Introduction

This is likely to be the most important book you will ever read about investing. It recommends a very simple, step-by-step strategy for individual investors to do what some of the most sophisticated professionals do -- use index funds as the vehicle of choice for their investment assets. Simply stated, index funds consist of the stocks in a broad stock market index, such as the Standard and Poor's 500 Stock Index or the even broader Wilshire 5000 Index. Index investing is thus nothing more than a strategy of buying and holding all, or a representative sample, of these stocks. Sure, it's a plain vanilla investment in an era when the more exotic flavors are highly touted by the leading investment magazines and many brokers. But this simple investment strategy has outperformed all but a tiny handful of the thousands of equity mutual funds that are sold to the public. Readers who follow the advice in these pages are likely to earn more from their investments while sleeping better as their returns become more predictable.

I have been a fan of index funds for more than twenty-five years. I first recommended them in 1973 in the first edition of my book A Random Walk Down Wall Street. In fact, in 1973, index funds were not available for the public -- they were then only used by a few institutional investors such as the big pension funds. The first publicly available index fund was started in 1976. I said then, as I say now, that index investing is a sure strategy to gain investment returns that exceed those available from the average mutual fund, which is constantly in the market actively buying and selling stocks in a futile attempt to gain extraordinary returns.

How Has Indexing Performed?

How has the indexing strategy fared over the past quarter of a century? The answer is very well indeed. The graph on page 15 shows the proportion of actively managed equity mutual funds that have failed to match the broad Wilshire 5000 stock index -- an index made up of essentially all the stocks in the S&P 500 (an index heavily weighted by the largest U.S. corporations) and a large number (more than 4,500) of smaller firms. The exhibit shows that there have been very few years when even half of the actively managed funds have been able to beat the index. About two-thirds of the actively managed funds are outperformed by the index in a typical year. On average, the typical actively managed fund underperforms the index by about two percentage points a year. And that calculation ignores the sales charges that are imposed by some actively managed funds and the extra taxes an investor pays on funds that turn over their portfolios rapidly. Throughout this book, my co-author Richard Evans prefers to call actively managed funds "non-index" funds. His point, which is entirely accurate, is that index funds also need active attention to ensure that they continue to mirror the index they are designed to represent. But what index funds don't do is try to select a portfolio of individual securities that the non-index manager hopes will beat the index. And the record clearly shows that such "active" or "non-index" managers do not usually match the records of the market as a whole.

When we look at returns over a ten-year period, the advantages of indexing look even better. For example, the graph on page 17 shows the number of equity mutual funds that have done better or worse than the S&P 500 Stock Index between 1988 and 1997. (The situation is similar for the Wilshire 5000 Index.) You can count on your fingers the number of funds that managed to beat the index by any meaningful amount. Moreover, substantial numbers of funds failed to meet the index return by several percentage points per year.

Does the average 2-percentage point underperformance of the typical actively managed equity mutual fund make a real difference to the individual investor? You bet it does! Small differences in returns compound into enormous differences over the years. Suppose you are a twenty-year-old who puts aside $10,000 for investment in stocks to be used at age seventy for retirement. Over very long periods of time stocks produce a gross return of about 10 percent per year, so after expenses the typical active manager will produce an 8 percent annual return. Over fifty years, $10,000 will grow to $1,174,000 if it earns 10 percent per year. But it will grow to $469,000 if it earns only 8 percent per year. The staggering difference of more than $700,000 is more than seventy times the investor's initial stake. Small wonder that Albert Einstein described compound interest as one of the most powerful forces in the world. In chapter 5, "Index versus Non-Index Fund Returns," Evans provides convincing evidence that index investors do indeed come out far ahead.

Why Does Indexing Work?

Why should indexing work? Why should a computer be able to put together a portfolio of stocks that can do better for the investor than one selected by intelligent, well-trained, and highly paid experts? There are four reasons.

