Introduction This is likely to be the most important book you will ever read about investing. It recommends a very simple, step-by-step strategy for individual investors to do what some of the most sophisticated professionals do -- use index funds as the vehicle of choice for their investment assets. Simply stated, index funds consist of the stocks in a broad stock market index, such as the Standard and Poor's 500 Stock Index or the even broader Wilshire 5000 Index. Index investing is thus nothing more than a strategy of buying and holding all, or a representative sample, of these stocks. Sure, it's a plain vanilla investment in an era when the more exotic flavors are highly touted by the leading investment magazines and many brokers. But this simple investment strategy has outperformed all but a tiny handful of the thousands of equity mutual funds that are sold to the public. Readers who follow the advice in these pages are likely to earn more from their investments while sleeping better as their returns become more predictable.
I have been a fan of index funds for more than twenty-five years. I first recommended them in 1973 in the first edition of my book A Random Walk Down Wall Street. In fact, in 1973, index funds were not available for the public -- they were then only used by a few institutional investors such as the big pension funds. The first publicly available index fund was started in 1976. I said then, as I say now, that index investing is a sure strategy to gain investment returns that exceed those available from the average mutual fund, which is constantly in the market actively buying and selling stocks in a futile attempt to gain extraordinary returns.
How Has Indexing Performed?
How has the indexing strategy fared over the past quarter of a century? The answer is very well indeed. The graph on page 15 shows the proportion of actively managed equity mutual funds that have failed to match the broad Wilshire 5000 stock index -- an index made up of essentially all the stocks in the S&P 500 (an index heavily weighted by the largest U.S. corporations) and a large number (more than 4,500) of smaller firms. The exhibit shows that there have been very few years when even half of the actively managed funds have been able to beat the index. About two-thirds of the actively managed funds are outperformed by the index in a typical year. On average, the typical actively managed fund underperforms the index by about two percentage points a year. And that calculation ignores the sales charges that are imposed by some actively managed funds and the extra taxes an investor pays on funds that turn over their portfolios rapidly. Throughout this book, my co-author Richard Evans prefers to call actively managed funds "non-index" funds. His point, which is entirely accurate, is that index funds also need active attention to ensure that they continue to mirror the index they are designed to represent. But what index funds don't do is try to select a portfolio of individual securities that the non-index manager hopes will beat the index. And the record clearly shows that such "active" or "non-index" managers do not usually match the records of the market as a whole.
When we look at returns over a ten-year period, the advantages of indexing look even better. For example, the graph on page 17 shows the number of equity mutual funds that have done better or worse than the S&P 500 Stock Index between 1988 and 1997. (The situation is similar for the Wilshire 5000 Index.) You can count on your fingers the number of funds that managed to beat the index by any meaningful amount. Moreover, substantial numbers of funds failed to meet the index return by several percentage points per year.
Does the average 2-percentage point underperformance of the typical actively managed equity mutual fund make a real difference to the individual investor? You bet it does! Small differences in returns compound into enormous differences over the years. Suppose you are a twenty-year-old who puts aside $10,000 for investment in stocks to be used at age seventy for retirement. Over very long periods of time stocks produce a gross return of about 10 percent per year, so after expenses the typical active manager will produce an 8 percent annual return. Over fifty years, $10,000 will grow to $1,174,000 if it earns 10 percent per year. But it will grow to $469,000 if it earns only 8 percent per year. The staggering difference of more than $700,000 is more than seventy times the investor's initial stake. Small wonder that Albert Einstein described compound interest as one of the most powerful forces in the world. In chapter 5, "Index versus Non-Index Fund Returns," Evans provides convincing evidence that index investors do indeed come out far ahead.
Why Does Indexing Work?
Why should indexing work? Why should a computer be able to put together a portfolio of stocks that can do better for the investor than one selected by intelligent, well-trained, and highly paid experts? There are four reasons.
First, there is considerable evidence that our securities markets are extremely efficient in digesting information about individual stocks or about the stock market in general. When information arises, the news spreads very quickly and is immediately incorporated into the prices of securities. Thus, neither technical analysis (of past price patterns) nor fundamental analysis (of a company's earnings, future prospects, and so on, to determine a stock's proper value) will help an investor to achieve returns greater than would be obtained by buying and holding one of the broad stock market indices. It is not that the experts are incompetent. Rather, it is precisely because professionals are so diligent in continuously examining stock prices for any mispricing that the market always reflects their best judgment regarding the implications of all information that is known.
This efficient-market theory, as it is known, is associated with the idea of a "random walk," which is a term loosely used to characterize a price series where all subsequent price changes represent random departures from previous prices. The term was first used to describe the unpredictable behavior of a drunk left in the middle of a field. The logic of the random-walk idea is not that the market is capricious but that if information is immediately reflected in stock prices, then tomorrow's price change will reflect only tomorrow's news and will be independent of the price changes today. But real news is by definition unpredictable, and thus resulting price changes must be unpredictable and random. As a result, prices fully reflect all known information, and even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as good as that achieved by the experts. The way I put it in my book A Random Walk Down Wall Street, a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts. Of course I didn't literally suggest that investors should throw darts, but rather that they should simply buy and hold a large group of stocks that represented the stock market as a whole. In other words, investors would be well served by buying an index fund.
The second reason that indexing works is because it is so cost efficient. The typical expense level for managing a public index fund is .2 percent (two-tenths of one percent) per year. Actively managed funds have a typical expense level of 1.5 percent and many of these funds have even higher expenses. Since professional portfolio managers dominate stock trading activity (most individuals own their stocks through funds), the experts as a whole cannot do any better than the whole market -- they are the market. This would be true even if the stock market were highly inefficient. Hence if active managers charge well over 1 percent per year in extra expenses, they must then underperform an index fund that buys the whole market by an equivalent amount.
A third reason why indexing outperforms managed funds is that the funds incur heavy trading expenses. The typical actively managed fund sells almost all the securities in the portfolio each year, replacing them with other stocks. Indeed, many funds turn over their entire portfolio more than once each year. But this portfolio turnover is expensive. The fund pays brokerage charges on each transaction as well as the security dealer's spread between buying and selling prices. The fund also pays a "market impact" cost. When it buys a stock it tends to drive up its price, making the purchase more expensive. When it sells it tends to drive the price down, reducing the fund's net proceeds. These trading costs can easily amount to between .5 percent and 1 percent per year. The index fund, on the other hand, simply holds on to its securities from year to year and thus largely avoids these transaction charges. Between extra professional portfolio management fees and trading costs, the active manager would have to outperform the index by 1.5 to 2 percentage points per year to produce net returns that just matched the index. No wonder that the typical performance gap between the experts and an index fund has generally been within the above range.
But the fourth and perhaps biggest advantage of indexing for the taxable investor lies in its tax advantage of deferring the realization of capital gains or avoiding them completely if the shares are later bequeathed. To the extent that the long-run uptrend in stock prices continues, switching from security to security involves realizing capital gains that are subject to tax. Taxes are a crucially important financial consideration since the earlier realization of capital gains will substantially reduce net returns, as Evans shows in chapter 14. Index funds do not trade from security to security and, thus, they tend to avoid capital gains taxes.
Stock trading among institutional investors is like an isometric exercise: Lots of energy is expended, but between one investment manager and anot...
