Index investing is one of the most popular investment strategies for beginner investors. But what is index investing, and how does it differ from other strategies?
Many investors attempt to be smarter than the crowd and beat the market by picking their own assets to invest in. However, most of them fail and only achieve below-average returns. But is it really necessary to spend a lot of time and effort to beat the market?
For the average investor, attempting to pick their own investments and achieve above-average returns is overkill. Instead, they can rely on a proven investment strategy that guarantees them to achieve the market's average return. This investment strategy is called index investing.
Index investing is a popular investment strategy that attempts to replicate the performance of either the whole market or a subset of it. Contrary to other investing strategies, you will not research individual assets when following an indexed investing strategy. Instead, you will invest in a so-called market index, which selects investments based on a fixed set of rules.
However, you will usually not make the investments into the market index by yourself. Instead, most index investors will purchase investment funds that follow the rules of a specific market index. Because these funds replicate a market index, they are called index funds.
You can typically either buy them as a mutual fund or an exchange-traded fund (ETF). The difference between mutual funds and exchange-traded funds is that the latter can be freely bought and sold on market exchanges. On the contrary, mutual funds can only be bought and sold from the fund manager.
As an index investor, you will invest based on predefined rules that include or exclude assets based on some of their characteristics. However, you will usually not define the rules yourself.
Instead, you will invest based on so-called market indices that are being created by independent organizations. These market indices define a transparent and rule-based methodology that describes what assets will be included or excluded and how often they will be added or removed from the index.
You can choose between thousands of market indices that track a variety of different assets, like:
In addition, market indices may define more elaborate selection rules, like the geographic region or asset-specific metrics. For example, the S&P 500, one of the most popular market indices, includes the 500 largest companies in the USA by market cap (the company’s total value).
Imagine you would like to invest in the German stock market. One way to approach this would be to purchase an equal amount of shares for each company that is listed on the Frankfurt stock exchange. Therefore, if the exchange would list 100 companies, each company would take up 1% of your total investment.
Because you now own every company that is listed on the Frankfurt stock exchange, your investments will now replicate the performance of all companies whose shares you bought. Therefore, if these companies do well, you will do well too and vice versa.
Because market indices are based on strict rules, their performance is not dependent on human intervention. As a result, index funds that replicate a market index are often called passive investment funds.
A passive investment fund only requires minimal intervention from a fund manager because its investments are made based on a market index. As a result, it is passively managed. Because no intervention is needed, passive investment funds tend to have lower fees and expenses. Therefore, your own return will be higher if you invest in a passively managed fund.
Contrary, active investment funds usually employ one or more fund managers. These fund managers will decide where to invest the funds' money. Therefore, all decisions are made actively and rely on the fund managers' knowledge, strategy, and luck. Because an active investment fund needs to employ humans to make investment decisions, their fees and expenses tend to be higher.
Now that you have a basic understanding of index investing, you might wonder why it works.
The answer is simple: Because most market indices consist of a broad range of diversified assets, you will always match the performance of those assets.
Let’s take a look at the S&P 500 again. As we mentioned earlier, it consists of the 500 largest companies in the USA by their market capitalization. Because the USA is a developed country with a well-functioning economy, you will find companies from many different industries in the S&P 500, like technology companies, manufacturing companies, food producers, and medical research companies.
Due to the broad diversification of these companies, you get some added protection against market influences, as it is quite rare that all companies will suffer simultaneously.
Another upside of index investing is that the lack of human intervention also guarantees the absence of emotional buy and sell decisions. An index fund will not sell an asset because of short-term price fluctuations. Instead, as long as the asset matches the criteria of the underlying market index, it will stay part of the index fund.
This effect is confirmed by the historical performance of the S&P 500. Between 2012 and 2022, it provided an average annual return of almost 11%. If you would have invested $100 on January 1st, 2012, you would have ended up with roughly $2800 on January 1st, 2022.
Continue with the next lesson of our beginner-friendly guide “Index Investing”.