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A Broader Definition of Indexing
The indexing strategy is one that I have recommended
since the first edition in 1973—even before index funds
existed. It was clearly an idea whose time had come. By far
the most popular index used is the Standard & Poor’s 500-
Stock Index, an index that well represents the major
corporations in the U.S. market. But now, although I still
recommend indexing, or so-called passive investing, there are
valid criticisms of too narrow a definition of indexing. Many
people incorrectly equate indexing with a strategy of simply
buying the S&P 500 Index. That is no longer the only game in
town. The S&P 500 omits the thousands of small companies
that are among the most dynamic in the economy. Thus, I
believe that if an investor is to buy only one U.S. index fund,
the best general U.S. index to emulate is one of the broader
indexes such as the Russell 3000, the Wilshire 5000 Total
Market Index, or the MSCI U.S. Broad Market Index—not
the S&P 500.
Over eighty years of market history confirm that, in the
aggregate, smaller stocks have tended to outperform larger
ones. For example, from 1926 to 2010 a portfolio of smaller
stocks produced a rate of return of more than 11 percent
annually, whereas the returns from larger stocks (such as
those in the S&P 500) were about 9.8 percent. Although the
smaller stocks were riskier than the major blue chips, the
point is that a well-diversified portfolio of small companies is
likely to produce enhanced returns. For this reason, I favor
investing in an index that contains a much broader
representation of U.S. companies, including large numbers of
the small dynamic companies that are likely to be in early
stages of their growth cycles.
Recall that the S&P 500 represents 75 to 80 percent of the
market value of all outstanding U.S. common stocks. Literally
thousands of companies represent the remaining 20 to 25
percent of the total U.S. market value. These are in many
cases the emerging growth companies that offer higher
investment rewards (as well as higher risks). The Wilshire
5000 Index contains all publicly traded U.S. common stocks.
The Russell 3000 and MSCI Index contain all but the smallest
(and much less liquid) stocks in the market. A number of
mutual funds are now based on these broader indexes. Such
index funds usually go by the name Total Stock Market
Portfolio. Although past performance can never assure future
results, the evidence clearly indicates that Total Stock Market
index funds have provided higher returns than the average
equity mutual-fund manager.
Moreover, unlike charity, indexing need not begin (and
end) at home. As I argued in chapter 8, investors can reduce
risk by diversifying internationally, by including asset classes
such as real estate in the portfolio, and by placing some
portion of their portfolio in bonds including Treasury
inflation-protection securities. This is the basic lesson of
modern portfolio theory. Thus, investors should not buy a
U.S. stock-market index fund and hold no other securities.
But this is not an argument against indexing, because index
funds currently exist that mimic the performance of various
international indexes such as the Morgan Stanley Capital
International (MSCI) index of European, Australasian, and
Far Eastern (EAFE) securities, and the MSCI emerging-
markets index. In addition, there are index funds holding real
estate investment trusts (REITs). Finally, Total Bond
Market index funds are available that track the Barclays
Aggregate Bond Market Index. Moreover, all these index
funds have also tended to outperform actively managed funds
investing in similar securities.
One of the biggest mistakes that investors make is to fail
to obtain sufficient international diversification. The United
States represents only slightly more than 40 percent of the
world economy. To be sure, a U.S. Total Stock Market fund
does provide some global diversification because many of the
multinational U.S. companies such as General Electric and
Coca-Cola do a great deal of their business abroad. But the
emerging markets of the world (such as China, India, and
Brazil) have been growing much faster than the developed
economies. China, for example, is still considered an emerging
market. But it is now the second-largest economy in the
world and is expected by the International Monetary Fund to
continue to be the fastest-growing large economy in the
world. Hence, in the recommendations that follow, you will
note that I suggest that a substantial part of every portfolio
be invested in emerging markets.
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