Index investing -- trying to match the performance of the overall stock market -- is a well-known strategy, but it seems most people still haven't gotten the message. The overwhelming majority of mutual fund assets are in funds that pay a bunch of people to outperform the indexes, but usually don't. And then there are the people who invest in individual stocks, which takes time and other resources, but can't manage to beat the index, either.
So should you be an index investor? Answering the following four questions will help you decide.
1. Does investing bore you?
Monitor your reactions to the following terms: cash flow statement, debt-to-equity ratio, asset turnover, net asset value, style drift, fandango.
Upon reading these words, did your heart begin racing, as does a gambler's when he hears a deck of cards being shuffled? Or did your eyes begin to glaze over, with visions of hot, cinnamon-covered apples dancing in your head when you read "turnover"? And if you didn't notice the term "fandango" -- which has nothing to do with investing -- then you probably didn't bother reading the whole list. (This is the sure sign of an index investor.)
If digging into a company's financials or analyzing a mutual fund's management team sounds about as fun to you as reading the phone book, then perhaps you should consider index investing. Picking and regularly monitoring individual stocks or non-index funds takes time, research, know-how, and stick-to-itiveness. Index investing takes all of these too, but much, much less.
Dallas Morning News financial columnist Scott Burns devised a portfolio split between a fund that mimics the Standard & Poor's 500 and a fund that mimics a short- to intermediate-term bond index. The name of this simple strategy: the Couch Potato Portfolio. That about sums up the beauty of index investing.
2. Has your current equity portfolio beat the overall stock market over the long term?
If you can match the stock market with great ease and little expense, then choosing not to use index investments should handily beat the market if the effort is to be worthwhile. Statistics show, however, that most non-indexers are expending extra time and money to underperform the indexes.
In the shorter term -- say, a couple of quarters or even years -- many individual investors and actively managed funds do beat the indexes. But extend the time horizon to three, five, and 10 years, the percentage of investors and mutual funds that beat the indexes gets dramatically smaller, settling to about 20%.
So it is possible to beat the market -- the question is, do you have what it takes to be the skilled one in five market-beaters? An examination of your investing history should provide that answer.
3. Does your current money manager earn his keep?
If you own actively managed funds, or employ a financial advisor, evaluate how much of your investment goes to line these professionals' pockets.
The average expense ratio (i.e., the percentage of your investment that a fund company keeps to pay the staff and run operations) on an actively managed fund is approximately 1.4%, whereas the expense ratio on index funds or exchange-traded funds can be as low as 0.18%. And financial advisors aren't cheap, either. Someone has to pay the six-figure salary that the average planner makes.
If these folks have you beating the indexes over the long term, bravo. Pay them their just due, and send them a fruitcake as well. However, if the equity portion of your portfolio is losing to the overall stock market, then fire your fund or advisor, and hire an index investment.
4. Have you paid a lot of taxes on your investments?
I know -- a discussion of capital gains is soooo '90s. But another benefit of index investing is lower turnover (i.e., how often investments are bought and sold in a portfolio) and thus lower taxes.
The average actively managed mutual fund has more than 100% turnover. This means that, theoretically, no investment is held for a year or more. That's a lot of trading -- and short-term gains that get passed on to shareholders. Index funds, however, have much lower turnover -- as little as 4%. They only sell investments to raise a bit of cash or rebalance the portfolio to match the index.
And there's another insidious tax aspect of mutual funds. The gains get distributed just once or twice a year, and everyone pays them no matter how long you've been a shareholder. So if you're a relatively recent investor, you'll essentially be paying taxes on someone else's gain.
If you own individual stocks, evaluate your own portfolio turnover. If you use the services of a stockbroker, question whether the trading activity he recommends has been good for your net worth in the form of good returns, or good for his net worth in the form of more commissions.
If all your investments are in tax-advantaged retirement accounts, this is all less of a concern. But since studies have shown that higher trading activity often leads to lower returns and higher costs, investments in IRAs and 401(k)s aren't completely shielded from the effects of high turnover.
Index plus a few
If you're not sure indexing is for you, or you're convinced but don't want to forgo picking a stock now and then, consider the "Index Plus a Few" strategy. That way, you'll match the market with a portion of your investments, yet still try your hand at beating it.
If you'd like to learn about how to buy index investments, read our 60-Second Guide on the topic.
Robert Brokamp employs the "Index Plus a Few" strategy until he can follow individual companies with the same passion he follows the World Champion Tampa Bay Buccaneers. He is co-author of The Motley Fool Personal Finance Workbook and author of The Motley Fool's Guide to Paying for School: How to Cover Education Costs From K to Ph.D. The Motley Fool is investors writing for investors.
