Mark Hebner / Mary Brunson

IFA's Quote of the Week - 29 (Benjamin Graham)

"The investor with a portfolio of sound stocks should expect their prices to fluctuate and should neither be concerned by sizable declines nor become excited by sizable advances. He should always remember that market quotations are there for his convenience, either to be taken advantage of or to be ignored."

Benjamin Graham, The Intelligent Investor, 1949 John C. Bogle, as quoted in The Little Book on Common Sense Investing

Widely regarded as the “Father of Modern Security Analysis”, Benjamin Graham (1894-1976) has inspired many investors, including professional investor Warren Buffett. In Graham’s quote above, he explains the importance of selecting a portfolio that enables you to ignore the short-term ups and downs of the market that ultimately have little, if any, impact on long-term returns. A portfolio of index funds is the perfect vehicle for following Graham’s advice. In contrast to funds run by active managers, investment managers of index funds are far less active in the buying and selling of stocks. Index funds managers do not pick stocks or active managers. They do not time markets, pick styles, or make attempts to forecast the future. The analytic techniques that index funds managers use are quantitative or scientific. The following Table summarizes the primary differences between active investing and indexing.

(click or scroll down to view the enlarged table)

As the Table shows, approximately 15% of all individual assets and 44% of all institutional assets are currently invested in different index funds. Many institutional funds are 100% indexed. Even Charles Schwab and Company recommends that investors put 80% of their large cap assets into index funds, and Mr. Schwab himself has 75% of his mutual funds in index funds. Other indexing proponents include Barclay's Global Investors, Dimensional Fund Advisors, The Vanguard Group, Warren Buffett, Peter Lynch, numerous academic institutions, Economic Nobel Laureates, and Index Funds Advisors (IFA). Insurance companies use a similar approach to indexing when setting premiums for the risks taken by insuring against thousands of different random events. Most of those premiums are also invested in index funds while held in reserves for the inevitable claim payment.

Most investors believe that index funds investing means investing in familiar market indexes, such as the Standard and Poor's 500. S&P 500 funds are structured with the aim to provide the same investment performance as the S&P. By holding all the stocks in the same proportionate amounts as the S&P index, the fund index represents about 86% of the market value of all U.S. companies, mostly large blue chip stocks. The problem is that market indexes, such as the S&P 500, were not originally designed as investment vehicles.

Since the late 1980’s, index funds have expanded and are based on more discrete customized indexes. Originally designed for very large pension funds, institutional-style index funds are meant to capture various financial risk factors or dimensions of the market. Exposure to a risk factor such as company size or value constitutes a risk dimension of the market. Investors have been compensated with higher returns for risk exposure to these risk factors since 1929. These dimensions of the market can also be referred to as indexes. Indexes are groups of stocks that have common risk and return characteristics and comply to specific and clearly defined sets of rules of ownership. These groups of stocks include companies from the United States, foreign companies, and even emerging markets. There are additional indexes within these markets, such as value, large value, small growth, large growth, real estate securities, and many fixed-income investments, such as short-term and long-term treasury bonds, municipal bonds, and corporate bonds.