First, there is considerable evidence that our securities markets are extremely efficient in digesting information about individual stocks or about the stock market in general. When information arises, the news spreads very quickly and is immediately incorporated into the prices of securities. Thus, neither technical analysis (of past price patterns) nor fundamental analysis (of a company's earnings, future prospects, and so on, to determine a stock's proper value) will help an investor to achieve returns greater than would be obtained by buying and holding one of the broad stock market indices. It is not that the experts are incompetent. Rather, it is precisely because professionals are so diligent in continuously examining stock prices for any mispricing that the market always reflects their best judgment regarding the implications of all information that is known.

This efficient-market theory, as it is known, is associated with the idea of a "random walk," which is a term loosely used to characterize a price series where all subsequent price changes represent random departures from previous prices. The term was first used to describe the unpredictable behavior of a drunk left in the middle of a field. The logic of the random-walk idea is not that the market is capricious but that if information is immediately reflected in stock prices, then tomorrow's price change will reflect only tomorrow's news and will be independent of the price changes today. But real news is by definition unpredictable, and thus resulting price changes must be unpredictable and random. As a result, prices fully reflect all known information, and even uninformed investors buying a diversified portfolio at the tableau of prices given by the market will obtain a rate of return as good as that achieved by the experts. The way I put it in my book A Random Walk Down Wall Street, a blindfolded chimpanzee throwing darts at the Wall Street Journal could select a portfolio that would do as well as the experts. Of course I didn't literally suggest that investors should throw darts, but rather that they should simply buy and hold a large group of stocks that represented the stock market as a whole. In other words, investors would be well served by buying an index fund.

The second reason that indexing works is because it is so cost efficient. The typical expense level for managing a public index fund is .2 percent (two-tenths of one percent) per year. Actively managed funds have a typical expense level of 1.5 percent and many of these funds have even higher expenses. Since professional portfolio managers dominate stock trading activity (most individuals own their stocks through funds), the experts as a whole cannot do any better than the whole market --they are the market.This would be true even if the stock market were highly inefficient. Hence if active managers charge well over 1 percent per year in extra expenses, they must then underperform an index fund that buys the whole market by an equivalent amount.

A third reason why indexing outperforms managed funds is that the funds incur heavy trading expenses. The typical actively managed fund sells almost all the securities in the portfolio each year, replacing them with other stocks. Indeed, many funds turn over their entire portfolio more than once each year. But this portfolio turnover is expensive. The fund pays brokerage charges on each transaction as well as the security dealer's spread between buying and selling prices. The fund also pays a "market impact" cost. When it buys a stock it tends to drive up its price, making the purchase more expensive. When it sells it tends to drive the price down, reducing the fund's net proceeds. These trading costs can easily amount to between .5 percent and 1 percent per year. The index fund, on the other hand, simply holds on to its securities from year to year and thus largely avoids these transaction charges. Between extra professional portfolio management fees and trading costs, the active manager would have to outperform the index by 1.5 to 2 percentage points per year to produce net returns that just matched the index. No wonder that the typical performance gap between the experts and an index fund has generally been within the above range.

But the fourth and perhaps biggest advantage of indexing for the taxable investor lies in its tax advantage of deferring the realization of capital gains or avoiding them completely if the shares are later bequeathed. To the extent that the long-run uptrend in stock prices continues, switching from security to security involves realizing capital gains that are subject to tax. Taxes are a crucially important financial consideration since the earlier realization of capital gains will substantially reduce net returns, as Evans shows in chapter 14. Index funds do not trade from security to security and, thus, they tend to avoid capital gains taxes.

Stock trading among institutional investors is like an isometric exercise: Lots of energy is expended, but between one investment manager and another it all balances out, and the transaction costs incurred by the managers detract from performance. The other big detractor from performance is fund expenses. As Don Phillips, the president of the Morningstar mutual-fund rating service, has said, "If you pay the executive at Sara Lee more, it doesn't make the cheesecake less good. But with mutual funds, it comes directly out of the batter." Moreover, the biggest advantage of indexing for the taxable investor lies in its advantage of deferring or avoiding capital gains taxes.

