I recently read "The Index Revolution" by Charles D. Ellis, a well-known investor who is widely respected for his success in institutional finance. He has authored 16 books and more than 100 articles on investing strategies. "The Index Revolution" offers numerous reasons why index investing is the best approach. Here are three reasons that stood out to me and that I wanted to share:
1. The changing market has changed investing strategies. Ellis walks readers through how the world and stock market has changed over the last 50 years. He cites two important factors that impact investors today: the increase in trading volume and who is doing the actual trading.
Ellis observes that "trading volume on the NYSE has gone from 3 million per day to 5 billion, a change in volume over 1,500 times." He also points out that "individual investors did over 90 percent of all NYSE trading 50 years ago. Today, institutional trading is over 98 percent. The 50 most active of these professionals do 50 percent of all NYSE trading and spend $100 million annually in fees and commission buying information services from the global securities industry."
What this means is that the increase in trading volume over the last five decades shows that the markets are much more efficient, which reduces arbitrage opportunities (the simultaneous purchase and sale of an asset to profit from a difference in the price). The more buyers and sellers of anything, the less chance for a large mispricing.
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This also means that no one has an elite inside track on the market. Remember, no one can see into the future and predict the market. If a local investment firm in your town claims to have a superior investment process and an ability to outperform the market by picking individual stocks, know that they are wrong. The data support that the bigger and better-funded players will continue to dominate the market.
2. Index investing outperforms active management. The investment pool has gone global, and it's filled with highly trained sharks. There is no shortage of investor talent or smart individuals who understand the market and know how to play the game. Ellis surmises as much when he claims that "history's largest, most capable, best informed and most highly competitive professional investors dominate today's stock market. So almost no one can expect to outperform the others regularly after cost and fees."
This means that for you and other investors a passive-investing approach that tracks the market is a better opportunity as opposed to an active management that attempts to beat the market. It allows regular people, who aren't investing experts, to participate in investing strategies created by experts.
Because investing is a global game with an abundance of talent, the firms of today are so skilled that their collective abilities are reducing the possible gains. The average investor doesn't necessarily have the time or expertise to compete at the elite level, but there is still opportunity to gain the market return with indexing.