So what are index funds and why passive investing?

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Passive investing is based on a theory called the efficient market hypothesis.  It basically says that all information is already known and incorporated into the stock price of publicly traded companies and so there is no way for investors to identify undervalued assets.  You hear a piece of news that causes a company’s share price to rise-by the time you are able to call your broker or place a trade online-the market has already moved.  Because the stock price of companies always already reflects all publicly available information it is impossible to “beat” or outperform the market so you’re better off trying to match the market through index funds.

Now you’re saying to yourself…what about all of those people who bought Amazon or Netflix ten years ago-they’ve far outperformed the S&P 500?  How likely is it that you with your family commitments and day job are going to have the time to go through all of the stocks traded on the Nasdaq or New York Stock Exchange and identify the next Netflix…slim to none.

So you’re humble enough to admit you’re no Warren Buffet and decide to turn control of your money to an investment advisor or invest directly in last year’s actively managed mutual fund.  Per Investopedia, through mid-year 2015 about 65% of active managers underperformed their benchmarks over a 1 and 5 year period and about 80% underperformed over the 10 year period.  How would you know which of the lucky 20% to give your money? And If you’d gone to an investment advisor he/she probably charged you 1-2% of fees and/or a flat fee per trade.  If that’s the case-is it in his/her best interest to only trade as little as possible? Or, of the thousands of funds available, is he/she going to put you in the lowest cost fund the competitor is pushing or the high cost fund his/her company is pushing?

So you can’t pick individual stocks and you can’t outsource managing your retirement.  So do the next best thing-invest in passively managed index funds.  Index funds are mutual funds and pool investor money to buy assets by the same weight as a target benchmark.  Say Amazon makes up 4% of the S&P 500, and S&P 500 index fund will buy a basket of stocks containing 4% of Amazon and x weight % of Exxon, Apple, Google, Johnson and Johnson, Home Depot, etc.  As the market moves and stocks prices go up and down, the computer will buy and sell holdings to keep the fund aligned with the benchmark.

And honestly, what’s wrong with the 9.8% average annual return delivered from 1926-2016 that you would get investing in an S&P 500 index fund, or 11.29% return for the Russell 2000 from 1980 through 2013? Visit my compound interest calculator to determine the value of a investment over time.  Let’s walk through a scenario:

1. Helen invests $5000 a year in an S&P 500 Index fund in her 401k for 30 years at a 9.8% rate of interest.
2. Her 401k brokerage charged her .035% in fees so her actual interest rate is 9.8%-.035% = 9.765%
3. Her company matches this investment making her total annual investment $10,000/year
4. After 30 years Helen has $1.8mln to retire with.

Let’s say instead Helen decided to invest her nest egg in an actively managed mutual fund that underperformed the S&P 500 by 2% and charged 1% of fees leaving her with 6.8% annual return. Sure she’d still have almost a million dollars at retirement but she’d have forgone over $800k in additional savings.