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Index Funds
Re: Index "Investing" isn't Investing

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By Mark12547
April 4, 2006

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Therefore indexing as a strategy allows most people to get most of the return of the market at the cheapest price. That is why it is a wonderful option for the know-nothing investor.

Index funds have several advantages, such as:

1. Their expenses tend to be lower. While stock picking may beat the "market" (more specifically, the relevant index), a fund doing active stock picking has to not only beat the relevant index, but has to do so by enough to overcome the expense ratios before it can beat an appropriate index fund. But a no-load, low-expense actively managed fund just might do that. The pesky expense ratios could be why index funds tend to beat the majority of actively managed funds with a substantially similar portfolio.

2. Unlike some actively managed funds (including a couple of funds I was in before I moved my assets to Vanguard), index funds don't have style drift. Sometimes that style drift comes by the change of manager, which was what turned one fund I was in into a telecom fund one year, and the next year into an Internet fund. But a fund that tries to invest to mimic the returns of an index won't change its composition just because the manager changes.

3. The broader-based index funds tend to have lower turnover than an actively managed fund. This reduces the fund's trading costs (which don't show up in the expense ratio but do in the returns) and tends to generate taxable distributions (which hurts one's returns in a taxable account). This has to be taken with a few grains of salt because tax-managed funds might be matching sales of winners with sales of losers to minimize taxable distributions.

4. Many index funds tend to keep more money invested than actively managed funds because many fund managers who actively manage their fund keep cash on the side for buying opportunities. But if I wanted a chunk of my money in cash, I would have had more in a money market fund or other cash instruments, not paying a high expense ratio for cash.

Those are reasons why I am inclined towards index funds, but not exclusively so.

I am not a stock picker. My mother is, but she is retired so she has time to enjoy researching stocks and then deciding whether or not to buy.

I am also an Asset Allocator, which is probably more "know nothing" than using index funds. I don't have to concern myself about whether I think the domestic stock market, international stock market, REIT or bond market will go up, down, or sideways. It takes a while to decide what the asset allocation should be for me (taking appropriate amount of risk, but not so much that a drop in portfolio value would cause me to panic and sell low), but the really hard part is sticking to the plan: it is very tempting to buy high when stocks are high, and very tempting to buy non-stock assets when stocks have a buying opportunity.

Does it allow them to retire respectfully? Possibly.

I have seen summaries of several different studies (not just the controversial Dalbar Funds Flow study) that show that the average investors are their own worst enemies: either buying high and selling low ("I'll buy when the market is hot, and sell when the market cools off" or some other way of letting the emotions take control of the investing decisions) or performance chasing ("I'll invest in a 5-star fund and next year I'll switch to the next 5-star fund").

On the other hand, I have read that the one factor that explains 93% of the difference of returns for pension plans is a slavish adherence to an asset allocation plan.

I wouldn't say my approach of sticking to low-cost, no load investments (such as index funds) and sticking to my asset allocation plan is the best way to go, but I would say it is a reasonable way for me and far superior to some of the alternatives, especially alternatives that would allow my emotions to drive me to make bad investment mistakes. 8)

--Mark (who traded the 0 for a Prime Number: 12547)

Said to a coworker earlier today: "What's the easiest way to make a small fortune on Wall Street? Start with a large fortune."

Also said to same coworker: "How do you become a millionaire? Become a billionaire and then buy an airline."


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