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Home > Investing > How To Move Beyond Index Funds…

How To Move Beyond Index Funds…

October 5th, 2010 Leave a comment Go to comments

In this recent article on TheDigeratiLife, SVB talks about how index funds are the most cost effective way to invest in the stock market, if not the best way to get the most performance for your dollar. Index funds are very popular, they are available in typical 401K plans and other retirement plans more than they used to be (I remember when they were not that common in retirement plans, say 10 years ago).

If you were getting into investing during the start of the Internet boom, you no doubt have visited or consumed some advice from the long time personal finance site, The Motley Fool. They have been making “folly” of the professional investment community; one of the main arguments they make is that the majority of active portfolio managers under perform compared to indexes, and usually at a higher investment cost.

So, this argument is very well known and has been out there in the virtual world and elsewhere (e.g., the book A Random Walk Down Wall Street) – it’s not that new of an idea.

Are Index Funds Really That Different?

When you consider how funds perform, whether they are actively managed or passively managed as an index, in the end you still will get some type of return at the market level. So, for example, in the past 5 years, the average yearly return for a large cap domestic fund has been negative. This means that you likely lost money no matter what type of fund you invested in.

Also, index funds in a certain sense are really actively managed. It’s just that the ‘manager’ is a group of professionals that determine the list of stocks by a pre-determined set of criteria. While this list of stocks contained in the index may change infrequently, it’s still being ‘managed’.

Another Investing Approach…

The approach I take in investing is a more proactive and realistic approach. Instead of trying to beat the market, I analyze each investment class, or individual investment and determine the following:

  • How I will make money in the investment.
  • What is a reasonable expectation for returns going forward.
  • How attractive is the investment right now.
  • What trends might affect the investment going forward.

Let’s start off with a simple example: Buy a 10 year U.S. Treasury Note that earns 2.5% per year. This is a simple investment to understand and its return, risk profile, and attractiveness can be summarized quickly.

Will it beat the market? I don’t know, but what I do know is I can determine a reasonable profile of this investment and how much money I will make.

It’s All About Expectations…

If you first determine at a high level what kind of returns you want to make over a period of time, it’s possible to then determine what kind of investments you need to achieve that goal. Of course, the key here is reasonable expectations. After all, everyone want’s to make 20% per year, but the amount of risk you would need to take to get it is prohibitive.

Once you have determined your goal and implemented an investment plan, you then only need to benchmark your returns against your own expectations and not an arbitrary index.

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