A random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing

The 
Index-Fund 
Solution: 
A
Summary
Let’s now summarize the advantages of using index funds
as your primary investment vehicle. Index funds have
regularly produced rates of return exceeding those of active

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managers. There are two fundamental reasons for this excess
performance: management fees and trading costs. Public index
funds are run at a fee of less than 1/10 of 1 percent. Actively
managed public mutual funds charge annual management
expenses that average one percentage point per year.
Moreover, index funds trade only when necessary, whereas
active funds typically have a turnover rate close to 100
percent. Using very modest estimates of trading costs, such
turnover is undoubtedly an additional drag on performance.
Even if stock markets were less than perfectly efficient,
active management as a whole could not achieve gross returns
exceeding the market. Therefore active managers must, on
average, underperform the indexes by the amount of these
expense and transactions costs disadvantages. Unfortunately,
active managers as a group cannot be like the radio
personality Garrison Keillor’s fictional hometown of Lake
Wobegon, where “all the children are above average.”
Index funds are also tax-friendly. Index funds allow
investors to defer the realization of capital gains or avoid
them completely if the shares are later bequeathed. To the
extent that the long-run uptrend in stock prices continues,
switching from security to security involves realizing capital

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gains that are subject to tax. Taxes are a crucially important
financial consideration because the earlier realization of
capital gains will substantially reduce net returns. Index funds
do not trade from security to security and, thus, tend to avoid
capital gains taxes.
Index funds are also relatively predictable. When you buy
an actively managed fund, you can never be sure how it will
do relative to its peers. When you buy an index fund, you can
be reasonably certain that it will track its index and that it is
likely to beat the average manager handily. Moreover, the
index fund is always fully invested. You should not believe
the active manager who claims that her fund will move into
cash at the correct times. We have seen that market timing
does not work. Finally, index funds are easier to evaluate.
There are now over 5,000 stock mutual funds out there, and
there is no reliable way to predict which ones are likely to
outperform in the future. With index funds, you know exactly
what you are getting, and the investment process is made
incredibly simple.

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