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.

Footnote¹ – many 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.

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