Some critics of indexing argue that the strategy is one of "guaranteed mediocrity." It is certainly true that the index-fund investor gives up the chance of boasting to one's golfing partners about the fantastic gains made by picking stock-market winners. But experience conclusively shows that index-fund buyers obtain results exceeding those of the typical fund managers whose large advisory fees and substantial portfolio turnover tend to reduce investment returns. I am convinced that most investors -- both individual and institutional -- will find the guarantee of playing the stock-market game at par every round a very attractive one.

Why Not Buy Just the Superior Performing Funds?

There is no doubt that some mutual-fund managers have been able to beat the market -- a few by significant amounts. This fact suggests an obvious strategy: Invest only in those funds with superior long-term records. The financial press is happy to help out by singing the praises of particular portfolio managers who recently have produced well above average returns. There is only one problem with that strategy. Good performance in one period does not predict good performance in the next. As long as there are averages, some managers will beat them. Undoubtedly, some actively managed funds will substantially beat the market in the years to come. The problem is that investors have no way of knowing in advance who those superior managers will be, as Evans shows in chapter 6, "Does the Past Predict?"

I have put the records of all mutual funds on the computer and attempted to find a strategy that would enable an investor to select the best ones. I tried a strategy of buying only those funds that had the best record over the past year, or the past two, five, or ten years. I tried a strategy of buying only those funds favored by the financial magazines or investment services, such as the "honor roll funds" selected byForbesmagazine or the "five-star" funds chosen by Morningstar mutual fund service. While some of these strategies worked for some periods during the late 1970s and early 1980s, none of these strategies were successful over the long run in consistently picking funds that could either beat the market or even do better than the average equity mutual fund. As Nobel laureate in economics Paul Samuelson has stated, "Investors would be well advised to avoid looking for such tiny needles in such large haystacks." The chances of identifying the very few managers who will beat the market are close to nil.

Survivorship Bias and Mutual Funds Returns

In 1997 I appeared on a public television program with Peter Lynch, the legendary former manager of the Magellan Fund, a fund with a superb long-term record. Lynch was asked why the average money manager has underperformed the S&P 500. He replied flatly, "That's just not true...the average mutual fund has beaten the market for twenty-five years, it's beaten it for thirty-five years, it's beaten it for, I think, fifteen years. It has not beaten it for five (years)." In short, Lynch admitted that the mid-1990s were not stunning years for active portfolio managers, but he claimed that during the 1980s and in earlier decades, the pros' records were superb.

There is a certain sense in which Lynch's statement is true, but only if one ignores what statisticians call "survivorship bias." If one looks only at the funds with twenty-five-year records, one is, in effect, looking at funds that survived for twenty-five years. But only the successful funds survive. Funds that do poorly are very difficult to sell and tend to get merged into more successful funds in the mutual-fund complex so that their bad records get buried. Thus, if you look only at the performance of funds with twenty-five-year records, you will tend to see an unrealistically rosy picture of the success of fund management. The problem is that the investor cannot know in advance which funds will be successful and therefore which funds will survive.

A numerical calculation will illustrate the difference between surviving and nonsurviving funds during the 1980s, a period when Peter Lynch claimed that active portfolio managers outperformed the S&P 500 Stock Index. Taking all mutual funds with an objective of capital appreciation that existed at the start of 1982 and survived through 1991, I found that their average rate of return was 18.1 percent, comfortably above the S&P 500 return of 17.5 percent for the same period. This is the kind of comparison you would make if you asked what was the average annual return for all such funds existing on January 1, 1992, that had at least a ten-year record. (I do the calculation up to the start of 1992 because Lynch did admit that the pros as a group did poorly after 1992.) So it appears that Lynch was correct.

