition. They could get lucky but it wouldn’t last. The market is just too competitive. As soon as someone makes it to the top they are quickly replaced. It’s like having to interview for your job all over again every morning while thousands of people fly in from around the world to compete with you. No one can last long. Many star mutual fund managers have “lost their touch” – or just run out of luck.

Mutual Funds Evolve

Then came the big question and the third act: why are we paying millions of dollars to brilliant fund managers who supposed to be the best when the evidence shows that they can’t do it? It’s not that they lost money. The average mutual fund does make money. Average isn’t good enough though. One good manager can do the same work as 100 bad ones so managers are paid a lot to be the best.

The fees that they charge can take away a quarter of an investor’s profits or more. If they really were the best this would make sense because they earned it. Who wouldn’t pay $25 to get an extra $100? Most fund managers don’t earn their fees though. Obviously most of them aren’t the best. And the ones that are the best don’t last for long. Why pay that cost if they just end up being just average or worse?

It turns out that some managers had the right idea. If they bought hundreds of stocks they were at least avoiding risk. The problem was just that this meant they were being paid millions of dollars to make simple decisions that anyone could do. So in the 1970s a few people created the first index funds to solve this problem. You invest in index funds in the same way that you invest in a mutual fund. They way they are managed is completely different though.

Instead of paying a manager to research the best stocks they just make a list of the stocks that match some basic criteria (like large Canadian companies). Then they buy all of those stocks. They still need to hire qualified people to do the work but they don’t need to pay salaries that are out of this world. Because of this the average index fund fees are 55 – 96% lower than mutual funds.

Their results will always be average. That’s ok though. Most mutual funds are average too. And since those mutual funds still have to pay big salaries they end up costing their customers more. The research shows that over three quarters of mutual funds will end up being average or worse. Most investors are going to get average results and there’s nothing they can do about it. They will still make money, but why overpay for those results if they can’t really do better?

How can this even work?

It’s partly because not just any company can be traded on the stock market. Only large, well-established companies can spend the millions of dollars that it takes to get started. And if they don’t follow certain regulations to protect investors they are removed from the market. Most companies on the stock market are pretty good businesses that follow strict rules.

Some companies will make more money but it depends a lot on luck. If you buy all of them then luck is on your side. Ten years ago we didn’t know that Apple would do so well. But index funds buy all the companies they can. Index fund customers got a piece of the profits for every iPhone even if they had never heard of it.

Some companies get unlucky too. Index funds also own the investment banks that can lose billions of dollars because of a single rogue trader. They are just a tiny part of the index fund though and those losses don’t make much difference. In the end it balances out.

It gets even better. If you invest in a single stock the company can go bankrupt and you will lose money. If you invest in a risky mutual fund the manager can make a bad choice and you will lose money. The stock or the fund might recover but a lot of the time the loss is permanent. Index funds can lose money too but because they own hundreds or even thousands of stocks in different industries and even in different countries, they usually recover from those losses after a few years. Customers who invest in an index fund and keep it for a long time have a lot less to worry about.

While mutual funds are built on speculation, index funds are built on passive long-term investing. On average they hold each company’s stock for 30 to 50 years. A few stocks get replaced every year because of bankruptcies, mergers, and new companies coming into the market. Other than that the index fund just keeps your money in the same stocks so you have a better chance of collecting a piece of the profit whenever they have a good year.

The average mutual fund manager today dumps their shares after 12 to 18 months (so why did they buy those in the first place…?). And the average mutual fund customer doesn’t stick around much longer. With all those constant changes a lot of people are missing out on the profits that are the reason they are investing in the first place.

Your job may be pretty much the same from year to year but in business and in the stock market there are shockingly bad years and amazingly good years. The best way to make money is to give it enough time for things to work themselves out. You wouldn’t have good relationships if you stopped talking to someone forever as soon as you had a disagreement for them. Many mutual fund managers (and their customers) work exactly like that. Index fund managers, and good index fund investors, know that it’s better to wait and work things out.

Because index funds are safer investments you can keep the same one for a long time without worrying that the manager is about to make a bad decision that will cost you money. Even the best mutual fund has very little chance of being good 10 years from now. You can count the managers who have been “the best” for 15 years or longer on your fingers. But the first index fund is still going strong 40 years later and still doing better than most mutual funds. If you had invested money in that fund in 1976 and never took it out you would have done very well.

And as it turns out, if you invested in every mutual fund that exists you would end up with results that are similar to investing in an index fund that has much lower fees. Investing in an index fund is like having all the smartest managers in the world working for you – while someone else pays their salary! It’s one of the best deals you can find.

Less work = more profits

Investors will always be tempted by the excitement of speculation. When fortunes are won and lost that fast we can’t help noticing. But for hundreds of years passive investing has been one of the safest ways to become wealthy even though it does take time. We know that it has a better chance of making you money, and it takes less work too. Index funds are a tool designed to give passive investors exactly what they need with even less work.

In the last 15 years investors have really started to take index funds seriously. They have seen that mutual funds are more expensive and more risky. There is a chance that a mutual fund will do really well. There’s also a chance that you could win the lottery. But you probably won’t. Successful investors don’t plan for that. They pick something that works and pay the lowest fees they can find.

For a long time people thought you had to be a genius to make money in the stock market. That’s not exactly true. You would need to be a genius to outsmart the millions of other people around the world who are trading stocks. But to make money you just need to pick a simple plan that works and avoid paying high fees.

Index funds and passive investing are the best way for ordinary people to make money, take less risks, and do less work. Doing this has allowed me to earn a good profit from my investments while ignoring them most of the time and never paying attention to the financial news. Thousands of companies around the world just keep on sending me money while I go about my life. That’s what good investing means to me.

Now, what do you think about index funds and passive investing?

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