The Case for Simple Index Investing

Recent research shows that everyday investors may be better off using index funds.

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We all love stories in which failure breeds success: Michael Jordan being cut from his high school basketball team, Thomas Edison being told by a teacher that he was too stupid to learn, Marilyn Monroe being dropped by 20th Century Fox for being unattractive and unable to act. Such inspirational stories grace the pages of self-help manuals and provide inspiration as we all struggle to learn and grow.

Unfortunately, for every account of failure turned to success, there seems to be a deep reservoir of plain old ugly failure that leads to nowhere. Whether it is the ignominy of WebTV, the demise of the billion dollar USFL and XFL football leagues, or the more recent demise of Bear Stearns, Lehman Brothers, and IndyMac Bank, the choices are plentiful.

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Particularly intriguing are failures from leaders that somehow find a way to snatch defeat from what otherwise appears to be the inevitable jaws of victory. In this year's Indy 500, JR Hildebrand was one turn away from winning the prestigious race on his first try. Then, within sight of the checkered flag, the 23-year-old Californian made the ultimate rookie mistake. After successfully racing 499.8 miles, he slammed into the wall on the final turn, and Dan Wheldon drove past him to claim an improbable Indy 500 win.

Transforming success into failure is not reserved for corporations and sports stars. Possibly the saddest example may be found in the everyday retirement investor. Recent research by Michael Mauboussin, Columbia University professor, has revealed this in three simple numbers: 9, 7.5, and 6.

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Nine percent is the annual historic growth of the S&P 500. The average investor could simply buy and hold the S&P 500 Index, go play golf, and look up in twenty years to see a nice achievement—9 percent returned year after year.

If, however, a retirement investor is not happy with this 9 percent success, he can hire a professional mutual fund manager to actively manage his money in an effort to beat the market. This brings us to our second number—7.5 percent, or the historic annual returns of actively managed mutual funds.

The spread between the historic returns of the S&P 500 and the historic returns of actively managed mutual funds is 1.5 percent or the amount collected in fees by these Wall Street pros. Which brings us to our third number: 6. According to Mauboussin's findings, 6 percent is the actual historic return that everyday retirement investors in America achieve over time.

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Fear and greed—the two mortal sins of investing—can also tempt the everyday investor to try to perfectly time the market (buying high and selling low). While investment giants like Warren Buffet have long understood that the wise investor should "be fearful when others are greedy and be greedy when others are fearful," the everyday investor underachieves by following the opposite principle.

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When markets are flying high the everyday investor allows greed to kick in, telling these underperformers to hold on for more or even double down on their winning stocks. Unable to embrace the investment discipline of trimming winning picks and buying losers, these investors set themselves up for the next big market adjustment. Eventually, the bubble bursts. When such market corrections hit, the everyday investor lets fear take the helm. Fear demands that the underperformer exit his position and rush to the safety of cash or bonds. In doing so, the cycle is complete, leaving the everyday investor with fewer retirement dollars and more sleepless nights.

If you prefer to enjoy life, sleep well and retire with more, simple index investing and disciplined rebalancing will deliver as promised.

Steve Beck is cofounder of MarketRiders, an online investment advisory and management service helping Americans invest for retirement. MarketRiders gives investors greater peace of mind knowing that they are leveraging the best thinking of Nobel laureates and the investing methods used by the world's most elite institutions and wealthiest families. MarketRiders is on the investor's side, helping reduce investment costs and risks, and increasing retirement savings.