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Index Your Way to Success

Posted: Nov 13, 2009 12:24 PM by Sham Gad

Tickers in this Article: VTI, VFINX, EWZ, FXI, EEM, EFA

Although simple in theory, the strategy of investing in indexes is arguably one of the most successful investment strategies for the vast majority of investors today. Yet so many people prefer to participate in individual securities, arguing that they can beat the market. While it's possible to beat Mr. Market, very few people can do it over the long-run.

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Why Not?
The reason most people fail to beat the market over a meaningful period of years has nothing to do with intelligence, but everything to do with behavioral finance, a discipline that examines why market participants behave the way they do.

One critical reason for market under performance by the majority is simply a result of all wanting to be invested in the same thing. Common sense will tell that if you invest in a space populated by the masses, you are investing in the most efficient of all markets. As a result, you will be investing in lockstep with the market. But you will do so while incurring frictional costs - commissions, taxes, etc. - absent from simply being in an index fund.

The Irony of Investing
Different studies reveal different percentages of those who fail to beat the market. According to a past speech by mutual fund giant John Bogle, 85% of active professionals fail to beat the market by three percentage points. Other studies simply show that 75% of active money managers fail to beat the S&P 500 index.

Whatever the number, what is beyond dispute is that a vast majority of pros fail to beat the market. Yet by investing in an index fund, a man or woman with zero knowledge of markets, finance, accounting or any other prerequisite for investing, can beat a majority of professionals. I can't think of any other profession where this is possible. You don't see individuals walking into hospitals and telling doctors to step aside because they can operate better. Such is the irony of investing. (For more on this topic, see Intro To Index Investing.)

Excellent Exposure
Thanks to the innovation of the capital markets over the years (not all market innovation has been bad!), investors can now be exposed to other regions besides the United States. The most comprehensive exposure to the U.S. stock market can be found in the Vanguard Total Stock Market Index (Nasdaq:VTI) which consists of all the regularly traded U.S. common stocks traded on the NYSE and Nasdaq. The Vanguard 500 Index (Nasdaq:VFINX) concentrates on the S&P 500 basket of stocks.

Those seeking international exposure can invest in the iShares MSCI EAFE Index Fund (NYSE:EFA) or the iShares Emerging Markets Index (NYSE:EEM) which tracks the emerging markets. Thanks to exchange-traded funds, investors can now make broad bets on the equity performance of certain countries as well like the iShares FTSE/China 25 Index (NYSE:FXI) or the iShares Brazil Index (NYSE:EWZ). In all instances, these funds or ETFs have very minimal expenses compared to mutual funds which often hold similar securities.

The Bottom Line
You don't need to be a brilliant stock-picker to beat the market, but rather a rational and patient investor. And for the majority of folks who can't expend the rigor and effort to analyze securities, participating in index funds is a brilliant strategy. (For more, see Investing With A Purpose and The Successful Investment Journey.)

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By Sham Gad

Sham Gad is the Managing Partner of Gad Partners Fund's, value inspired investment partnerships modeled after the Buffett Partnerships of the 1950's. Previously, Gad ran the Gad Investment Group and delivered annualized returns of 22% from 2002 to 2005. Gad is also the author of "The Business of Value Investing" which will be out in the fall of 2009. Gad earned his MBA at the University of Georgia in May of 2007. Gad runs a value investing blog. He can also be reached by visiting the Gad Partners Funds site. When not writing or analyzing businesses, Gad enjoys hanging out with his wife Maggie, reading, golf, and yoga

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