Instead of trying to beat the market you should own the market.

Choose diversification. Own a piece of each market player in proportion to their market capitalization. Re-balance periodically. Choose lower fees. Pick an appropriate index for your market. Most markets have an index tracking fund, ETF or other instrument, now including the cryptocurrency market.

Passive Index Tracking

An index tracking investment approach is one that aims to track a market index as closely as possible. The goal is not to beat the market, but to be the market. Being passive means not taking active decisions about specific components with the intention of beating the market, i.e. guessing.  Beating the market requires both extraordinary luck and extraordinary skill – a truly rare combination.

An active investment approach aims to beat the market by modifying portfolio holdings away from the market component weightings. An extreme active approach would be picking one equity in an equity market.

Warren Buffet is a legendary market beater. His will says to invest his money in an index fund (p.20) that tracks the United States stock market’s S&P 500 index. He recommends Vanguard’s index funds. Vanguard pioneered the index fund concept in the 1970s. Decades later we have clear data showing actively managed funds fail to beat the market most of the time. Most experts can’t divine which components will outperform. You can’t either.

Interest in passive investing has boomed in recent years.

Diversification with Index Tracking

Buying an index fund means you own a piece of every component in the market index that you are tracking. You are diversifying your investment across that market (or market sub-set). The fund is then regularly re-balanced to keep aligned to the index.

For example, the S&P 500 index reflects the market capitalisation of the top 500 companies in the America stock market. Investment performance is not tied to the future of a given company but instead matches that of the whole market index. Nature shows us that true resilience comes from all parts of the whole. Nobody knows the future.

Lower Fees with Passive Funds

Management fees for passive funds tend to be much lower than for active funds. Total expense ratios for most passive funds are below 1% per annum; often well below 0.5%.

I was recently offered active management fees of well over 2.0% per year! Active funds are usually above 1% and can be as high as 3%. Savings from reduced fees compound over time. “Only” 1% in saved fees increases a lump sum by 30% over a working life.

Investment fees really eat into earnings over time
Investment fees really eat into compound earnings over time. Vanguard illustrates this over a 25 year period.

Savings from the stock picking mistakes you didn’t make are even more valuable. Buffet is saving us from ourselves. An index fund buys all components of the index or in some way replicates the index components. Generally the replication is in proportion to each component’s market capitalisation. The index fund re-balances component holdings to ensure that components are held in proportion to the changing market capitalisations.

How to Invest in tracking an index: Index Funds, ETFs and more

Investment instruments that track a market index generally are formed as Mutual Funds or as Exchange Traded Funds (ETFs). On the blockchain, index funds can be implemented using a token. Whichever vehicle, look for funds with low fees and that seek to replicate directly the underlying index. Some funds use options and other more sophisticated forms of speculation. This means they don’t hold the actual underlying components.

The differences between mutual funds and ETFs are largely irrelevant to long term investors. They are different wrappers to implement the same strategy:

  • ETFs are more liquid as they trade on the stock exchange throughout opening hours.
  • Mutual Funds have their prices set by the fund managers once or twice a day.
  • Both Mutual Funds and ETFs that track an index generally have comparably low fees. For example, Vanguard has ETFs and Mutual Funds tracking the FTSE 100 index.

Conclusion

To learn more about index investing, I can’t recommend a better book than JL Collins’s (2016) The Simple Path to Wealth (book UK and USA). His rolling voice soothes me (get the audiobook UK and USA) and he’s been preaching this path for years.

What’s your approach?

Diversity provides great resilience.
Invest in a broad market index.
For money I can’t afford to lose, I take a passive investing approach.
For money I can afford to lose, I’m prepared to take an active approach.


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