Indexing 101

First My Own Advisor reader:  “Great site, but I don’t know what you mean by indexing?”

Me:  I should write a post on that.

Second My Own Advisor reader:  “Hi Mark, I found this article interesting and while unable to send to my younger self, I did send to my daughter who is just starting her financial journey.  Her quick reply was:  thanks, I don’t understand all of it.  What is indexing?

Me:  I should write a post on that.

Rightly so, the second reader reminded me of something I think about often, whether it concerns personal finances or just my life in general:

You don’t know what you don’t know.

As a follow-up to this post how would I explain index investing (indexing) to my younger self?   What do I know now (versus what I didn’t know back in my 20s)?

Here goes…

Active investing vs. passive investing

You already know a bit about stock markets or at least you’ve seen the movie Wall Street.   Investing in companies listed on a stock market (there are many stock markets around the world) is not gambling although some people treat their investments that way, they buy and sell often, they make good dramatic movies about that.  With “active investing” an investor tries to select the company or companies on a stock market that will outperform other companies, often.  You may appreciate this is not easy work because you are trying to predict the future amongst thousands of companies and their performance.  It’s like knowing what the weather will be a few days or weeks from now, on a particular day, accurately and putting a bet on that.  If you make your company predictions for only days or weeks in advance, you are “actively” managing your money (or someone is actively managing your money for you; a financial advisor or a portfolio manager maybe).  You might see or hear about “active investing” with Do-It-Yourself (DIY) investors that like to trade a lot but you may also see it with some investors who hold some mutual funds.  Some of the holdings in some mutual funds are being reshuffled frequently to predict to or react to stock market conditions.   That reshuffling act costs money in the form of money management fees, and an investor pays for those services hoping to get better than average results from the chosen market.

With passive investing (also called for the purposes of this post “index investing” or “indexing”), an investor simply decides to buy most of the companies in the stock market, largely avoiding any predictions about which companies will outperform the others.  Investors do this because they already know it’s not only difficult to predict the weather short-term (or company outperformance in our case), it’s emotionally draining for some investors to keep up to company news, and it’s costly to spend money to constantly reshuffle the portfolio.   By owning the stock market or at least many companies in it using an indexed product, our passive investor doesn’t have to trade, they don’t need to react to market conditions, and they don’t have to worry about what happens when the markets rise or fall because they own most of it – how the market performs is largely what the investor gets in terms of performance.  Now, there are some money management fees to pay as part of “passive investing”1 but you can appreciate you don’t need to spend very much money, or time, if you’re riding the coattails of something.  Our weatherman may not predict the weather forecast accurately tomorrow or next week but I’m pretty sure they will be right when they say summer will be warm, winter will be cold and don’t forget to expect some rain here and there.

The Summary

So, you get the basic idea:  passive investing is lazy and active investing is, well active.  Passive investing can provide more diversification at a lower-cost than active investing.   Active investing generally takes on more risk for potentially more reward.   You can be successful at both but active investing, like our weatherman, might not get the short-term predictions right.

There’s more to this story, what is a stock market index, are there other indexes outside stocks, what products can you use for passive investing, what if you hold individual stocks for many years (is that “passive investing”) but those are posts for another day.   At least for now I hope you have a better appreciation what indexing is and why this approach can work for you.

Footnote1many of Canada’s actively managed funds typically have management fees of 2% or more.  By comparison, some passively managed indexed funds have management fees below 1%, some as low as 0.05%.   You may be overpaying for performance.  In many cases, you’re overpaying for underperforming the market.  Think about that.

Got a question for me?  Want me to write about a specific topic?  Respond in a comment below or send me an email via my About & Contact page.

Mark Seed is the founder, editor and owner of My Own Advisor. As my own financial advisor, I've grown our portfolio from $100,000 to well over $500,000. Our next big goal is to own a $1 million investment portfolio for an early retirement. Come follow my saving and investing journey by subscribing to my site. Delivered by Subscribe Here to My Own Advisor

9 Responses to "Indexing 101"

  1. great post mark. i’ve sent it to my daughter and son! where where you 45 years ago — lol! when did the first etf show up in canada?

    Reply
    1. Thanks Gary!

      My understanding from a quick Google search (and what I know about ETFs), the first ETF-product in Canada was the TIP 35 in 1990, over two decades ago.

      The TSX exchange was actually the first stock market in the world to list an ETF in 1990.
      http://www.tmx.com/en/news_events/news/news_releases/2010/4-22-2010_TMXGroup-ETF20years.html

      So, Canadians are actually pioneers!

      Actually, the XIU iShares product is a distant relative of the TIP 35 ETF launched almost 25 years ago. If it ain’t broken, don’t fix it 🙂

      Now, there are almost 400 ETFs in Canada I recall but not all ETFs are created equal. Some are actively managed vs. passively managed.

      I think the Vanguard group is the third largest provider of Exchange-traded funds (ETFs) in the world.

      The first Vanguard index fund was launched in the mid-1970s.

      Reply
  2. I think you’re blurring the lines between passive investing and indexes.

    -An index fund is simply a fund that invests in the market as a whole, no buying or selling.

    -Passive investing means investing for the long term, with a corollary of not investing for the short term.

    A passive investor may (and likely will) use an index fund as part of their investments, but passive investing index investing.

    I’m a passive investor, and only some of my retirement savings are in indexes.

    Nevertheless, good article. So many people don’t understand the basics.

    Reply
    1. Thanks for your comment Glenn.

      I tried not to blur the lines but if you see it that way, I can understand.

      Indexing is a passive investment strategy. An investor can achieve the same risk and return of an index by investing in an index fund. – Investopedia.

      The premise of the post was for readers to realize indexing is a passive, lazy investment strategy.

      By passive investing, investors can lower their investment costs and potentially earn just under what the equity market earns. Not all indexes are the same, but that wasn’t the story I wanted to tell. At least not today 🙂

      Passive investing is largely investing for the long-term, but some passive products also focus on the short-term (i.e., short-term duration bonds). It’s not a cut and dry issue as you well know.

      A long-term owner of many dividend stocks could be considered a “passive investor” perhaps. More posts for another day 🙂

      Reply
  3. Thanks for the explanation and it does make sense to me. It’s true though that with risk comes the potential to spend or lose more money but like the weather sometimes it’s right and other times… it’s down right the opposite.

    Reply
  4. I started indexing years ago in my RRSP portfolio though to be honest, I didn’t know the term for it. I did know that I wasn’t knowledgable enough about the stock market to partake in any sort of active investing, so I defaulted on indexing. Recently, after reading about it on your blog, I ramped it up a notch and began indexing in my TFSA, too. IT’s worked well for me.

    Reply

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