What’s “passive investing”? Do you want to make money in the stock market without managing a portfolio or paying someone else to do it?
In Beating the Street, famed mutual fund manager Peter Lynch says anyone can succeed in the stock market if they make the right choices and put in the hard work. But, he also offers an option for people who’d rather stay away from active portfolio management.
Continue reading to learn about the benefits of index funds.
The Benefits of Index Funds
Lynch explains that index funds are a type of stock fund, and he outlines the benefits of index funds for certain types of investors. Let’s look at what stock funds are in general and then zoom in on index funds and why Lynch believes they can be a good option for some.
In his book, Lynch argues that you should invest in stocks instead of bonds and explains how you should build and manage your personal stock portfolio. But, what if you want to get exposure to the stock market without going through the trouble of researching, building, and managing your own portfolio of individual stocks?
Lynch writes that stock funds can offer a good alternative to constructing and maintaining your own stock portfolio. So, what are stock funds and how do they work? A stock fund is a type of investment fund that pools money from multiple investors to invest in a selection of stocks. When you buy shares in a stock fund, you don’t actually own the underlying stocks—instead, you own shares of the fund itself. The fund manager is responsible for selecting and maintaining the mix of stocks in the fund, which saves you the time and trouble of having to do this.
But, as we’ve seen, Lynch is skeptical of pricey fund managers, who he argues often charge high fees and deliver returns that don’t even beat the average market returns. That’s why he recommends stock index funds as a particular type of stock fund for investors who want to enjoy solid returns without having to manage their own portfolio—or see their returns eaten up by high management fees.
Index funds are stock funds composed of a broad portfolio of stocks that are designed to mirror one of the big market indexes. Many popular index funds at large investment companies like Vanguard, Fidelity, or State Street offer index funds that track well-known market indexes like the S&P 500 or the Dow Jones Industrial Average.
The stocks in an index-tracking mutual fund are automatically selected based on their position in these indexes. You’re not actively managing it, nor is a fund manager. The fund you invest in purchases shares of companies in proportion to those companies’ positions within whichever index the fund is tracking. For example, if the fund you bought into tracks the S&P 500—and Google stock comprises 3% of the total market capitalization of the S&P 500—your fund will have 3% of its holdings in Google stock.
| The Rise—and Risks—of Passive Investing In the years since Lynch wrote Beating the Street, index funds have risen greatly in popularity. These funds are described as being “passively managed.” They don’t have an active manager like Lynch selecting stocks for inclusion in the portfolio based on their financial performance or projections for future growth. Instead, these passively managed funds buy and sell stocks automatically when those stocks enter or exit indexes like the S&P 500 or the Dow Jones Industrial Average. And, because index funds have become such major purchasers of US stocks, index funds now control 20% to 30% of the US equities market. Despite their popularity, some observers are concerned that the growth of index funds represents a dangerous concentration of economic power. Today, for nine in 10 companies listed on the S&P 500, their largest single shareholder is one of the “Big Three” money managers—BlackRock, Vanguard, and State Street. And these three firms control 80-90% of the index fund market. With this level of concentration, we could soon be facing an economic future where a small handful of individuals would have vastly disproportionate power over most publicly traded companies. |
Different Types of Index Funds for Different Investment Needs
Lynch advises that there are many different types of index funds that track different segments of the financial market, depending on where an investor wants to put her money, such as market cap funds, sector-based funds, and regional funds.
Market Cap Index Funds
These are funds that invest in stocks based on those stocks’ total market capitalization (or “market cap”)—the number of shares currently issued multiplied by the price per share. So, for example, a company with one million shares currently issued trading at $50 per share would have a market cap of $50 million. There are funds that invest in large-cap stocks (those with market caps above $10 billion), mid-cap stocks (with market caps between $2 billion and $10 billion), and small-cap stocks (those with market caps between $250 million and $2 billion).
You’d purchase shares in large-cap index funds if you want the relative stability of investing in mature, well-established companies that are more likely to earn steady returns than small companies or startups. On the other hand, you’d invest in medium- or small-cap index funds if you want the potentially high returns that can come from investing in startups and growing companies—and can stomach the higher volatility and risk that can come with it.
Sector-Based Index Funds
There are also index funds that buy stock in companies exclusively in a specific industry or market. For example, a fund may buy shares of companies in sectors like energy, consumer goods, health care, information technology, or real estate. You’d invest in a sector-based fund if you believe that that sector offers higher potential for growth than other sectors of the economy, or if you want to hedge your portfolio if you’ve invested in other sectors.
For example, let’s say you’ve invested heavily in the traditional energy sector (which includes oil companies, natural gas producers, and coal mine operators). You might then want to purchase shares in a renewable energy index fund (which includes companies engaged in wind, solar, hydroelectric, and even nuclear energy), so you can offset potential losses in case the price of oil drops or if the government passes new regulations that restrict fossil fuel production.
Regional Index Funds
There are also index funds that buy shares in companies (often those with the largest market caps across a wide range of industries) that are based in a particular region or country. So, for example, there are funds that trade exclusively in North American, European, Asian, or South American stocks.
You would invest in regional index funds if you believe that a particular region or country’s economy offers the kind of growth you want. If you want more stable, but potentially lower returns, you would perhaps invest in a regional fund that comprises companies from more developed markets, such as North America or Western Europe. If you’re looking for potentially high returns (and can handle higher risk), you might invest in regional index funds composed of stocks from companies in developing parts of the world—such as sub-Saharan Africa or Southeast Asia.
