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Throughout this site and on my book, The Confident Investor, I encourage investors to have a balanced portfolio of stocks and index funds.  I have discussed mutual funds before but I need to discuss the reason for index funds, my preferred pooled investment vehicle.

First, let’s talk about what indexes are and why they exist. Most people recognize that Charles Dow published the first workable index in his newsletter Customer’s Afternoon Letter and then later in the Wall Street Journal. His average was eventually called the Dow Jones Industrial Average (often shortened to Dow, Dow Average or DJIA) and is the most widely quoted number regarding the movement of the US stock market.

A stock market index is a basket of securities designed to track market changes. The most widely followed US stock market indexes, along with the DJIA, are the S&P 500, and the Nasdaq Composite. Important international stock market indexes are the Nikkei 225 (Japan), FTSE 100 (UK) and Hang Seng (Hong Kong).

Each stock market index has its own way to combine the changes in index components. The Dow Jones, for example, is a price-weighted stock market index where an increase of $1 in the stock of a $300B company produces the same change as an increase of $1 in the stock of a $30M company stock. Most stock market indexes use capitalization-weighted adjustments to account for the differences in company size.

An index fund is an investment framework that tries to mimic the movements of a particular index. The fund is usually structured as a mutual fund or an exchange-traded fund (ETF). An index fund is created to hold all of the securities in the index or a representative set designed to mimic the entire index. Many index funds rely on computer models with little human input in the decision as to which securities to purchase. This is a form of passive management. The absence of active management usually provides the benefit of lower fees and lower taxes in taxable accounts.

EXAMPLE: An S&P 500 Index Fund takes all the stocks in the S&P 500 and buys enough shares in each company to represent the dollar value that each company represents as a percentage of that market. So, if the Acme Company represented 2% of the combined value of all the S&P 500 companies, then an S&P 500 Index Fund would have 2% of its dollar value in Acme stock.

Index funds frequently outperform and have lower fees than managed funds. Index funds are often a better investment alternative. I encourage you not to have too much of your portfolio in managed funds but instead focus on index funds.

It is easy to track the results of an index. If the S&P 500 went up 1.5% over a one week period, your S&P 500 Index Fund did too. The same would be true if it went down. Index funds can be part of a balanced stress-free portfolio. You can use them to buy a comprehensive “market” position.

The problem with index funds is that they only perform as well as the market. In any trading day, there are stocks that go up or down. This is the same over the period of a week, month, several months or even years. While an index fund is easy, it is not necessarily advantageous for your entire portfolio. You are, by definition, only doing “average” with your hard-earned money.

Also, the increase over the long term in any given index is almost always reduced by inflation. If the market increases 6% or 7% in a year, you can almost bet that inflation, measured by the consumer price index (CPI), rose two or three percentage points. You need to stay ahead of the CPI in order to be able to buy more things for you and your family.

Every year, Standard & Poor’s conducts a study of actively managed mutual funds. Some of the conclusions from one of its latest studies:

1. Over the five year market cycle from 2007 to 2011, the S&P 500 outperformed 59.4% of actively managed large cap funds. In the same period, the S&P MidCap 400 outperformed 63.5% of mid cap funds. Also, the S&P SmallCap 600 outperformed 63.1% of small cap funds. These results are similar to that of the previous five-year cycle.
2. It is a myth that bear markets favor active management. In the two true bear markets over the last decade, most active equity managers failed to beat their benchmarks.
3. Benchmark indices outperformed a majority of actively managed fixed income funds in all categories over a five-year horizon.

Note: You can read this yourself on the web by going to http://www.standardandpoors.com/indices/spiva/en/us.

Obviously, I do not want you to destroy your retirement! However, it is good to think about what you can do incorrectly that will hurt your financial future. By studying the mistakes, you can hopefully avoid them.

Yahoo Finance had a great article on the subject. You should jump over and read the entire article but here are the five ways that were identified.

1. Too much debt.
2. Spend your retirement savings on college.
3. No emergency plan.
4. No long-term investment strategy.
5. No retirement plan.

All of these are bad choices. If I had to pick a 6th one it would be to trust that the US government was going to provide for you. This is not a political site and I do not want to get into political arguments. I do encourage you to be pragmatic if you are under the age of 55 and definitely under the age of 40. Assume that Social Security as it exists at this writing will likely change before you need it.