Uncommon Cents

It was pointed out to me the other day that I discussed index funds before I really discussed an index. Considering that this blog is supposed to be about simple personal finance, perhaps we need to go back in time to discuss what an index actually is.

An index is a theoretical portfolio of stocks or bonds representing a particular market or a portion of it. One of the best known of all indices is the Standard & Poors 500, which represents the stocks of 500 very large corporations, the majority of which are American. Another well known index is the Dow Jones Industrial Average (typically referred to as “The Dow”), an index of 30 of the largest publicly held companies in the United States.

An index serves several functions; one of them is that they can be considered an indicator of the health of an economy. Many economists follow the S&P 500 to try to gauge in what direction the economy is headed. In addition, an index is often used as a baseline for determining how well investments are doing; many (including me) will often say something like, “I’m outperforming the market,” meaning that I’m comparing how my personal investments are doing versus the S&P 500 index (or perhaps another index, such as the Wilshire 5000).

Studying the performance of an index over time–for this post we will use the S&P 500 as the example–tells us that while the numbers vary depending on the calculation, the historic return of the S&P 500 is approximately 10% per year. While the performance varies yearly–sometimes great, sometimes negative, always unpredictable–over the years, the index has produced fine, if somewhat unexciting, performance. Think of it as the tortoise.

What if you wish to be the hare? How do you beat the index? Well, first, assuming you can–which we’ll address in a minute–you will have to take an approach unlike an index fund, which tracks the index. All the index fund does is approximate the performance of the index, usually by holding the same securities in the same weighting as the index (in, of course, a smaller scale). Because it owns a large number of different stocks, it has the risk reduction strategy of diversification built-in, insuring that if one of its stocks goes horribly south, it won’t ruin the entire portfolio. Since it doesn’t often sell securities, it doesn’t experience the capital gains–and tax consequences–that happen with frequent selling, and it doesn’t require much effort on the part of the fund manager, resulting in very little in the way of expenses and taxes, so owning the index fund means that you’ll come very, very close to matching the performance of the index.

An attempt to beat the index must either concentrate its assets–meaning less diversification, meaning more risk–in stocks it hopes will outperform the index, actively trade from one asset to another in search of performance (meaning tax consequences and lots of effort on the part of the investor, as well as the costs of trading), or both. While it certainly is possible to beat the index from time to time, sometimes for long periods of time, eventually risk catches up to the vast majority of folks out there who try to beat it, or their costs catch up to them (I estimate that in an actively traded portfolio, beating the index by 2% is necessary to actually be “even”, given the tax and expenses of trading), or both.

The performance of the index is relentless, and the performance of those who try to beat the index is variable. The vast majority of investors, professional or otherwise, who attempt to beat the index fail, at least over the long term. Yes, some–such as Peter Lynch and Bill Miller–are able to do so for years, but they are a very rare breed. Even if it is possible to beat the index, is the performance of “just” the index unacceptable? The stock market has proven itself over the years to be the best performing investment over time, and owning an index fund is the lowest cost, lowest risk way to invest in it. Yes, it’s fun to try to beat the index–I try it all the time, in very small increments–but in the long run, like the tortoise, the index catches up to the hare and passes it by.

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