Basic Principles of Index Investing
„Purchase the “Simpelton’s Portfolio” consisting of index funds […] At the end of each year rebalance your accounts. If the next 20 years are anything like the last 20, then you will outperform the portfolios of 75% of all professional money managers”.
W. Bernstein, The Intelligent Asset Allocator, McGrow-Hill, 2001, p. iv.
Investing in an index portfolio leads to diversification which means reducing risk by investing in different assets. The first level of diversification comes with investing in different instruments of one asset class, i.e. in a number of stocks or in a stock index. Deep and meaningful diversification is achieved by investing in different asset classes like stocks, bonds, real estate, precious metals, etc. This is due to the different performance of asset classes (for example when stocks go down, bonds usually go up). The long term result is lower risk and higher returns of the portfolio compared to its components.
Creating a portfolio composed of different asset classes in accordance with the investor’s risk profile and investment goals is referred to as asset allocation. It is largely agreed that in the long term the strategic asset allocation decision determines up to 90% of the portfolio’s future performance. There is already enough statistical data asserting that passive index strategies outperform active strategies in the long run. It is impossible even for professional market analysts and money managers to forecast and time the market for long time periods.
Alongside with the diversification effect, indexing is a very good idea for at least two other reasons. First, when you start indexing you no longer keep analyzing and worrying about hundreds of individual stocks or bonds and instead begin monitoring industries, economic cycles, countries and geographical regions, etc. Second, unlike individual companies or even countries which can go bankrupt (remember Enron or Lehman Brothers?) indexes survive because companies that are gone are being replaced with others in the index.
Once you set up an index portfolio all you have to do is to stick to the initial (target) asset allocation by periodically rebalancing the portfolio. It can be done quarterly, yearly or when some of the components shift with more than 5 or 10 per cent. Rebalancing is important but you do not need to get preoccupied with it: long term portfolios can be rebalanced when they exceed the 10 per cent trigger while short term portfolios usually do not need rebalancing.
Index funds or ETFs are used to allocate the investments between asset classes. For this platform we prefer to use index ETFs as efficient and inexpensive instruments with no minimums, loads, etc. and with some tax advantages. As a rule the ETFs used are with at least 3 years of history and with no less than $1,0 bln. of net assets.
A very important element of successful investing is keeping expenses down. Although management and trading fees may not seem such a burden, they can reach up to 40% of your returns in the long term. This means that if you decrease the annual management fees and avoid frequent trading you will save considerable amount of your wealth.