Why index investing makes sense for most people

  • 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 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.
  • Indexing, or passive investing, is a way for today's investor to participate in the market without the high expense of your time and money.

No one knows with certainty where the market is headed on a daily, monthly or yearly basis. While you can always find an example of an active investment manager who beat the market for a year or two, it's nearly impossible to find evidence of any manager doing so on a consistent basis over the decades of time that most people invest.

With this in mind, when it comes to investing, a passive (or index) investment strategy makes sense for the majority of people.

Market Index
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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.

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3. Index investing requires less of your time. Most people have other priorities for their time that don't include active investing. Chasing performance is not only a waste of your monetary resources but it's a giant waste of your time, too.

Indexing, or passive investing, is a way for today's investor to participate in the market without the high expense of your time and money. Preparing for your future and saving toward retirement doesn't have to be complicated, expensive or all-consuming. Ellis, a famous institutional investor, takes an entire book to make the case for indexing. If he sees it as a smart opportunity, you know there has to be something to it.

Ellis admits: "Fifty years ago, I thought it was realistic to expect that an experienced team of portfolio managers would 'beat the market.' But over a half century it has become virtually impossible for all but a very few investment organizations to outperform the market after fees and costs over the long-term future. … The past 10 years have accumulated undeniable evidence that almost all investors would do better to rely on indexing for their investment operations and concentrate their time and talent on tailoring investment policies to achieve their own specific objectives."

Questions to ask

As you consider your own investment strategy, ask yourself these three important questions:

  • Are your investments tailored to your own specific objectives?
  • Is your money focused on your goals and things you can control?
  • Are you paying too much in time and resources to be invested in the market in the first place?

If your answer is yes to any one of these important questions, then it may be time to pause and reconsider how you're investing. Remember, while no one can predict the market, everyone can control how their money is invested. How you invest can make all the difference, not only in your financial future but your overall quality of life today and in retirement.

(Editor's Note: This column originally appeared on Investopedia.com.)

— By Paul Sydlansky, founder of Lake Road Advisors

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