Crackerjack Greenback Prudent Advice for a Prosperous Future

November 21, 2008

What is Index Fund Investing?

Filed under: Investing,Retirement Planning,The Basics — Paul Williams @ Crackerjack Greenback @ 4:00 am

       Last week, we talked about a definition of Active Investing. This week, we’ll talk about Index Fund Investing and how it differs from Active Investing.

Characteristics of Index Fund Investing

       Just as I started last week’s discussion of Active Investing by describing its characteristics, we’ll being talking about Index Fund Investing by looking at its characteristics and the behaviors of Index Fund Investors.

The Slippery Slope of the Stock Market by Ergo Martini - Gone 'til December on Flickr

1.  Index Fund Investors understand that stock prices change unpredictably based on unexpected news. Index Fund Investors know that no matter how much research you put into a company random events will occur that you could never have predicted. They also understand that free financial markets (no government intervention) are mostly efficient. All known and publicly available information is already reflected in current stock prices, and these prices change almost instantly as new information becomes available. These factors make it nearly impossible to “beat the market” (appropriate benchmark) without some dumb luck.

2.  Index Fund Investors understand that Market Timing, in any form, is a loser’s game. They understand that the bulk of stock market returns are often contained in the best few days—and missing those few days means your return ends up much lower than it would have been if you had just held tight. Index Fund Investors know that no one in history has a long term (10-20+ year) track record of being able to figure out when to get in or out of the market. They also realize that Market Timers end up paying more in taxes because of their excessive trading—often negating any gains they might have had from their activities.

New York Stock Exchange by Helico on Flickr

3.  Index Fund Investors understand that it takes more than an S&P 500 Index Fund to be diversified. A true Index Fund Investor will have their portfolio split between several different asset classes: Large U.S. Stocks, Large Value U.S. Stocks, Small U.S. Stocks, Small Value U.S. Stocks, Large Int’l Stocks, Large Value Int’l Stocks, Small Int’l Stocks, Small Value Int’l Stocks, U.S. Short-term Bonds, U.S. Intermediate-Term Bonds, and Global Bonds to name a few.

4.  Index Fund Investors know that investment returns are related to the risk you take. They understand diversification is a way to lower risk, and they have a feel for their risk tolerance. They also understand the risk of not meeting their goals and are willing to take the risk necessary to achieve their goals.

5.  Index Fund Investors read and understand the academic research about free markets and investing. They know that university professors and Nobel laureates are proponents of Index Fund Investing because it has been proven and backed by academic research. Index Fund Investors know that nearly all of the academic research available points to Index Fund Investing as the superior long-term choice for investors.

My Definition of Index Fund Investing

       Index Fund Investing is an investment strategy backed by academic research and over 80 years of history. It doesn’t try to “beat the market”. Instead, it attempts to duplicate market returns by keeping costs as low as possible. Index Fund Investors don’t have to be as worried about the short-term fluctuations in the market because they match their portfolios to their goals based on their time horizon. This means they’re much more relaxed than Active Investors and have more time for the things they really enjoy in life.
189 - Family Dinner by eyeliam on Flickr
       If you want more great information on Index Fund Investing and why you should consider it, check out Trent’s post at The Simple Dollar on The Chorus of Voices for Index Funds.

2 Comments »

  1. Excellent introduction to the topic. On a related note, I only recently got a chance to read John Bogle’s The Little Book of Common Sense Investing. Highly recommend it if you haven’t had the chance to pick it up yet!

    Comment by Oblivious Investor — November 21, 2008 @ 8:04 am

  2. Thanks, Oblivious Investor. I’m glad you liked it! John Bogle has a lot of great stuff. You might also like The Boglehead’s Guide to Investing.

    Comment by Paul Williams @ Crackerjack Greenback — November 21, 2008 @ 8:35 am

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