But if we examine the average fund returns forallfunds with a capital appreciation objective existing during the 1980s irrespective of whether they survived for ten years or not, we get a different result. When we figure the average fund return for the decade, we include all funds existing during every year of the period, including those funds that didn't make it all the way through 1991. Now we find that the average fund return was only 16.3 percent, well below the 18.1 percent return of the survivors and also well below the 17.5 percent return of the S&P 500. The differences are even more dramatic for the fifteen-year period ending December 31, 1991. The average return for equity funds surviving over the whole fifteen-year period was 18.7 percent per annum. The average yearly return forallfunds, including nonsurvivors, was only 14.5 percent.

I have done similar analysis for "growth and income" funds as well as for all equity funds, whatever their stated objective. The results are the same. Analyses that exclude nonsurviving funds will significantly overstate the returns received by mutual fund investors. This is the error Peter Lynch makes when he claims that the average mutual fund has outperformed the S&P index. The facts remain that the average manager significantly underperforms the index and has done so not only over the past five years, but over the past ten, fifteen, and twenty-five years as well.

Are Bigger Funds Better Than Smaller Ones?

One of the reasons even the successful actively managed fund fails to maintain any advantage over an index fund is that as the fund grows in size, it gets harder and harder to manage the portfolio. Investors should remember that many of the best long-run performing mutual funds attained their excellent records when they were small. Indeed, some fund complexes will start a number of "incubator" funds and continue to market only those that have succeeded. For example, suppose ten funds are initiated and three are successful in beating the market. Those three survive and the other seven are merged into more successful funds, thus burying their poor records. Of course, the long-run rates of return of these three successful funds will reflect the early years of superior performance.

There are several reasons why larger size tends to inhibit performance. First, small funds can benefit from a strategic placement of new issues in the fund. A mutual fund complex might concentrate its allocation of a hot initial public offering in a very small fund, thus boosting performance substantially. A multibillion-dollar fund has no such opportunity since the effect of a new issue's stock-price appreciation is likely to get lost in the rounding.

A second reason large size may inhibit performance is that the universe of securities available for the fund's portfolio decreases with size. Mutual funds usually operate with two constraints. First, they will want to limit the holdings of any individual security in their portfolio to at most 2 percent to 5 percent of their total portfolio to maintain adequate diversification. Second, they will usually be unwilling to hold positions representing more than 5 percent to 10 percent of the firm's outstanding shares to ensure adequate liquidity should the fund wish to sell the shares. Together, these constraints sharply limit the number of companies available for investment.

Suppose one mutual fund has $1 billion in assets and decides that to maintain adequate diversification it will hold fifty securities, putting 2 percent of the portfolio ($20 million) in each individual stock. Suppose, further, that the fund decides it does not want to hold more than 5 percent of the value of any one company. John Bogle, the founder of The Vanguard Group, has estimated that 1,850 stocks would be available for investment by the fund. Now suppose the fund grows to $20 billion and operates with the same constraints. Limiting itself to no more than 5 percent of a firm's total capitalization will reduce the number of available securities by more than tenfold to 182 companies. In other words, growing from $1 billion to $20 billion in size is likely to reduce the number of securities available for purchase by as much as 90 percent.

A third reason size makes performance more difficult is that transaction costs increase with size. While big institutions can trade at pennies per share in brokerage commissions, moving substantial blocks of securities around tends to move market prices. The funds will be able to take on a large position only at a premium from going market prices and to liquidate that position only at a discount. Moreover, since other funds (and other accounts) in the complex are likely to take on similar stock positions, the effects are likely to be larger than would be the case if the funds were independent. While reliable studies of transactions costs do not exist, most professionals recognize that they are potentially quite substantial. According to a study by the Plexus Group, typical trading costs for investment managers may be as large as .8 percent of the dollar amount of a transaction involving a sale and purchase. And the trading costs of larger funds are likely to be substantially higher than for smaller funds.

