Index Investing – A Gentle Introduction

Index Investing represents an investment strategy which aims to track the performance of a market index.

So, not “picking winning stocks”, “timing the market”, or “beating the market”. This strategy is synonymous with matching the market – at least the one you choose to match.

Table of Contents

Index Investing in Action

As you saw in the previous post, there are various indices that cover specific segments of the market.

This means that you might have preferences for picking your investments based on field, industry, country, region, market cap, how developed a market is, etc. And regardless how you want to do it, you’d most probably find an index or a combination of indices that will suit your needs.

Example

Let’s say you want to track the performance of the large-cap companies of the US market.

You do some research and figure out that the S&P 500 index would be most suitable to do this.

Here’s a 5 year performance of the S&P 500:

index investing

As you can see in the image, it grew 61.76% in this period.

This means that if you distribute your money in the same way as the allocation in the S&P 500, you would capture the index’s performance.

Actually, it’s not a coincidence that I picked the S&P 500 as an example. It’s the most popular index and many retail investors’ portfolios are actually built to track it.

Passive Investing

The Index Investing style is sometimes referred to as “passive investing”.

It means that it’s more suitable for a buy-and-forget type of investors. In other words, there’s no active portfolio management, frequent buying or selling, rebalancing, or picking stocks.

So whenever you hear someone talking about passive or “lazy portfolios”, investing “in the market” or “in stocks” (without mentioning specifics), they most probably refer to tracking a common market index. Most probably the S&P 500 or MSCI World, for a more global diversification.

At this point, it’s worth mentioning that history shows that index investing overperforms most active traders in the long run.

So given the limited amount of money, knowledge, and time you posses, matching an index would be your best strategy.

Your only input is upfront – to determine which indices you’d prefer to track.

How to invest in an index?

You can’t invest in an index.

But while it is true that you can’t invest in one, you can still use indices to build your portfolio.

There are entities called investment funds, whose business model is managing a portfolio in order to track an index. These companies allow investors to buy shares in the fund to capture the index’s performance, for a small fee.

This would generate returns such as the index itself would, if we were able to invest in it.

So as an index investor, after choosing the index you prefer, it boils down to putting your money in a fund that tracks it.

There’s some methodology in picking the right funds, which we will get into soon. But let’s not oversimplify just yet – there will be dedicated posts for all of this throughout the series.

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Considering their low fees, broad diversification, and somewhat predictable behavior, index investing is the best and safest long-term investment strategy, proven to outperform active portfolio management on the long run.