The “index” refers to the entire investable market in proportions to their company valuations.
So if Commonwealth Bank is valued at double BHP, it would be valued at double in the index and similarly for all companies.
An Australian index contains all the stocks in the Australian market in their valuation proportions.
An emerging market index contains all the investable stocks in the 23 emerging countries in their valuation proportions.
A developed countries index contains all the stocks in the 23 developed countries in their valuation proportions.
You get the idea.
Investing in an index allows you to say
I don’t know anything about choosing a company, sector, country, or anything else, and I also don’t know how to choose a fund manager capable of choosing them. I accept that I don’t know. But I still need to invest for my future.
Investing in an index fund allows you to invest in the entire market without the risk of you or anyone else selecting the wrong stocks by just buying everything.
Important points about index funds
Before index funds were available, if you had no idea how to pick stocks to invest in, your only option was to invest in actively managed funds.
They generally charged around 2% of your total assets invested with them each year for picking their stocks for you.
Let’s take a look at the numbers.
The long-term return for Australia and the US has been 6% over inflation.
2% in fees means you have lost a third of your return.
And compounding works both ways – the longer you compound gains, the more of a positive effect compounding has, but the longer you compound losses, the more of an effect compounding has on your returns, but in the other direction.
Let’s look at the effect after 40 years of compounding on a $100,000 investment.
The first with 2% management fees taken out. The second at 0.2% management fees of index funds taken out.
$100,000 for 40 years at 4% compounded annually = $480,102
$100,000 for 40 years at 5.8% compounded annually = $953,732
Those fees cost you half your net worth. When it comes to fund management fees, 2% is an enormous amount. Even 1% is nowhere near acceptable, as you can see in the chart below. At the 10 year mark, you can get an estimate of your costs by multiplying the expense ratio by ten, and it just gets worse after that.
In case it is still unintuitive, this article articulates how small-sounding 1% fees cost you a third of your nest egg.
With index funds, you’re guaranteed the performance of the entire index.
You might think that fund managers can pick better performing stocks so you can get a return that makes up for the fee and more, but the data is out on this. S&P has been tracking active management performance for a long time now and release regular SPIVA reports. Their findings are that while over any 1 or 2 year period, an active manager may outperform the index, over 15+ years, more than 80% of active managers fail even to match the index after fees.
This can be explained by the Pareto Principle (the 80/20 rule).
Most of the future performance will come from a disproportionately small number of companies in the market1,2, and it’s much easier to miss some of these few companies resulting in lower returns than just investing in everything. As a consequence, a disproportionately small number of fund managers outperform by a large magnitude, and a disproportionately large number of fund managers underperform. So when you pick a fund manager with no real idea where they will end up, you have a much higher chance (over 80% going by the SPIVA reports) of ending up with one that underperforms.
And while there are some actively managed funds that outperform, the probability of identifying them ahead of time is very low. Not many people knew in 1960 that Warren from Omaha, Nebraska, was going to deliver stunning returns, and he only became famous once most of his stunning returns had already been delivered.
3. Fund Manager Risk
Fund managers can and do make mistakes in their investment choices. Just today, I read another article about a fund manager who the BBC once described as “The man who can’t stop making money”. He messed up so badly, with billions of investors’ dollars in funds, that they had to “gate the fund” to stop investors taking out their own money to avoid a fire sale (selling below value to pay out investors), causing massive losses to his investors.
The greatest benefit of indexing, which is never really discussed, is that it also removes agency risk — the risk that the management uses its authority to benefit itself at the expense of shareholders.
All investors in the market are made up of a combination of index investors and actively managed funds. The index investors are, by definition, getting the market return. So when we look at the average of all funds collectively under active management, the performance will also be that of the market (minus fees) – because if you could pick which managers will outperform, we would all pick those. When you go with active management, you get the same expected return as indexing, but you now have additional risk. Why take a risk without a reward?
For those who argue that you can outperform by picking an active manager, the problem is that since you can’t know in advance which funds will outperform and which will underperform, you’re not increasing your expected return. What you’re doing is increasing the range of possible outcomes (which is the definition of risk) without increasing the expected return, which is the definition of gambling.
