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Five reasons why you’ll love index investing

When I first looked into investing, it was like staring across the Atlantic Ocean. All I could see was a vast, churning deep, full of danger that could swallow my wealth whole.

I needed help to sail these seas, and among the competing offers I found a little rowing boat named index investing.

The animal spirit of investing

While you can make the journey in luxury liners like active management or ironclad battleships crewed by stock-pickers, here are five reasons why a more modest vessel makes the most sense:

1. Index investing is simple

Never invest in anything you don’t understand is a mantra repeated time and again in personal finance. Like never crossing the road between parked cars, it’s excellent advice that’s all too easy to ignore.

Happily, index investing is easy to understand, even for those with little investment experience.

  • You make regular contributions to your funds and rebalance your portfolio as little as once a year (some prefer never).
  • Holiest of holies: You don’t try to time the market or pick hot stocks.

2. Index investing works

Index investors can beat the average active investor after costs and taxes, according to Nobel Prize winners like William Sharpe.

Study after study shows that most actively managed funds are trumped by index funds over the long-term. Why? Because index trackers are dirt cheap. Their low costs nibble away less of your pie than pricier active funds, which rarely put in the consistently stellar performance required to justify their high fees.

Index investing is not a ticket to instant riches. It doesn’t aim to beat the market but to capture the returns of the market. We’re putting our money on the tortoise not the hare.

3. Index investing is affordable

Cheap index trackers can be bought from online brokers. You can buy in small, regular chunks (down to £50 per month) and build up your portfolio slowly over time.

With a bit of confidence, you can do it yourself, without paying commission or fees to a financial advisor.

4. Index investing doesn’t waste your life

Stock-picking hoovers up vast amounts of time whereas index investing leaves you free to sniff the roses. There’s no need to grapple with complex methodologies, pour over company accounts or entangle yourself in charts.

5. Index investing puts you in control

Ever hire a financial advisor only to discover later you’re paying sky-high fees for mediocre funds that didn’t suit your needs? Or was that just me?

Knowledge of index investing strategies can help you avoid a similar fate by revealing:

  • The risks you’re taking and how to dilute those risks to a level you’re comfortable with.
  • How much you need to invest to achieve your financial goals.
  • The D-I-Y approach that avoids rip-off merchants and can save you a bundle in the long term.

Hopefully I’ll be able to lend a hand with some of these aspects of index investing in future posts.

Until then, take it steady,

The Accumulator

Filed under: Passive investing

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{ 13 comments… add one and remember nothing here is personal advice }
  • 1 Neil Wilson September 21, 2010, 1:07 pm

    6. Index investing has gone nowhere for over ten years.

    Cheap they maybe, but perform they have not.

    You need one where the dividends are not used to make up the tracking error.
    .-= Neil Wilson on: The solution to the European debt crisis =-.

  • 2 Edindie September 21, 2010, 4:01 pm
  • 3 Khaleef @ KNS Financial September 21, 2010, 8:58 pm

    I was always in favor of index funds for people who lack the understanding or time to perform their own research on a consistent basis.

    However, this shouldn’t mean that people just put everything on autopilot and never check or re-balance their holdings.

    As with almost everything else in finance, there needs to be a balance.
    .-= Khaleef @ KNS Financial on: How to Create a Budget – Evaluate Expenses =-.

  • 4 The Accumulator September 23, 2010, 7:47 pm

    @Edindie – That’s an astounding article. It gets even better in the comments when the author and swaldman start fencing like a pair of master swordsmen. Hopefully this is an angle that will get picked up by others and investigated thoroughly. It’s a salutary reminder that nothing is certain out there and risks abound, including the risk of being paralysed by every scare story that emerges. I don’t intend for that to sound like I’m trying to dismiss the article as a scare story. Doubtless this one will unfold over time.

    @ Khaleef – I totally agree with you. And that’s a lot of people. Especially as we’re increasingly expected to rely on our own pension provision with little or no financial education. And especially as there’s lots of talk that as the UK moves to fee-only IFAs, small investors will find it ever more difficult to find someone who will give them the time of day.

  • 5 Rick September 24, 2010, 9:40 pm

    Neil,

    If index investing has gone nowhere the last ten years, can you tell us what has gone somewhere? Virtually every actively managed fund has done worse over the last ten years. And even the ones that survived…can you guarantee that they’ll do just as well in the future? Indexing is a terrible choice, if you can predict the future. The problem is that none of us seem to be able to predict the future very well.

    –Rick

  • 6 George September 25, 2010, 2:04 am

    Bonds went up

  • 7 The Investor September 25, 2010, 7:56 am

    @George – True, but as I see it index investing isn’t quite synonymous with equity investing (though I concede it’s almost always used as a term for tracking stock markets).