The records of two of the most successful mutual funds will illustrate the tendency of superior performance to disappear as the size of the fund increases. The graph on page 26 shows the performance of the "Around the World Fund," which is the Magellan Fund, the largest equity mutual fund and a stellar long-run performer. In the early years of the fund, when its assets were less than a billion dollars, performance was particularly outstanding. The fund beat the market over three-year periods in the late 1970s and early 1980s by 20 to 30 percentage points per year. Note, however, that the excess performance during the remainder of the 1980s and into the 1990s, while certainly impressive, was substantially lower than in the earlier periods. The exhibit shows that the three-year performance through 1996 was substantially worse than the S&P; and in the period ending in 1997, the Magellan Fund was more than 650 basis points (6.5 percentage points) behind the Vanguard Index Trust S&P 500 portfolio, where both returns are calculated after expenses. And the fact that the Magellan Fund charged a load or sales charge on investors entering the fund means that the net returns for investors were even worse.

The graph below shows a similar pattern for the "Alpha Equity Fund," actually the Investment Company of America, the third largest equity mutual fund. (The Vanguard Index Trust S&P 500 Stock portfolio is the second largest equity mutual fund.) When the fund was smaller, its ten-year performance numbers stayed consistently above the S&P 500 index. As the fund grew rapidly during the late 1980s and 1990s, however, performance deteriorated. Bigger is not better when it comes to the profession of managing money. It is important to point out, however, that index funds do not suffer from a size disadvantage. They simply hold on to a market portfolio no matter how large it may get. To the extent the fund grows and new purchases need to be made, they can be done gradually over time through efficient electronic means.

A Preview

In the pages that follow, Evans clearly spells out the advantages of index-fund investing. He documents the index advantages of better performance, lower costs, and minimization of taxes. He demonstrates how index funds provide better diversification and more predictability of performance. He also shows the reader how index funds are particularly user-friendly. And he does it all with wit, grace, and clarity.

Readers will find especially helpful Evans's advice on how to build a financial plan and how to construct a portfolio consistent with that plan and with each investor's risk tolerance and particular circumstances. Chapter 10, "Investing for Retirement," covers retirement planning, and it alone is worth far more than the price of this book. Chapter 12 presents enormously helpful advice on taking advantage of all the tax breaks allowed by law. Evans helps ordinary individuals to "invest with confidence." In the final chapter, I put it all together and recommend specific index-fund portfolios for investors in different circumstances.

Chapter 2

The Emperor Has No Clothes

On Water Street near the tip of lower Manhattan, a man sits at his desk on the thirty-second floor of a gleaming office tower. It's dark out. Looking north, a visitor sees a checkerboard of light revealing the financial center of the world.

The office is dimly lit, but the visitor can make out a free-form sculpture in one corner, offset in another by a covey of floor-to-ceiling plants. Abstract oils grace the walls. The chalky glow of a computer monitor lights the man's face as he talks on the phone and stares, frowning, at numbers on the screen. He's telling his wife in their $2 million Montclair, New Jersey, home that he'll be home late, as usual. His clothes display his status: A $2,500 Armani suit; a custom-made, $225 shirt (light blue, with a white collar) from his favorite shop in Hong Kong; paisley-patterned, $125 braces; and $500 shoes (black, of course) from Church of London.

He manages a mutual fund. A sales brochure says his fund has grown by an average of 21 percent a year for the last five years. A stylish graph suggests this was good enough to beat Standard & Poor's Composite Index of 500 Stocks (S&P 500) by a wide margin. He is quoted inBarron'sandThe Wall Street Journaland mentioned inMoney.He has appeared twice on Rukeyser'sWall Street Week.For his astute advice, his firm charges investors 1.5 percent of assets per year. Last year he earned $545,000.

What's wrong with this picture?

