What is index investing? You may already be aware that there are a variety of different approaches to investing. Some people are dividend investors, some are day traders while others are index investors. This post looks at index investing and its benefits.
What is an Index?
To understand what index investing is, we must first understand what an index is. The Dow Jones, the S&P 500, the TSX – these are all examples of stock indexes. But what are they? A stock index is a statistical average of a representative sample of stocks that make up the entire stock market. Most indexes are weighted by market capitalization which means that the larger, more valuable companies represent a larger, but proportionate, share of the index.
4 Major Reasons to be an Index Investor
1. Indexing is a passive approach to investing. You simply buy the entire market as opposed to actively picking and choosing individual stocks.
2. Indexing is a low-cost way to invest. As I mentioned in a previous post, over long periods of time mutual fund fees kill investment returns. Index funds are cheaper because you don’t have to pay a fund manager to pick stocks. There is also less buying and selling of stocks in an index fund and this further reduces trading costs.
3. Indexing is a simple, low maintenance way to invest. You can build a diversified, low-cost investment portfolio with just 3 or 4 funds. You don’t have to constantly watch the daily gyrations of the stock market and the only maintenance you’ll ever have to do is to take a few minutes to re-balance your portfolio once a year. In fact, the less tinkering you do to the portfolio, the better off you’ll be if you just sit back and stick with your investment plan.
4. The absolute best part of index investing is that you’ll most certainly beat 100% of the fancy Wall Street/Bay Street money managers. Some money managers can “beat” the market over a short period of time but over longer periods the index always wins out. Even if fund managers could beat the market consistently over the long term you likely won’t come out ahead because of their high fees. John Bogle, a pioneer of index investing and former CEO of Vanguard, nailed it when he said “active [investment] strategies as a group lose because they are expensive. Passive indexing strategies win because they are cheap.”
What Does Warren Buffett say About Index Investing?
What does a wise old sage like Warren Buffett thing of index investing? In the 2014 Berkshire Hathaway letter to shareholders, he gave this advice to the trustee of his multi-billion dollar estate:
“put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s). I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”
What’s striking about this is that Warren Buffett is someone who has built his entire career on stock picking and his advice to just buy the index comes as a surprise because he has made a fortune by following the exact opposite approach. That said, in recent years even Buffett himself was unable to beat the index.
Index investing is an overall winning strategy because it’s a cost effective and easy approach to follow. And it’s one that very few money managers can beat consistently, net of fees, over time. I’ve been indexing with TD e-series funds ever since I started investing in my family’s retirement and education accounts. I also use low-cost index funds in my defined contribution pension plan. What about you? Are you an Index Investor?
Photo Credit: Photo by Jeroen van Oostrom