If you have heard these numbers and terms before and not really known what they have meant don’t worry, you aren’t alone. These terms are indexes of equities, or stock market indexes. They are basically a way of measuring a certain part of the market. The TSX 60 for example is the 60 largest companies on the Toronto Stock Exchange and the Dow is short for the Dow Jones Industrial Average which tracks 30 large USA companies. If these indexes are said to be “up” or “down” it means as a group. Think of a stock market index as an average of a certain list. These lists can be made according to any criteria, but for some reason we have all sort of commonly agreed to the main ones.
So why are indexes important anyway? Their primary function is to provide a baseline to measure your portfolio or someone else’s stock picks against. This is commonly referred to as a “benchmark”. For example, if you are an American mutual fund manager and you invest in pretty much all fairly large American-based companies, you would measure your performance against the S&P 500. If you were in the same position, but invested in US companies of all sizes you would likely compare your results to the average of the Russell 2000 index. If you specialize in the American technology sector then the most relevant comparison to your portfolio would be the NASDAQ index. If your investment results did not beat the average generated by their relevant index/benchmark it stands to reason that you “underperformed your market” or failed to “beat the street”. This is all industry jargon for “you’re not very good at your job are you?”
Who Knew Being Average Made You So Cool?
You want to know the funny part? The vast majority of mutual fund managers fail to beat their index. How can so many people fail to be “average” you might ask? Well, I have a pretty in-depth description in my eBook, but the basic idea is that people like hedge fund managers and holding company-types have huge informational advantages, as well as less restrictions than mutual fund managers. This is a large part of the reason why I recommend against ever holding mutual funds. From our perspective as small scale investors, the revolutionary outcome of indexes today is that we can actually “buy the index”. When you purchase TD Index Funds or ETFs to put in your RRSP or TFSA (my preferred method – using my Questrade account) that track an index, you are locking yourself into the average returns of that specific index. This means that by default you will already beat the vast majority of mutual fund managers out there, and you didn’t even have to calculate in their substantial fees!
Why Own One When You Can Own 7000?
When you “buy an index” you get great diversity and exposure. The Vanguard Total Stock Market ETF (VTI) gives you exposure to 3,000 USA-based companies of all shapes and sizes, and when you purchase units of the Total World Stock ETF (VT) you essentially but a small piece of 3,750 companies from all around the world. Just by purchasing these two ETFs (that are based on indexes) you are diversified into every single sector and geographical market on the planet. Investing has never been as easy as it is today, yet we make it so complicated.
So next time your financial advisor tries to sign you up for the newest mutual fund offering that they are getting a huge kickback from, ask them first if that mutual fund beat its benchmark index last year. If the advisor can’t answer that question off the top of their head, then they probably aren’t worth your time and money. If they tell you that it did in fact beat this specific index, ask them what its performance is against it for the last 10 years and if the same management team is still in place. If an advisor truly believes in a mutual fund they will know this information. You can also sound smart around the water cooler when someone mentions the Dow is up or down, and you can respond it doesn’t really matter what those companies do, I’m invested in 2,970 other American companies thank you very much.
2017 Update – Robo Advisors
With robo advisors becoming more and more popular over the last few years, we’d remiss if we did not mention them here within the context of index investing. These companies basically use automated computer commands (algorithms) to purchase you a basket of index funds. If you determine right off the bat that your RRSP should be split between the TSX 60 (30%) and a few international indexes (70%) your robo advisor will simply take whatever contribution that you make and divide it up so that your basket of indexes always has the same percentage of allocation. For our take on the best Canadian robo advisor in the market today, check out our Wealthsimple review and use our special promo offer code to try the service for absolutely free!