Indexing is not the same as smart, low cost investing. With indexing, you accept the market performance of an index designed to measure market performance. A key point here: market indices are designed to measure performance, not as investments in and of themselves.
The basic premise of index investing is an index will beat most managed mutual funds. It’s amazingly true, and goes against all logic. You would think a human being could cull thru the 500 stocks of the S&P 500, nix the “bad” ones, buy the “good” ones, and beat the average return of all 500. But there are three reasons why most mutual funds cannot beat their index: 1. The markets incredible efficiency negates any perceived price advantages. 2. The cost of paying for a well-heeled Wall Street type to pick, buy, and sell stocks reduces return more significantly than most would expect. 3. When the mutual fund manager picks a few stocks out of many, the lower diversification increases volatility for about the same amount of potential market return.
Armed with this information, many investors and their adviser’s have flocked to index funds and ETF’s that replicate index performance. That’s a fine strategy, if average is good enough and you are not interested in the rest of the story.
The rest of the story is there are types of stocks that tend to outperform the market as a whole. Instead of investing blindly in indices that were designed as evaluation tools, you can tilt your portfolio towards the types of stocks that outperform. Academic research suggests value, small cap, and profitability are three indicators of above-market performance. Stocks with these characteristics are inexpensive to identify and purchase at a price more comparable to index funds than managed mutual funds.
A strong portfolio will include other investments, ranging from stocks in countries around the World, bonds, and real estate. This is called asset allocation, and improves overall long-term performance and reduces risk thru diversification and anti-correlation.
In summary, you don’t have to give up on maximizing investment performance just because you acknowledge the fact most mutual funds cannot beat the market. The same academic research used to expose fund under-performance provides us with additional useful information. It makes a lot of sense to buy baskets of stocks, where data suggests the type of stocks you are buying can outperform the market as a whole.