When investors aim to "beat the market," what they're really trying to beat is an index -- a measure of a market's overall performance. However, some investors look at overall performance and think to themselves: "That's pretty good. I'd be happy with that." So-called index investing is for them.
In financial markets, an index is simply a formula that uses the current prices of securities to try to gauge the overall health and direction of a market, a segment of a market, an industry, a regional economy or something else. Perhaps the most famous index is the Dow Jones Industrial Average, which tracks the stocks of 30 major U.S. companies. The S&P; 500 is an index, as are the Nasdaq Composite, the Wilshire 5000, the Russell 2000. There are thousands of others as well.
Indexes really measure only the performance of the particular stocks, bonds or other securities included in them. Even so, they're commonly viewed as stand-ins or proxies for larger markets. If the S&P; 500 is soaring, for example, then the "large-cap" stock category is doing well, since that's what the index tracks. If the Dow Jones transportation average is sagging, that means the transport industry as a whole is performing poorly. But the performance of a market index doesn't scale down to the individual securities in the index. Owning a share in one of the 500 stocks in the S&P; index doesn't guarantee that you'll get the same return as the S&P; 500. The index is the average. There are losers even in boom times and winners even during a bust cycle.
To use an old metaphor, investors who are out to beat the market are trying to find needles in haystacks. They want just the winners, with no losers, so that they always exceed the market average. Beating the market is far from impossible. In any given year, a sizable number of investors will beat the average. What's difficult is doing it consistently, year after year. "Index investors," by contrast, buy the whole haystack, needles and all. They buy every security in an index, so that they get both the winners and the losers. If you have a portfolio that mirrors the makeup of the S&P; 500, then you get the same return as the S&P; 500 -- the average. Historically, the gains of the winners more than overcome the losses of the losers, which is why markets have always risen over the long term.
Acquiring and maintaining a portfolio that perfectly matches a particular index is usually expensive and time-consuming. That's why index investors don't do it themselves; they rely on mutual funds. Funds are available that track just about every available index -- for stocks, bonds, commodities, precious metals, whatever. Because these funds don't need to be actively managed, they typically charge lower fees than other funds. On the flip side, you're not going to "hit it big" with index investing. You'll get the same return as the rest of the fund's investors, no more and no less.
- The Bogleheads Guide to Investing; Taylor Larimore, et al
- The Random Walk Guide to Investing; Burton Malkiel
- MoneyChimp: Index Funds and Indexes, Explained
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