When investing money you have a choice you can have it invested actively or passively.
Active management means handing your money over to an investment or fund manager who will routinely buy and sell individual stocks in order to hopefully produce superior results.
Conversely passive management involves investing usually in an index tracker fund (such as the S&P 500) and leaving it. Although there is a manager looking over it, it is more for book keeping purposes as there is little active trading of the money.
Lets look at the two styles in more detail.
Active management was the normal way for people to invest up until the last 30 years or so. You would routinely use a broker or investment adviser to buy and sell individual stocks, hopefully they would buy when a stock was low, sell when high and then use those proceeds to buy another low stock. You would have a portfolio consisting of maybe 10- 20 individual companies. The simple fact is that less than 25% of active managers will beat “the market” (usually when we talk about the market, we are referring to the S&P 500 or the Russell 2000, unless we are specifically focused on a particular sector). Even if your fund manager beats the market one year there is only a 25% chance they will beat the market the next year.
Furthermore, you are often charged 1-1.5% of your portfolio each year for this privilege. So realistically to be worthwhile your manager has to not only beat the market but do so by at least 1.5%. Then do this again the next year. Frankly if someone could do this every year, they wouldn’t be managing your money, they would be sipping mojitos on Barbados.
So if it is almost impossible to beat the market, why not join it?
Like all statistics the noise on one data point is high, by adding many data points you smooth out the risk. i’m sure we all wish we had invested our life savings into amazon.com in 1997, however in 1997 we could just as easily have invested in pets.com instead and gone broke. So the the lowest risk way to invest in stocks is to buy as many different companies as possible (for a balanced portfolio adding a healthy dose of bonds will help too, but that is a separate post).
Also it is almost impossible to time the market, the world is rife with people who moved their stocks into cash in 2008, but then never bought back in; these people are considerably worse off than those who rode out the Great Recession.
So ideally we want to buy many stocks and then hold on to them, i.e be passively managed. Luckily such a product exists, they are called index funds.
A history lesson. As mentioned above until 30 years ago or so everyone had their stocks managed by a professional. The pioneer in changing the perception was John Bogle who founded the Vanguard Group in 1974. Building on the work of economists like Paul Samuelson, he realized that it makes sense to simply offer people a product that tracked the market. Because it tracked the market and wasn’t being actively traded, his company could also offer very low expenses too (less than 0.1%). In 1976 Vanguard launched the first fund that actively tracked the S&P 500 rather than individual stocks.
At first this was seen as “un-American” after all shouldn’t investors be seeking superior returns that beat the market rather than simply average returns that by design will never beat the market? But the idea took off and especially now in these days of internet trading everyone can track the S&P 500 in matter of minutes from the comfort of their own living room.
If you are interested there is a great interview with Bogle on the Freakonomics Podcast.
So when you buy an index fund you are doing exactly that, buying a fund that tracks the index you are interested in be it the S&P 500, large cap companies, small cap companies, international, domestic or health care.
Yes you wont beat the market, but you will have the confidence of knowing exactly where your money is going.
In a follow up post i’ll write about how you can diversify further with balanced and time-horizon funds.