Index investing

Index investing was popularized by Boggle, the founder of Vanguard. The strategy is based on buying a broad basket of stocks that track an index such as SP500. Although this could be achieved by buying the stocks directly, it is more common to invest in index tracking mutual fund or ETF.

On the surface, the case for index investing is appealing:

1. No stock selection is needed.

2. Instant diversification.

3. Efficient market hypothesis gives the theoretical justification to buying stocks “blind” with no research. Other market participants have done the research already and the price is right.

4. Low cost. Good total return. On average, active funds return market return minus trading costs whereas index guarantees average return.

5. Piece of mind for knowing that one gets the average market return, whether it is +/-50%!

6. Index investing is so stupidly easy that even simple minded people can implement this strategy. Note though, KISS does not stand for

Due to the above, index investing has broad appeal and it widely advocated in personal finance books and blogs. Index investing does have drawbacks:

1. Typical indexes have low dividend yield. Investor typically cannot rely on dividends alone for income and needs to sell the stocks for income. This exposes the index investor to market fluctuations with potentially disastrous outcomes. The first thing that can happen to index investor is a market crash during the first years of retirement: Investor that is forced to sell stocks during the crash that may last several years will not recover fully even if the market eventually recovers.

2. Due to low yield, index investing relies on dividend growth. This makes index investing volatile in comparison to investing in higher dividend stocks.

3. Due to low yield and large volatility, index investing is really suited for investments that have very long duration. Fine, you may be investing for life but what about the day you retire and need the money right there and not in 50 years?

4. There something intuitively creepy in the notion of buying stocks blind. We don’t buy used cars blind at “market price”. Why should we buy stocks blind?

5. Because the yield from index investing is low, it usually does not generate sufficient income. To obtain income, the index must be sold at the market price. The return, therefore, is less guaranteed than for dividend investing.

6. If the efficient market hypothesis is correct, a properly diversified random basket of stocks should perform as well as the index. The only advantage of index would be low fees. But if one invests in stocks and holds the stocks long term, the cost of buying individual stocks is negligible and index offers no advantage.