The simplest, most effective investment decision you will ever make

There are more than 6,500 actively traded US stocks. Some 2,000 companies are listed on the London Stock Exchange. 2,271 Japanese companies call the Tokyo Stock exchange home. Then there’s China, India, Canada, Germany, Australia…

Happily, you can forget about companies, earnings, forecasts and ratios and still make more money than most investors.

By passively investing in index tracking funds instead of managed funds or your own stock picks, you’ll capture the benefits of equity investing quickly, cheaply and relatively safely.

This post explains why index funds are the best choice for your core equity holdings. (What’s an index? Wikipedia: Stock Market Index).

Why index funds produce superior returns

Index investing is all about simplicity, so I’ll try to keep this brief.

When you invest in an index fund, it’s like putting money into every single company tracked by that index, for just a tiny fraction of the cost.

Since you own a bit of every company, your index investment is wholly aligned with the returns of the stock market segment tracked by that index – as opposed to the performance of a fund manager (with an active fund) or individual companies (with your own stock picks).

Track the S&P500 or the FTSE 100 via a cheap index fund and you’re guaranteed to get the market return each year, minus <1% for fees. (I’m ignoring small tracking errors for now as insignificant.)

Index investing works because:

• Over the long-term, the return on a broad spread of stocks has usually beaten cash or bonds.

• Index investing enables you to capture this superior return at a low cost.

Couldn’t an actively managed fund beat the index?

If a particular fund manager buys more of the better performing stocks and avoids the losers, he or she will beat the index, but…

…academic research and investors’ costly experience has proved that very few do beat their benchmark index over long periods of time.

Even if some do, you probably won’t discover such amazing managers at their very start of their careers and your investing lifetime.

For obvious reasons you’re much more likely to discover them after a period of outperformance, when it’s more probable they’ll underperform and revert to the mean.

Fees and hidden trading costs and other inefficiencies will erode most of the extra returns from all but the rarest rarer-than-pandas fund managers.

What about picking your own stocks?

This won’t work because – apologies – you’re the descendant of a club-wielding, monkey brained, prehistoric caveman…

…which is to say fear, greed and other primitive instincts drive your decision making. (Mine too, if it’s any consolation.)

Want fancier terms? As investors, we suffer from cognitive biases. Our decision making is skewed by framing. The herd instinct means we chase up bubbles and miss opportunities. And don’t even mention dynamic inconsistency, which sounds like a 1970s glam rock band.

As a stock picker, you’re like a lone fund manager without access to company directors, teams of researchers, or any of the training or tools enjoyed by fund managers. And we’ve just discussed how most full-time fund managers can’t beat the market after fees, even with their resources. (Yes, there are minor caveats – I’ll cover those in another post).

Private investors tend to churn their portfolios. Over-trading increases your costs and reduces returns, making it even harder to consistently beat the market.

You may fool yourself, too. Most investors believe their returns are much better than they are, because their record keeping is poor. (Including, I’m ashamed to say, me). This will cost you in the long run.

If against all odds you really are the next Warren Buffett, you’d be better off making millions managing a fund in New York, in The City of London, or from an office in Omaha than merely making a few extra thousand by trading your retirement portfolio.

More reasons to love index funds

Superior performance at a cheaper price achieved in far less time not enough for you?

Extra advantages of index investing include:

• It’s easy and cheap to drip money into an index fund over time, to benefit from dollar-cost averaging.

• Alternatively (or additionally), buying the appropriate index-tracking exchange-trade fund (ETF) enables you to add the market returns of say small-caps or Japanese equities with a single stock purchase.

• Add ETFs that track bond indices and exchange traded commodities (ETCs) to the picture and you can construct a diversified portfolio across multiple asset classes for the cost of buying ten conventional stocks.

• If you go to the gym and lift weights instead of reading The Wall Street Journal, you’ll be more physically attractive and you’ll live longer, too.

Hang on! Don’t you discuss individual share picks?

It’s true, to my shame I buy and sell individual shares. I’ve even started writing my own reports on Monevator for the entertainment of my readers.

I can’t logically justify stock picking in investment terms, but here are some of the fringe benefits of buying and selling individual shares:

• If you’re a business geek, then reading the financial pages, analyzing shares and placing your bets is fun.

• It sounds much cooler at certain parties to name drop specific shares than to discuss the low fees you’re being charged by your index fund. (Note: at most parties you’re probably better off talking about sports or Julia Roberts).

• You feel like a genius when a stock you pick doubles.

• You quickly forget it when one halves and you sell. (No more nasty red!)

• Owning some companies’ shares gives you modest perks like discounts.

• There’s a tiny chance you might beat the market when picking shares, whereas you’ll never do that with an index fund1. So you might just make a fortune by picking stocks versus buying the market. (We’re talking lottery winner odds).

I personally read the business pages instead of the sports pages and I believe that picking stocks is a passion and a vice. Stock picking is basically an expensive hobby for an investment geek, like sports fishing or off-road racing only without the danger of bleeding.

But stockpicking is NOT likely to be more profitable than index investing. Notice that ‘potentially beating the market’ was last on my list of reasons for buying and selling individual shares.

Put index funds at the core and have fun at the periphery

I do think certain direct share investments might make sense for particular private investors. Buying and holding shares with a high dividend yield at the right time offers the possibility of securing a regular income with no ongoing costs at all. But I’m not suggesting a high yield portfolio would necessarily beat the market.

Some investment trusts (i.e. listed investment companies, not funds) can add uncorrelated returns for fairly low fees. There are also managed funds that provide exposure to specific asset classes that are hard to reach via index funds.

Logic and evidence says the best thing to do is invest in 5-10 index funds / ETFs (even including small holdings of commodities and the like) to get a diversified portfolio and higher returns for lower risks. But logic isn’t everything to humans: buying and selling individual shares can be too tempting to resist.

My personal solution is to make index tracking funds the core of my portfolio and to allow myself a much smaller remaining portion of my savings to invest directly.

Like this I get most of the benefits of passive investing, and a little fun on the side: When I do better than the market I’m pleased, and if I don’t I’m thrilled I’m in index funds!

I’ll explore the idea (and risks) of such a side portfolio in a future post, so please do subscribe for free to get my posts via email or in an RSS reader.

But all this is tinkering. The takeaway message is the boring but sensible one: If you want the best chance of making satisfactory returns at the lowest possible cost, get your equity exposure using index funds.

More on index tracking funds

We have a dedicated passive investing section all about easy, cost-cutting investment via tracker funds and ETFs.

Want a second opinion? Here’s some useful guides from elsewhere (all open in a new window):

• Moneychimp offers a quick, elegant case for index funds
• Investopedia goes into more detail on index funds (mainly US)
• Seeking Alpha has a great ETF Investing guide (mainly US)

The last word on index funds

“A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.” – Warren Buffett (in 2007)

1. Since even the tiny fees charged by an index fund will mean your return is slightly less than the market. [↩]