Why Index Funds Deliver Such Great Returns

I recently read The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (Little Book Big Profits) and simply LOVED it. Much of it is very similar to The Bogleheads' Guide to Investing as it should be since the Little Book is written by John Bogle himself. Anyway, the Little Book, while small in size, makes several great arguments for index fund investing. I'll be sharing some of my favorite points from the book with all of you over the next few weeks.

In the book's introduction, Bogle gives a brief but very interesting and compelling summary of why index funds deliver such great returns relative to other investments. His thoughts:

As investors, all of us as a group earn the stock market's return. As a group -- I hope you're sitting down for this astonishing revelation -- we are average. Each extra return that one of us earns means that another of our fellow investors suffers a return shortfall of precisely the same dimension. Before the deduction of costs of investing, beating the market is a zero-sum game.

It makes complete sense that all of our collective investment returns add up to the market's average. Here's a simple example: if the market's average return is 10% and there are only two people in it (with the same amount of money invested), if one earns a 12% return the other has to earn an 8% return. Yes, one does better than average and the other does equally poorly versus the average.

Now take this example and spread it over the millions of investors in the market. They all earn various returns (before expenses) but when those returns are all put together, the market average return is what we get. Obviously, some people will beat the average and some won't. It's basic math. Simple concept, huh?

At this point, you're probably thinking "then that means index funds are only average investments and why would I want to be only average?" But Bogle goes on:

But the costs of playing the investment game both reduce the gains of the winners and increases the losses of the losers. So who wins? You know who wins. The man in the middle (the brokers, the investment bankers, the money managers, the marketers, the lawyers, the accountants, the operations departments of our financial system) is the only sure winner in the game of investing. Our financial croupiers always win. In the casino, the house always wins. In the powerball lottery, the state always wins. Investing is no different. After the deduction of the costs of investing, beating the market is a loser's game.

That's a powerful statement to end a post on, but we'll cover more of this book later and you can really see where he's going. But for now, let me take a shot at it:

• In addition to a return, every given investment also has associated costs with it. These are sales loads, fees, management expenses, planner fees, marketing expenses, taxes and the like.

• In most investments, these expenses can add up to fairly significant numbers. Later in the book, Bogle adds them up to show that expenses/taxes run in the 1-3% range for most investments.

• Index funds are usually very inexpensive to run and very tax efficient. As such, their overall costs are low.

• Therefore, when you subtract costs, index funds out-perform most investments. After all, which would you rather have, an investment that had a return of 12% and costs of 2% or an investment that had a return of 11% and a cost of 0.2%? I think the answer is clear.

More to come. Stay tuned to hear some additional nuggets of information from this great book.

Comments

[NCN]

When you say "index" funds... specifically, WHICH INDEXES? Thanks, NCN

[plonkee]

Just to be pedantic:

Beating the index is not a loser's game, if you could be certain of doing it, then you would probably be a winner (depending on costs).

Aiming to beat the index is a loser's game as you are not certain of doing it, and the chances are very good that you will not, even more so after costs.

And no one is in the position of beating the index, the are at most aiming to beat it.

[FMF]

NCN --

I use Vanguard index funds. If you're interested in how to invest only using index funds, check out this post:

http://www.freemoneyfinance.com/2007/03/how_to_invest_u.html

[Lord]

Is a discussion of return without risk ever valuable?

[tinyhands]

I've said this in a few different places. You don't HAVE to beat the market, you only have to beat inflation. Any return better than inflation is great.

[Dr. Artfredo C. Abella - Philippines SLU H]

When we refer to Index Funds it always leads us on the stocks in the market. Given the situation whether an investor would earn or lose is simply this basic rule: The investors would want that the stocks that he purchased would increase its par value and its saleability in the markets while the stock's firms would wish that his par value would remain constant or at best goes a lower to avoid losses, this kind of game played in the markets are indispensable. There are so many indicators that determine whether one would play or lay all his cards and money in the stocks exchange given the plus and minuses that must be taken into consideration. If the stocks become bearish, optimist would say it's time to buy for possible speculations that in the near distant future the stocks of it's par value would rise, hence he gains. If the markets becomes bullish most investors would unload some of their stocks and sell a portion of it for possible and visible gains or opportunities like having tours, vacations, buying cars or even real estate. As the Index Funds in the markets plays its roles there are significant and indispensable factors that affects its rise or fall or its gains or losses. For one the markets react sharply to political events happening in ones vicinity. If the political aspects of one country loses its cool, then the Index Funds tends to get bearish while if the political system is sound, the stocks strengthens and become bullish, hence investors would gain. The economic factors of ones locality is also affected, if there is wide spread inflation, the Index Funds would suffer the most. We therefore conclude that as the economy of ones country is stable and sound then the better it will be for the Index Funds and its gains as well as for the best interest of its investors. Another noteworthy observations that we can also see is the ability of firms listed in the Stocks Exchange to meet the requirements of the Stocks Exchange Commission or Bureau as far as legal requirements are concerned. Erring firms listed in the stock exchange who could not comply with laws and regulations imposed by the government get suspended, hence the money of the investors are held in suspense. The guiding and basic principle in buying stocks is as much as gaining its Index Funds and earn huge liquidity but foremost is the ability to buy the ownership of the companies, hence the concept of buy the ownership of business instead of their products apply. Over and above the plus and minuses, investing in stocks would enable one to earn cash and stocks dividends not disregarding stock option rights plus the notices to attend Annual Stockholder's Meeting. Investing in the marketable securities is one mode of taking risk to attain gains or possible losses. Take note money is just a game, so if John Doe's invest his money in stocks and flops then he says it is not right to invest in stocks but if his Index Funds affords him a hefty sums, he then says its luck and a wise decision. Given all these factors and indicators, an investor would then fantasize is it really worth risking most of his money on the marketable securities given that the Index Funds is in the ambivalent situation. Taking a long grasp and contemplating things in the plains to appreciate the highlands one investor would say it is indeed worth the risk for the greater is the risk, the greater would be the rewards and gains. As the saying goes: " The ship in the port is safe but for what is the ship for."