The Ins and Outs of Index Investing

Saving and investing should be a top priority for all 20-something year olds. As Yeshiva University and other college students alike work their way through college and enter the workforce, they’re going to face the question of what to do with their hard-earned money not spent on daily consumptions. This quandary is not unique to college students. Most individuals, to escape the effects of inflation, choose to invest their money. Whatever one’s profession, the consensus logical thing to do with his or her money is to put a portion of it away, watch it continuously grow over time, add to it annually, and experience the magic of compounding. In the 21st century, the public fortunately has many investment options geared towards how much risk they want to take on. While bonds are deemed less risky than stocks, the lower return can push some people who are looking for a higher return to invest in stocks.

The problem many college students and young professionals face in investing is determining which stocks are undervalued and are expected to grow in years to come. The assumption is that only a select few experts might understand why a stock is undervalued or what’s driving the growth of a certain stock, due to their strong interest in investing. However, that may no longer be the case. What can help that engineer or doctor in training properly invest is a 20th century innovation, known as the index fund. Specifically, the Exchange-Traded Fund (ETF) has burst onto the scene as offering tremendous opportunity to investors.

An index fund is an instrument that invests in and tracks a group of large stocks such as the S&P 500 (500 largest U.S companies by market capitalization), as opposed to investing in just a few companies. Conceptually, an ETF is the same as an index fund but is more appealing in that it is easily accessible for buying and selling on an exchange like a stock. Conversely, an index fund trades like any other mutual fund, being bought and sold only at the end of each trading day. Just like a stock, an ETF can be bought or sold using a brokerage account. ETFs are essentially the evolutionary product of index funds.

Index funds were invented back in the 1970’s to provide investors with an option to invest in mutual funds that don’t solely rely on a mutual fund manager’s stock-picking skills or expertise. Managers’ performances were and still are benchmarked to certain stock indexes, usually the S&P 500. As these managers trailed their benchmarks, often due to the higher fees paid to the manager of the fund, the popularity of index funds surged. This lower cost option provided investors with an opportunity to invest in the market as a whole, while saving money on fees.

One of the major proponents of index funds since their creation has been Burton Malkiel, a long time economics professor at Princeton (and a former Yeshiva University part-time professor). In a book which is now known as an investment classic, A Random Walk Down Wall Street, Malkiel campaigns for the average retail investor to stick to investing in index funds. In a bold analogy, he exclaims how a blindfolded monkey could throw darts at the financial section of a newspaper and select a better portfolio of stocks than an expert. While this may or may not be factually true for mutual fund managers in general, there is a tremendous emphasis being placed on not spending time trying to pick individual stocks. If Malkiel thinks a monkey would form a better portfolio than experts, then certainly for any average investor it’s better to buy an index fund.

Malkiel isn’t the only strong proponent for individual investors to put their money in an index fund. The king of stock picking himself and subject of my article Unlocking Buffett’s Billions: Understanding his Investment Philosophy, Warren Buffett, has voiced similar suggestions. In the 2013 annual Berkshire Hathaway letter to investors, Buffett wrote regarding how his money should be managed once he passes away. (He is currently 86.)

"My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.”

This quote from Buffett couldn’t be more straightforward about his attitude towards index funds. This isn’t to say no one is able to pick stocks consistently and beat the benchmarks. However, for the average investor, the time-conscious decision is to allocate most savings into an index fund or ETF.

Although an ETF can track a benchmark just like an index fund, the S&P 500 is just one of the many benchmarks ETFs track. As of 2015, there were 4,396 ETFs globally. ETFs are differentiated by many characteristics. There are ETFs that track baskets of commodities, fixed-income (bonds), currencies, and more. Stock ETFs track different sized companies, from large-caps, to mid-caps, to small caps. There are even ETFs that utilize investing strategies formerly reserved for hedge funds, such as the ProShares Merger ETF, which tracks a group of companies involved in possible merger deals.

It’s easy to get lost in the world of ETFs, as it is in the world of stocks. With so many options to choose from, how should investors know which ETFs to put their money into? If one keeps to Buffett’s preference for his own estate, then he or she only needs two ETFs, one for the S&P 500 and one for US Treasuries. For investors looking for diversification (a fancy word to describe adding different types of investments to one’s portfolio in order to reduce the potential riskiness of it), ETFs offer many options. For instance, if an investor wants to diversify based on countries, there are ETFs that track each country’s main stock index such as the Nikkei for Japan or DAX for Germany. Evidently, ETFs offer much more variability than a standard index fund and might be an easier, more accessible option for college students. While index funds usually require a substantial minimal investment, typically about $1000 but sometimes as high as $10,000, ETFs could be bought by the share just like any stock.

Two of the most important investing principles are to be conscious of what one’s future financial goals are and to understand oneself in order to gauge how much risk he or she is willing to take on. With the accessibility and cost-effective options that ETFs and index funds have brought to the table over the last 40 years (Vanguard’s first index mutual fund launched just about 40 years ago), investors have an opportunity to build an investment portfolio to watch grow for years to come.