A Video Intro to Indexing

Things have been pretty hectic around here so I'm going to offer up a quick video for anyone that wants to see how and why passively managed (indexed) investment strategies outperform actively managed strategies over the long-term. This is a video inspired by the Bogleheads - investors who follow Vanguard founder Jack Bogle's investment philosophy - and is right on the money. While it may seem goofy at first, there are plenty of truisms within that are often overlooked by investors.

Why You Should Turn Off CNBC

Up until yesterday, it had been a long time since I really watched CNBC. The business news network is a ubiquitous presence on trading floors and in the homes of many investors throughout the world. As a younger investor, I was one of those people addicted to the constant flow of information and endless ticker scrolling across the screen. Ultimately, I wised up and turned the channel to something that became more interesting, namely, SportsCenter. The problem with CNBC and other business news networks is that not only do you suffer from information overload, but by being drawn into the constant drone of information, you're more likely to make a rash investment decision as you begin to believe in the madness of crowds and adopt the "herd mentality." You may even think things like, "hey, if everyone is doing it, why am I so late to the party?"

I tried watching yesterday but I felt compelled to turn it off after a half hour. A key afternoon segment focused on gold prices hitting all-time highs and the show highlighted different ways individuals could "profit from rising gold prices". This is precisely the problem with CNBC - where were they when gold prices were at levels much lower than they are now? I fear some investors watching the network may have felt compelled to add a significant gold position to their portfolio at the expense of a more rational thesis (namely, having a plan and sticking to it). Unfortunately, this type of thing happens all the time on business networks. If it's not gold that they're talking about, you can simply insert whatever commodity/market sector/area of the world that's experiencing major out or underperformance and CNBC will have plenty of "experts" on telling you how you can make money off the moves.

This is not to say that I blame CNBC - they're simply catering to an audience who craves business and market news - but therein lies the problem. A financial news network should never dictate what investment decisions you make and the noise that it represents serves as a big distraction when it comes to your overall investment plan. If investors are serious about building wealth, they would realize that you don't build wealth by following what CNBC says. You build wealth by creating an asset allocation plan that works for you and systematically investing in it for the long-term.

Proof That Compounding Works

When thinking about investments, it never ceases to amaze me at how effective compounding investment returns are. As they say, the proof is in the pudding, and by using a simple financial calculator, it's easy to show how beneficial saving and compounding actually is.

One of the things I often hear from young investors - Gen Y in particular - is that they feel that investing for retirement is something that can be put off since it's so far away. I don't like this line of thinking at all because it's self defeating: we save and invest not to retire at an old age, but to have enough of a nest egg built up to retire whenever we want!

Even worse, investors tell me that $100 saved here and there or their small $1,000 savings today won't amount to much so it's not worth investing until they start their careers. This is even worse thinking! Here's proof: If you invest $1,000 in an index fund, assuming a 7% average return and never touch it for 40 years you will wind up with $14,974 due to investment compounding. If the market gets cooking and long-term returns average 10%, you will wind up with $45,259.

Now just imagine what would happen with each additional dollar saved!

Mutual Fund Performance Measures

Much has been made about mutual fund performance figures and how certain pieces of data don't tell the full story when it comes to evaluating a fund. I would advocate not worrying about what a mutual fund's Morningstar Star Rating is because star ratings are assigned based on risk-adjusted past returns which are not indicative of future performance.

Further, it may also be a stretch to compare a fund to a certain benchmark because its mandate and overall investment policy may be drastically different than what the index's is. For example, a bond fund that does not invest in U.S. Treasury securities may be compared to a bond index with a heavy weighting towards Treasury securities. If U.S. Treasuries perform well compared to other global bonds, it may be a stretch to legitimately say the fund "outperformed" the index. On the other hand, a fund investing primarily in small-cap growth stocks may experience style drift and its strategy could begin to include beaten down companies that qualify as small-cap "value" firms.

A recent Wall Street Journal article noted that looking at total returns works best when you understand what a fund's expense ratio is and also when you look at fund returns over longer time periods in order to smooth out the effects of short-term market movements. However, even this approach isn't foolproof as the Journal notes; "even if a fund has outperformed for 10 years, its odds of outperforming over the following three to five years are only about 50-50, research by Vanguard Group suggests."

Overall, investors are best served by focusing on the index rather than on an actively managed fund. If you simply index your money, your index funds will own the entire market rather than cherry-picking certain securities. This strategy is beneficial because not only is it extremely inexpensive, you also won't have to worry about comparing your fund's performance relative to the benchmark because it is the benchmark.