“There ain’t no such thing as a free lunch” is a well-known and widely used adage, which when used in economic relation indicates that opportunity costs are always present. There is, however, one exception: passive index investing.
Passive investing, as the term implies, is the opposite of active investing. Rather than continuously and actively trading stocks for relatively short-term profit, passive investing in based on long-term appreciation and profits.
So how does one index? The most common way is to invest in stock index funds, which are based on such as indexes as NASDAQ Composite, S&P 500 or the Finnish OMX Helsinki 25. By buying such securities you simultaneously invest in all the stocks included in the specific index. Indexes are weighted in different ways, which determines how its price is calculated and how the stock movements affect it. The composition of companies included in indexes is not unalterable, and changes are made based on chosen factors. Alternatively an investor (with seriously deep pockets) could diversify his portfolio by simply buying the stocks of a large number of different stocks from across the market. This is not that profitable of a practice for an average investor with limited resources, though. Additionally, transactional costs are also relatively high when using this method.
The superiority of passive index portfolios compared to actively re-assembled portfolios was realized already in the 1970s at Wells Fargo. It was found through academic research and theory that as markets became more efficient and information flow increased, stock pickers could not beat market averages anymore. It was realized that it’s rather irrational to actively trade in and out of the market, and that it’s logical as well as cheaper to create a portfolio composing of stocks from across the market and sit still instead. Transaction costs and management fees are a key factor, but also the fact that individuals and professional managers alike often have tendencies to persist in certain (bad) strategies is significant.
Yes, concentrating your portfolio in a few stocks maximizes your chances of getting rich, but it unfortunately also maximizes your chances of becoming poor. Therefore the most reliable way of achieving satisfactory gains is to index i.e. own the whole market. By doing this you minimize your chances of both outcomes by guaranteeing you the market return.
It must be remembered however, that indexing works well only in in deep, efficient markets. But market efficiency is exactly what makes indexing such a superior tactic. Because of the efficiency stock prices are assumed to reflect the best possible estimate of their value, therefore there it’s not rational to actively buy and sell individual securities. In more nontransparent markets where information is more likely to give an advantage, active managers generally outperform indexers. Efficient markets and information flow are indeed crucial for indexing to work.
Although there is tons of information of the markets and stocks available these days for analysis, few can truly beat the markets on a continual basis and even fewer can foresee the future. Studies conducted on the matter have had results where dart-throwing chimpanzees beat highly regarded stock market investors and experts in gain performance. Of course indexing DOES underperform many actively managed funds time to time, but as Jonathan Clements once put it: “Performance comes and goes. Expenses are forever.”