    Several of the nine simple ETF portfolios I’ve noted on Monevator include ETFs that track various bond market indexes, for instance.

  • 8 The Accumulator September 28, 2010, 9:18 pm
  • 9 The Investor September 29, 2010, 8:04 am

    Thanks for following these up, Accumulator! The length of the defenses at least reminds us that while buying ETF portfolios is a simple option for investors, ETFs themselves are not. But hey, I can fly to New York without understanding how a plane can fly. (Actually I do understand how a plane can fly – I’m talking about Mrs Miggins sitting to my right in seat B4!)

    I actually see this wave of fear about a very technical subject as heartening. It shows many more people understanding investments can fail you for technical as well as market reasons, doubtless as a result of the credit crunch. I wonder how long such penicillin will last this time?

  • 10 Sunny September 16, 2013, 12:09 pm

    Hi
    i am reading your articles since 2 months and really thankful for all this information.One thing i can’t get is yearly return and performance ratios .for example vanguard ls 60% income has been quoted 12 month yield as 1.68% and but 1 year return has been quoted as 10%.so, i will get 1.68% back on 100 pounds or 10% on 100 pounds.
    Kind regards

  • 11 Oldie February 3, 2014, 4:30 am

    @Accumulator: I just discovered this blog, and read your post. Disclosure — I have been a student of Passive Index Investing for a while; since I started, the more technical and financial data I have since continued to accumulate and digest only has serves to confirm in a mathematical and statistical sense what I grasped intuitively at the start. (I also don’t live or invest in the UK). I must admit, the initial intuitive hurdle was the most difficult to cross: the wonder at how could I, the untrained and naive investor possibly hope to do as well, let alone better than the highly trained expensive teams of financial wizards who have devoted their whole lives to this black art of discerning the economic future from divining the entrails of impossibly dense financial data.

    I welcome reading comments from other followers of this principle; there is always some nugget of wisdom to learn from other practitioners. Particularly, learning subtle differences in practices in other countries can often lead one towards an objective re-looking at common wisdom in one’s own country.

    I have no disagreement with your statements of principle above: however, I felt you did not go far enough.

    It is difficult to explain Index Investing succinctly and accurately to the uninitiated, and unfortunately sometimes statements of truth lead to unintended conclusions by listeners.

    For instance, I thought your mantra “Never invest in anything you don’t understand” was a necessary first statement to your explanation. However, the corollary to that statement, especially in this context, deduced by many listeners would be that those “experts” who have far deeper and sophisticated knowledge of financial parameters and data would have a far greater certainty of deducing future financial trends than anyone else. (And therefore the investor needs to spend vast amounts of time, effort and study to achieve this expertise, or alternatively needs to pay the high going price for such experts to advise you, or else you cannot hope to invest profitably and safely).

    I thought it would have been useful specifically to explode that myth; unless it is explained specifically that this ain’t necessarily so (and, actually, it ain’t so at all!), investors are likely to come away with the idea that Index Advising is only second best, and is the refuge of those who are too stupid or too lazy to do the necessary diligence (the “grapple with complex methodologies… or entangle yourself in charts” of your point number 4). Investors, especially those exposed for years to the awe given to the so-called “wizards of Wall Street” etc., need to be exposed to the robust data that exists which demonstrates that, despite great depths of this arcane knowledge held by these experts (I would be the first to admit that these experts certainly have familiarity with these data far more than I could ever hope to achieve), this great knowledge has failed to translate in any predictable way to any consistent probability of improved investment profit for any given level of investment risk. This point is the most poorly understood to those trying, and failing, to grasp the fundamental wisdom underlying Passive Index Investing.

    Unless this point is fully understood, which it must be before you can believe it, then your good advice given at the end of point number 1, “Holiest of holies: You don’t try to time the market or pick hot stocks” doesn’t make much sense, and will be forgotten, or worse, ignored, when all the financial experts are screaming in the papers that interest rates are going to rise, so get out bonds now, or equities are overvalued, so sell this and buy that, etc. I think the real test of the Index Adviser is his/her ability to hold true to an investment plan despite distractions like that, and, hopefully to give an adequate explanation, if questioned to the effect that nobody can predict the future in a way that enables one to exploit this prediction for a profit.

  • 12 Oldie February 3, 2014, 4:32 am

    @Accumulater: I was just spouting off in immediate response to this single article. I just realized that this was only the first in an intended series of articles that will, no doubt, fill in the blanks indicated by my unnecessary prodding, for which I apologize. I, of course, am fully in agreement with what you say.

  • 13 David November 17, 2015, 9:42 am

    To be honest I have never heard of this kind of investing, but it sounds quite interesting. I hope it is actually simpler than Forex trading, which requires a lot of skills and knowledge.

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