Imagine a game of roulette. 1 in 37 times you get 37 times your original bet, and the other 36 times you get nothing, so your expected return is (37 x bet + 36 x 0)/37 = your original bet. Your expected return equals your original bet, but you’re hoping that it will land in the higher end of that larger range of outcomes, but hope is not an investment strategy. This is the difference between gambling and investing.
4. Idiosyncratic risk
Idiosyncratic risk is the risk of buying a single stock or a single sector of stocks, or a single country’s stocks.
Let’s say you expect a company to fail, on average, 5% of the time.
If you invest in 1 company, you have a 5% chance of a complete loss of capital.
If you invest in thousands of companies, there’s no chance that all companies will fail. Instead, you will get much closer to your expected return of a 5% loss of capital. Compensated by the profits of the other 95%, you wouldn’t even notice it.
What about blue chip companies – they’re too big to fail, they’ll always land on their feet.
Are you sure? What about Xerox? And Polaroid? Kodak? Nokia, Blackberry, Control Data, Nortel, Worldcom, Palm, Blockbuster, Burroughs, Reader’s Digest, Digital Equipment Corporation, Schlitz, Enron, General Motors, General Electric, …
So if we go back to the risk-reward spectrum in the previous article, we can see that with diversification, you’re getting the same expected return but with lower risk, i.e. a lower range of possible outcomes.
What this means is that diversification is a free lunch – an upside with no corresponding downside.
It goes the other way too – idiosyncratic risk, just like fund manager risk, is a risk without a reward – it’s a silly risk to take when you think about it.
When you invest in just one company, one sector, or one country, you’re taking an uncompensated risk.
The take-home message is to diversify broadly.
Index funds are the cheapest and most efficient way to diversify broadly to mitigate idiosyncratic risk.
As an enthusiast and expert in the field of index fund investing, let me share my knowledge to help you understand the concepts discussed in the provided article.
1. Index Definition and Composition: The "index" in the context of investing refers to a benchmark that represents the entire investable market, comprising various stocks or securities. These are weighted based on their individual company valuations. For example, if Commonwealth Bank is valued at double BHP, it would be given double weight in the index. An Australian index would include all stocks in the Australian market, and similarly, emerging and developed market indices include stocks from 23 emerging countries and 23 developed countries, respectively.
2. Investing in an Index: Investing in an index involves allocating funds across the entire market without the need for individual stock, sector, or country selection. It serves as a passive investment strategy for individuals who may not have the expertise to make such selections. This approach allows investors to benefit from the overall market performance.
3. Index Fund Benefits:
- Fees: Index funds typically have lower management fees compared to actively managed funds. The article emphasizes the impact of fees on long-term returns, showcasing how high fees can significantly erode the compounded value of an investment over time.
- Performance: Index funds guarantee the performance of the entire index. The article cites data suggesting that over extended periods, a majority of actively managed funds fail to outperform their respective indices after accounting for fees.
4. Fund Manager Risk:
- The article discusses the risks associated with fund managers making mistakes in investment choices. It highlights a case where a fund manager's errors led to significant losses for investors. The benefit of indexing is seen as removing agency risk, where fund managers may act in their interest at the expense of shareholders.
5. Idiosyncratic Risk and Diversification:
- Idiosyncratic Risk: This refers to the risk associated with investing in a single stock, sector, or country. The article argues that such risks are better mitigated through diversification across a broad range of assets.
- Diversification: The article suggests that diversification, achieved through index funds, is a "free lunch" — it provides the same expected return with lower risk. It contrasts this with idiosyncratic risk, which is deemed an uncompensated risk.
6. Further Reading:
- The article recommends further reading on the case for low-cost index-fund investing from Vanguard, explains why index funds are an optimal starting point, and presents ten reasons for investing in index funds.
In conclusion, index fund investing offers a cost-effective and efficient way for investors to participate in the broader market, minimizing risks associated with fees, fund manager decisions, and idiosyncratic factors through diversification.