Why should I Index?
Not indexing implies that I can pick stocks that will outperform the market.
What special insight do I have that will allow me to identify a company that will beat the market?
No matter how knowledgeable I may be about a particualr sector or field, there are others who are more knowledgeable than me.
So whatever knowledge I may have about a company ABC, there are others who know more about it than I do.
If this knowledge is not my exclusive knowledge than enough others know about it, whcih includes the analysts whose full time job is to cover the company ABC.
If it is known that the company will outperform the market, then would its price be not bid up? Yes it would. There are enough people with money looking for sure shot opportunities. If the price is bid up then all the supposed out performance is gone.
The above says, that all the known information about a company including inside information is priced into the stock
It also says you cannot really cherry pick stocks based on some specialized exclusive knowledge or information that you have.
If the above is true then how come every year there are stocks that go up 100% plus and people make money at those? Any public company or even private company, its stock is owned by someone or the other. Companies move up much faster than market because of many factors, new products that are well accepted, new contracts, or other factors that suddenly remove uncertainity from some future and current income or significantly increase the current or future income annuity. Income annuity of course is from the meaningful life of the product and its marketshare.
Speculators and arbitrageurs bid up (or down) the price. Any information about these new contracts, products, etc is priced into the stock to the extent known. Any new information hits the market at the same time and it would be difficult to take advantage of that information. For every two or three investors who are gung ho about a particular stock, there is an equally enthusiastic bear who is shorting the stock.
The above process basically says markets are efficient and stocks cannot really be cherry picked.
Once we accept the above hypothesis, then the question arises is that if stocks cannot be picked, why should investors pay millions to the Mutual fund manager and his staff for buying and selling stocks. These costs lower the net performance as costs are pulled out of the assets.
A mutual fund manager may have a staff of 10 and offices in some ritzy building. They may be travelling often. All these are costs investors of managed funds have to bear. In addition, the trading in and out costs money also and this further hurts your fund performance. There are trading costs. Costs associated with tax inefficiency as all this trading results in taxable events.
So if unmanaged basket of stocks is the way to go, then the next question arises is hwo to pcik that basket. Should I plunk equal money into the the Taco Joint by Jose and into IBM? Why or why not? This is where market capitalization based weighting comes in. It has been shown that smaller the company, greater is the risk. The local cleaners shop could easily go bankrupt but not IBM, GE or Microsoft. The local cleaners may also out perform a larger company. But, the larger the company, the more resoources they have at their disposal to figure ways to make money, smaller companies do not have that many resources.
There are other issues such as when investing - is the focus to manage risk or chase performance and growth. The cardinal rule of investing is to manage risk first.
Having said all of the the above, where do I personally stand? Well, we will leave that for some other day.
I think 99.9% of investors should heed to above.
