| Too often, index fund proponents get bogged | | | | In contrast, asset allocation for an index investor |
| down in intellectual discussions about market | | | | is greatly simplified. A small cap value index fund |
| theory and statistical relationships. You probably | | | | always maintains a 100% investment in small cap |
| aren't interested in a debate about the efficiency | | | | value stocks, so the investor knows exactly what |
| of our financial markets; you just want to know | | | | he's getting for each dollar invested. This |
| which investments will give you the greatest | | | | transparency greatly simplifies the task of |
| chance of a lengthy, enjoyable retirement. This | | | | portfolio management. Once an index investor |
| article describes three simple and practical reasons | | | | determines his risk capacity, or the degree of |
| why you can't afford to ignore index funds. | | | | downside uncertainty that he can tolerate in his |
| Reason #1: Performance | | | | portfolio, he periodically monitors his investments |
| Index funds consistently outperform the vast | | | | to ensure that his asset allocation stays consistent |
| majority of actively-managed mutual funds. | | | | with his capacity for risk. When market |
| According to data compiled by the Bogle Financial | | | | movements cause his portfolio to become too |
| Markets Research Center, two-thirds of | | | | risky or conservative, he simply makes a |
| actively-managed mutual funds fail to beat the | | | | rebalancing trade to restore his target allocation. |
| relevant index in a typical year and over 80% fail | | | | Reason #3: Psychology |
| to beat the index over a typical 20-year period. | | | | Index investing helps to counteract several |
| Actively-managed funds, where a manager or | | | | harmful behavioral biases. When it comes to |
| committee makes the investment decisions, find | | | | investing, you can be your own worst enemy! |
| such rare success because of numerous | | | | Overconfidence, loss aversion, and herding are |
| debilitating costs. Data from Morningstar shows | | | | just a few of the natural human tendencies that |
| that administrative, transaction, and opportunity | | | | can keep you from making good investment |
| costs result in total annual expenses of over 2.5% | | | | decisions. A risk-appropriate index portfolio, when |
| for the average actively-managed mutual fund. | | | | combined with a strict rebalancing program, |
| Index funds, on the other hand, minimize | | | | provides a powerful defense against these |
| expenses by employing computer systems rather | | | | damaging behavioral forces. |
| than expensive financial analysts and by trading | | | | We (humans) tend to be overconfident about our |
| far less frequently than active funds. A typical | | | | mental and physical abilities. Eight out of 10 college |
| index fund has total annual expenses of less than | | | | students believe that they are |
| 0.5%. | | | | better-than-average drivers and seven out of 10 |
| Simple math tells us that the average mutual fund | | | | Americans believe that they are smarter than the |
| investor earns the market return minus any | | | | average American. For investors, overconfidence |
| expenses incurred. Therefore, based on the | | | | in one's ability to beat the market leads to |
| numbers in the paragraph above, the average | | | | frequent trading, higher expenses, and poor |
| index investor outperforms the average active | | | | performance. |
| investor by 2% annually. If that doesn't sound like | | | | We also have a tendency to be loss averse. This |
| a lot, consider the indexing advantage when | | | | phenomenon causes us to feel more pain from a |
| compounded over 50 years (the longevity of | | | | $1000 loss than we feel happiness from a $1000 |
| many retirement accounts). Assuming an initial | | | | gain. As a result, we tend to hold losing |
| investment of $10,000 and an annual market | | | | investments for too long (in order to avoid the |
| return of 8%, an index investor would retire with | | | | pain associated with realizing the loss) and sell |
| savings of $372,000 while an active investor | | | | winning investments too soon. Both of these |
| would retire with just $145,000 - that's less than | | | | practices destroy investment returns. |
| half! | | | | Finally, we follow the herd. During the late 1990s |
| Reason #2: Simplicity | | | | and early 2000s, countless "sophisticated" |
| Index investing brings simplicity and transparency | | | | investors ignored fundamentals and invested in |
| to an investment portfolio. In the wake of the | | | | the latest dot-com, only to see their wealth |
| recent financial crisis, individual investors are paying | | | | destroyed soon thereafter. Herd behavior is so |
| unprecedented attention to their investment | | | | damaging because it often causes us to buy at |
| portfolios. Some are abandoning high-priced | | | | the worst possible time (the top of the market) |
| professionals and managing their own money; | | | | and sell at the worst possible time (the bottom). |
| others are examining their advisor's activities with | | | | By building a risk-appropriate portfolio and |
| increased scrutiny and skepticism. Effective | | | | maintaining it through a rebalancing program, you |
| investing is challenging, but it doesn't have to be | | | | can systematically avoid these harmful behavioral |
| complex. | | | | biases. First, eliminate the damaging effects of |
| According to a study by Ibbotson and Associates, | | | | overconfidence by building a portfolio based on |
| over 90% of investing returns can be attributed | | | | your risk capacity, not based on what you think |
| to asset allocation, or the proportions of different | | | | the market or a particular sector is going to do. |
| types of financial assets (e.g., stocks, bonds, cash) | | | | Next, fight your tendency to be loss averse by |
| in an investor's portfolio. Unfortunately, asset | | | | establishing target bands for portfolio rebalancing, |
| allocation can be difficult to determine when | | | | thereby removing your ability to make harmful |
| dealing with a portfolio of actively-managed funds. | | | | buy/sell decisions. Finally, ignore the herd and stick |
| Active managers can drift from their described | | | | with your plan! |
| investment style in the hope of increasing returns, | | | | Summary |
| so an actively-managed "small cap value fund" | | | | By investing in a risk-appropriate portfolio of index |
| could actually consist of some large cap, growth, | | | | funds, you can boost your investing returns, |
| or cash holdings at any time. Style drift takes the | | | | simplify the task of portfolio management, and |
| asset allocation decision out of the hands of the | | | | fight the harmful biases that are naturally present |
| investor, potentially reducing overall portfolio | | | | in your psyche. The benefits of index investing |
| diversification and subsequently increasing risk. | | | | make this strategy anything but boring! |