If you answered NO to all questions, you are well on your way towards understanding the benefits of a diversified portfolio of index funds, which is the basis of Index Funds Investing.

If you keep reading, you will soon understand the wisdom of index funds, how much wealth you may have lost in the past, and how much you can accumulate if you learn how to change the way you invest. Let's start!

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Step1-Quotes

"Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement." William F. Sharpe, Nobel Laureate in Economics, 1990, The Arithmetic of Active Management, The Financial Analysts' Journal Vol. 47, No. 1, January/February 1991. pp. 7-9.	"Most investors are pretty smart. Yet most investors also remain heavily invested in actively managed stock funds. This is puzzling. The temptation, of course, is to dismiss these folks as ignorant fools. But I suspect these folks know the odds are stacked against them, and yet they are more than happy to take their chances." Jonathan Clements; The Wall Street Journal, February 27, 2001
"The sheer magnitude of the difference we discovered between the total returns earned by funds and the results captured by the average shareholder is shocking and tragic." [over 4 years: Funds = 5.7%, Investors = 1%] Charles Trzcinka, Professor of Finance, Indiana University. Money Magazine, June 2002. What Fund Investors Really Need to Know, by Jazon Zweig (see 1.3.3)	"Over the 10-year period ending 2003, 142 of the largest, smartest pension funds in the USA lost an average 0.3% per year in their active large cap domestic equities programs, relative to simply investing in index funds." Keith Ambachtsheer, author of The Ambachtsheer Letter Independence, p.90 June 8, 2005
" The deeper one delves, the worse things look for actively managed funds." William Bernstein, The Intelligent Asset Allocator	" [ Most investors would ] be better off in an index fund." Peter Lynch, famous stock picker, Barron's, p. 15, April 2, 1990

Step1-Definitions

What Is Active Investing?

Active investing is a strategy that investors use when trying to beat a market or appropriate benchmark. Active investors commonly engage in picking stocks, times, managers, or styles. As later steps demonstrate, active investors who claim to outperform a market also claim the power to predict the future. When accurately measured, this is simply not possible. Surprisingly, the analytical techniques that active investors use can best be described as qualitative or speculative. They include predictions of future sales and earnings growth, and are often based on gut feelings and intuition. On the other hand, the passive index investing approach is best described as quantitative or scientific. Indexing techniques include statistical analysis of risk and return data of twenty years or more, in addition to extensive measurements of numerous performance criteria. Many indexes are now based on seventy-five years of risk, return, and correlation data.


What Is Index Funds Investing?

As opposed to active managers, investment managers of index funds are far less active in the buying and selling of stocks, because they do not pick stocks or managers, time markets, pick styles, or make attempts to forecast the future. As previously mentioned, the analytical techniques that index funds managers use are best described as quantitative or scientific.

Approximately seven percent of all individual assets and thirty percent of all institutional assets are currently invested in different index funds. Many institutional funds are one hundred percent indexed. Even Charles Schwab and Company recommends that investors put eighty percent of their large cap assets into index funds. Mr. Schwab himself has 75% of his mutual funds in index funds. Other indexing proponents include Barclay's Global Investors, Dimensional Fund Advisors, The Vanguard Group, Warren Buffet, Peter Lynch, numerous academic institutions, Economic Nobel Laureates, and Index Funds Advisors (IFA). Insurance companies use a similar approach to indexing when setting premiums for the risks taken by insuring against thousands of different random events. Most of those premiums are also invested in index funds while held in reserves for the inevitable claim payment.

Most investors believe that index funds investing means investing in familiar market indexes, such as the Standard and Poor's 500. S&P 500 funds are structured with the aim to provide the same investment performance as the S&P. By holding all the stocks in the same proportionate amounts as the S&P index, the fund index represents about eighty-six percent of the market value of all U.S. companies, mostly large blue chip stocks. The problem is that market indexes, such as the S&P 500, were not originally designed as investment vehicles.

Since the late 1980's, index funds have expanded and are based on more discrete customized indexes. Originally designed for very large pension funds, institutional-style index funds are meant to capture various financial risk factors or dimensions of the market. Exposure to a risk factor such as company size or value constitutes a risk dimension of the market. Investors have been compensated with higher returns for risk exposure to these risk factors since 1929. These dimensions of the market can also be referred to as indexes. Indexes are groups of stocks that have common risk and return characteristics and comply to specific and clearly defined sets of rules of ownership. These groups of stocks include companies from the United States, foreign companies, and even emerging markets. There are additional indexes within these markets, such as value, large value, small growth, large growth, real estate securities, and many fixed-income investments, such as short-term and long-term treasury bonds, municipal bonds, and corporate bonds. Companies are purchased and held within the index when they meet the index parameters. Stocks are sold when they move outside of these parameters and no longer meet the index rules.

An example of an index fund is Dimensional Fund Advisors' (DFA) Micro-Cap index fund, which invests in securities of U.S. companies whose size (market capitalization) falls within the smallest 4% of the total market universe. This includes all stocks traded on the New York Stock Exchange and the American Stock Exchange, as well as those listed in the National Association of Securities Dealers Automated Quotation Over-the-counter (NASDAQ OTC) market. Another example would be DFA's Small Cap Value Fund, which invests in companies ranked in the lowest eight percent by size, as well as the highest twenty-fifth percentile by book-to-market ratio (value).

DFA funds are now available to individual investors through a small qualified group of registered investment advisors who have demonstrated their understanding and commitment to the concepts described in this 12-Step Program.

The overwhelming majority of investors are active investors. Extensive research by many academics and investment professionals has shown that investors cannot beat a market in the long run with stock, time, manager, or style picking. It is disconcerting that about seventy percent of all institutional money invested in U.S. stocks is still actively managed.

Active Investors are Everywhere

Over ninety percent of investors are active investors. The most popular strategies in attempting to beat a market include stock, time, manager, and style picking. Steps 3, 4, 5, and 6 describe these strategies and explain the futility of all these methods.

Stock pickers try to pick winning stocks rather than diversify their portfolio.

Market timers, or time pickers, try to make money off timing the markets. They think they can strategically pick specific times to get in and out of a market, believing this approach is more profitable than a buy-and-hold strategy. Time picking also refers to the purchase or sale of individual stocks.

Manager pickers buy stock portfolios or mutual funds managed by the money managers who seem to have the best recent performance record.

Active Investors are Gamblers

Active investors are deluded that they are in control. They believe they have a special understanding of the market, a superior edge over less knowledgeable investors, and that they are immune to disaster. The truth is that all investors can access the same information as professional money managers through the Internet and many other sources. Still, many investors believe they are smarter and more sophisticated than the average investor. Those under this illusion fail to realize just how much investment performance depends on luck. Most of them eventually pay dearly for this mistake.

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