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In many areas of life, settling for average is not a strategy for winning. Not so with investing. The truth is that most investors — otherwise known as people with full-time jobs that don’t involve analyzing the stock market — would do better just to obtain the stock market’s average return. The way to do this is through a subset of mutual funds called index funds. An index fund seeks to replicate the performance of a broad market index — that is, a large, representative group of a certain type of stock. Examples of indexes include the Wilshire 5000 (large and small stocks in the U.S. market), the S&P 500 (large U.S. stocks), or the EAFE (stocks from developed countries in Europe, Australasia, and the Far East). Index funds are designed to provide only the market return, which averages roughly 11 percent a year for the S&P 500. So some people mock them as “average.” And it’s true that index funds aren’t exciting. They don’t offer the nonstop excitement of trying to beat the market. They don’t provide the occasional thrill of actually beating the market. They aren’t popular with many financial advisers (if only because index funds usually don’t pay any commissions). In short, index funds are dull. Nevertheless, I argue, they should be the core of your stock portfolio. In presenting the case for index funds, I am happy to have help from a timely ally. The latest edition of Burton Malkiel’s A Random Walk Down Wall Street was released at the end of January. Malkiel is an economics professor at Princeton. His book, first published in 1973 and now in its ninth edition, provides a now-classic presentation of academic investing theory, which (to boil it down) indicates that index funds should be a key part of your portfolio. STOCK PICKING? My enthusiasm for index funds is not universal. The Investment Company Institute, a trade association of mutual-fund firms, reports that in 2005 indexed investments constituted only about 9 percent of all assets managed by investment companies. What are so many investors doing instead? For some, the answer is selecting individual stocks. The potential advantage of picking stocks one by one is that, if you make great choices that outperform the market, you will earn higher returns than those from an index fund. But the disadvantages are significant. For starters, you’re going to need to pick a lot of those high-performing stocks. At least 30 stocks are necessary to obtain the benefits of a diversified portfolio. Malkiel says 50 stocks is the better number to reduce risk. And that’s just for U.S. holdings. Add another 30 to 50 foreign stocks for the international portion of your stock portfolio. In the midst of your busy law practice, do you have the time to select 100 stocks? Do you have any systematic plan for how to pick them? And after you buy these stocks, do you have the time and knowledge to study financial filings and evaluate whe-ther the stocks are still good holdings? I know that I sure didn’t back in my litigation days. CHARTS GONE WILD If picking stocks doesn’t sound like your new favorite pastime, what about hiring a manager to do it for you? Don’t the investment professionals have special techniques to outperform the market? Well, they certainly try. The two main approaches to stock picking, according to Malkiel, are technical analysis and fundamental analysis. Technical analysis, writes Malkiel, is essentially interpreting charts that track a stock’s price changes. According to the technicians, the past movements of the stock’s price can predict its future movements, and investors can thus profit by buying and selling a stock according to these indicators. “I personally have never known a successful technician,” Malkiel notes. He argues that many common stock patterns can be produced by flips of a coin. In other words, the charts may often be products of randomness. He also argues that the transaction costs involved in trying to exploit price trends are far greater than any potential profits and that a simple buy-and-hold strategy typically makes as much or even more money. Only if technical schemes materially outperform the market are they worthwhile, he concludes, and thus far, “none has consistently passed the test.” In contrast to the technicians’ focus on stock prices, fundamental analysts try to ascertain what a stock is really worth, often by evaluating the company’s “fundamentals” to try to estimate its future earnings. If the stock’s true value is different from its current stock price, the market will realize that eventually and react accordingly. Investors who buy undervalued stocks should be able to profit when the stock price rises. So the theory goes. Unfortunately, predicting the future earnings of a company, and thus its true value, is extremely difficult. Malkiel notes a study of one-year projections of corporate earnings for 1,000 companies. The study found that the average annual error in these projections was 31.3 percent. Malkiel concludes, “Financial forecasting appears to be a science that makes astrology look respectable.” Even the very best analysts fail at stock picking. Mutual-fund managers are often in the top ranks of the financial-services industry’s pecking order, yet over time the average fund manager does not outperform the relevant stock index. “Although funds may have very good records for short time periods,” Malkiel says, “there is generally no consistency to superior performance.” Although Malkiel does believe in the possibility of superior investment performance, he concludes, “It is clear that if there are exceptional financial managers, they are very rare, and there is no way of telling in advance who they will be.” THE INDEX ADVANTAGE How, then, should the ordinary investor deal with these disconcerting facts? The answer is index funds. As noted above, over the long term most managed mutual funds will fail to outperform the relevant market index. The exact statistic will vary with the stocks and the time period measured, but it is not unusual to see 80 percent of mutual funds fail to beat their index over a five- to 10-year period. And most people invest for considerably longer time periods. They may save for 35 years while working and then spend an additional 20 years in retirement. Over the course of this 55-year period, a managed fund will almost certainly underperform the relevant index. If these better investment returns are not reason enough, index funds also dramatically simplify the investment process — an advantage for busy people. No need to worry about picking good stocks or finding a wizard of a fund manager. Just identify the asset class you want (such as large U.S. companies, small U.S. companies, or large foreign companies) and select the relevant index fund from a reputable mutual-fund company. Significantly, index funds don’t waste a lot of the investor’s money in fees and expenses. Managed mutual funds often can have fees of more than 1 percent (the average stock-fund expense ratio in 2005 was 1.5 percent). In contrast, most index funds have fees of less than 0.2 percent — a cost savings for the investor of more than 85 percent. Granted, choosing index funds means that you won’t be the next Warren Buffett. And you won’t be able to boast about beating the market or finding a great investment manager. But index funds will let you efficiently capture your share of the growth of global equity markets. You won’t miss the next market rise; you won’t be the biggest loser in the next market fall. So go index. When it comes to investing, the average return is superb.
Robert L. Rogers, associate opinion editor at Legal Times , writes the Legal Tender column on personal finance. E-mail Rob with comments or suggestions for future columns.

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