Index investing: because average is better than most

I’ve met quite a few people who complain that their ‘investors’ or mutual funds lose their money all the time.  Some of them use this as justification to just blow all their money on boats and going out for lunch every couple of days.  Bad call bros.  Your investor may be making terrible choices (which you have allowed) but more than likely you can fix the problem, get in control and stop being such a fatalist about your financial future by switching to index investing.  Of all the potential reasons why your investment situation is sucking, there are two that are most likely the problem for you:

  1. Your investor or mutual fund is picking stocks that suck
  2. You’re paying insane MERs.

Index investing is the way to beat half of the money investing in the stock market, guaranteed! Seriously.

Index investing stops bad stock picks by buying everything

An index is a set of rules that rarely change and clearly define a collection of assets regardless of how well or poorly the market performs.  Got that?  No?  Here’s an example.  There’s a well-known index called the S&P 500 that you may have heard of.  The clearly defined rules that is uses are simple: it contains the 500 largest companies by market capitalization from the NYSE or NASDAQ stock exchanges.  Actually it’s not that simple, but for the sake of argument it’s close enough.  The index is weighted by market capitalization as well which means that if company X has a market cap 3 times as much as company Y, then the index moves 3 times as much for company X’s share price changes as for company Y’s share price changes.  This is key because it means the tiny weak companies whose stock prices swing wildly aren’t nearly as well represented as the big strong ones.

What is index investing?

Index investing is the process of buying an index.  The thing is you can’t actually buy an index because it’s just a set of rules, so to “buy the index” you have to buy all of the things that make up the index to mirror its performance.  If you’re loaded you could individually buy each stock or asset that makes up the index in the proper amounts based on weighting.  But most of us aren’t loaded so we buy pieces of a big pie that has already done that buying and weighting for us.  These are almost always mutual funds or ETFs (exchange traded funds).  The performance of these tracks the index fairly well usually, and their MERs are very low because the people investing the money don’t have to work very hard since they’re just following the index rules.  Of course shopping around will get you the lowest MER since there’s always a mutual fund company wanting to fleece you for the most they can.

Why is index investing so great?

Imagine there are three investors.  One investor throws her money into an index and the other two don’t.  How the index investor will perform this year is a foregone conclusion: she’ll match the index.  How about the other two?  Well, they’re trying to beat the index.  They want to have a higher return than the index otherwise they would’ve just bought the index.  One guy does beat the index!  The other one comes up short by exactly the same amount as the first guy beat it.  Why?  Well let’s make it even simpler.  When someone buys an equity, they’re buying it from someone else who is selling it in the hopes that it will go higher.  But the guy selling it thinks it has topped-out otherwise he wouldn’t be selling it!  In fact mathematically speaking the same amount of money that people earn beating the index has to be lost by people trailing the index on a continual basis.  It’s basically a zero-sum game.  The index is average, the 50th percentile.  This is one case in life where being average is pretty great because it’s dependable.

Diversity is easy with indexes too

Buying indexes around the world is a cinch.  If you want to buy Canada you can buy a Canadian index like the TSX 60.  If you want to buy the US you could buy the S&P 500.  If you want to buy emerging markets, you could buy the FTSE Emerging markets index.  Basically it’s really easy to get a piece of all the pies and be globally average.

What is that management expense ratio (MER) thing?

At least part of the problem with not making good money is the MER or management expense ratio.  This insidious number which shows up on the prospectus for whatever the heck you’re investing in is of ultra importance.  In basic terms the MER is the amount of the total value of a mutual fund or ETF that is used for managing that fund in a given year and is expressed as a percentage.  For example if a fund has $50 million in it and it cost $1 million to run it—pay the fund manager(s) and their expenses—during the 2012 fiscal year, then the MER for 2012 is 2%.  Here’s the thing.  Most MERs are higher than they have to be.  According to Investor Economics, the average MER of a Canadian mutual fund in 2006 was 2.2%.  That means that if the average fund gained 2.2%, then the average investor would pocket 0%.  Nothing.  Some of you are probably thinking “yeah but Dean my investor is awesome and totally justifies the MER”.  Maybe, but you’re lucky.  About one in a thousand mutual funds beat the S&P 500 over the long term, and you can buy the S&P 500 index through any number of ETFs and mutual funds with incredibly low MERs.

Balance that portfolio

Unless you have a good reason, it’s usually smart to keep your portfolio balanced.  If one holding goes up, buy more of the other so they’re balanced.  That way you’ll average their performance over time.

Buy regularly

Dollar cost averaging is the process of investing the same amount of money on a regular basis, preferably really often.  As the value of your mutual fund or index (or stock or any other financial instrument) goes up or down, the actual number of units you buy changes.  You actually end up buying more when they’re cheaper and less when they’re more expensive.  In this way, you average our your cost basis.

Hold my hand, I need help!

Ok.  Get yourself a cheap place to invest.  I use Questrade because they don’t charge ANY commission when you buy ETFs.  This is a huge deal, they’re the only organization in Canada at the time of this writing that does this.  That means I never pay fees to buy, only to sell.  Then research what you want to buy.  Might I suggest indexes?  Here are a few index-tracking ETFs to look at.  I’m glossing over these with few details because I think you should read about them yourself.

Some index-tracking ETFs worth checking out
Institution S&P TSX 60 S&P 500 Emerging Markets MCSI EAFE
Vanguard index ETFs (US dollars) VTI VWO VEA
iShares index ETFs (CAD dollars) XIU XSP XEM XIN

I’m mentioning ETFs because they’re usually even cheaper than mutual funds, but you’re welcome to check out mutuals too.  All the major banks in Canada have index-tracking mutual funds with (relatively) low MERs.  Anyway, hit up Questrade and open an account for free.  If you don’t have a TFSA or RRSP yet, they’ll open one for you.  If you’ve maxed both of those out already lucky you; just get a non-registered account.  Happy investing!

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