Here's another excerpt from Wealth by Stuart Lucas. I liked the book -- giving it 6 stars. So it's my pleasure to offer this excerpt from Chapter 5:
Mutual Fund Indexing: Why it’s the Investment Path for Most Individuals
When push comes to shove, investing is a tough business. For that reason, it’s probably best that most investors limit their investment ambitions to the world of The Capital Kibbutz. And there’s nothing wrong with that.
Of all the investment instruments available to investors in The Capital Kibbutz, there is one that is ideal for most investors to consider using. It’s not a glamorous, exciting solution. It doesn’t mirror the bold impetuosity of the Country Club Gambler. Nor does it embody the secrecy and mystery of The Secret Society. Even the term to define it isn’t terribly compelling. But it is truly the best way for most investors to go. It’s called “indexing.”
Briefly stated, indexing involves investing in a statistical composite of securities that mimics the characteristics of an entire investment market or asset class, like the S&P 500, the Russell 3000, the Wilshire 5000, or other well-known, broad-based indices.
Because most index funds contain a broad and representative cross section of desirable financial markets, there’s no portfolio manager trying to improve performance by buying or selling individual securities. For that reason, most of the well-designed ones create very little in the way of investment fees, brokerage commissions, or capital gains taxes—at least until the index itself is sold.
So, should you pin your wealth management strategy on effective use of index funds? Consider this: Approximately $3.5 trillion of America’s pension plans are indexed, or about a third of the total. This is up 400% since 1990.
Corporations know the value of indexing. In the last 20 years, most large pension plans have gone from having dozens of portfolio managers with various risk strategies to having a core stock portfolio that is indexed to a broad market benchmark.
What’s more, there’s broad agreement that indexing makes sense for a wide variety of investors.
“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals,” notes Warren Buffett, Chairman of Berkshire Hathaway, and considered by many people to be the world’s most astute investor.
But despite Buffett’s advice, individual clients have been surprisingly slow to embrace indexing. After all, most individual investors don’t have the expertise to build the Four A’s needed for Active Alpha Investing. What’s more, the case for indexing is actually stronger for individuals than it is for institutions for two reasons:
1. Indexing is tax efficient relative to active management. This can save taxable investors a lot of money, but is of no benefit to pension plans or endowments.
2. While most private investors can’t compete with institutions for access to the best active managers, they do have access to the same indexed products as institutional investors do at almost the same cost. Indeed, for index products the fee differential between institutions and individuals is a mere .2% or less. By contrast, in the case of active management, the fee differential (between individual investors and institutions) is often a half a percent or more.
Indexing really is the way most individual investors should go.
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Oh yeah, he's singing my song again. As most regular readers know, I really like index funds.
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