Strange question. The manager's investors have done well, and he has beaten a universally accepted measure of the stock markets. The fund shareholders are delighted when they see him quoted in business publications. They pride themselves on having entrusted their money to a brilliant, hard-working manager. As for his high income, who could deny he has earned it?

I think you will. Objective evidence will show you why this manager's performance is not what it seems. In fact, you'll learn why he has not earned a nickel's worth of his fee. The same can be said for most of the thousands of alleged wizards who manage $5 trillion in more than 7,000 separate stock or bond mutual funds. The numbers are new; the point is not.

THE $5 TRILLION QUESTION

Way back in 1975, in the summer issue ofThe Financial Analysts Journal,Charles Ellis, founder of Greenwich Research Associates, stated:

The investment management business is built upon a simple and basic premise: professional managers can beat the market. That premise appears to be false. The ultimate outcome (of the game) is determined by who can lose the fewest points, not who can win the most. Money mangement has been transformed from a Winner's Game to a Loser's Game.

Mr. Ellis was referring to the fact that the average manager trails his or her relevant index by a significant margin. And there's no reliable way to pick out,in advance,which managers will rise above the average. Yet all managers charge substantial fees. Given these facts, index funds are the logical way to invest.

Why pay a premium for inferior performance? That's the $5 trillion question.

A look at the record shows why it's a good question. For the fifteen-year period ending June 30, 1998, a Standard & Poor's (S&P)indexfund beat 84 percent of diversified stock funds. And this is not a one-time event. The Vanguard Index 500 Portfolio, the largest stock index fund, has outpaced the pack over a wide range of time periods.

Good as it is, this record actuallyunderstatesthe power of indexing. The superior performance stated here is based on usinggrossreturns -- the figures you see published in magazines and sales brochures. I call these figures "gross" because they don't reflect sales charges and other factors that reduce the apparent return of conventional funds. As you'll see in chapter 5, indexing wins even on a gross basis in many different asset classes, from large capitalization stocks to short-term bonds. Whennetfigures are used, indexing leaves conventional funds even farther behind. More on that to come.

BASIC IDEAS

As you go through this book, you'll notice certain terms and ideas come up again and again. Might as well learn what they mean right now.

Index

Roughly, a group of stocks or bonds representing a specified portion of the stock or bond markets. Instead of someone's selection, an index includesallthe securities that meet certain objective criteria, such as market price, country of origin, and type of industry. The Dow Jones Industrial Average -- the one you see quoted all the time -- is an index that measures the average price of stocks representing thirty massive U.S. companies. The Standard and Poor's Index of 500 Stocks reflects the stock price of more than 500 mostly large companies. When measuring the performance of a conventional fund, you need to compare it with a "relevant" index -- one that's in the same asset class as the fund.

Index fund

A mutual fund containing either all or a statistically valid sample of the stocks or bonds in a specified index. The dollar value of each security in the fund is usually proportional to its market capitalization (price times number of securities outstanding). An indexfunddoes not exactly match its index, because it has operating expenses that must be deducted from the total return. Also, there may be "tracking error," a slight difference between the fund and the index, caused by technical factors. You can invest in an index fund, but not in an index. In the Introduction, my coauthor Burton G. Malkiel explained what makes indexing such a powerful way to invest. In simple terms, it's as though you said to yourself:

Let's be realistic. There's no way I can pick out which handful of mutual funds may outperform their relevant index. And based on the record, I don't think anybody else can, either. So what I'll do is buy a fund withallthe stocks or bonds in a given index. I'll sleep better, because I'll always come very close to matching the index, rain or shine. And I'll earn more, because index funds have proved they can outperform the average non-index fund in their asset class.

Asset class

A group of stocks, bonds, or other kinds of assets with similar characteristics, such as size, price range, growth rate, and industry. Important asset classes include large U.S. corporations (like those in the S&P 500) and large foreign companies in developed countries. In this book, asset classes are divided into "major" asset classes (stocks, bonds, cash) and "subasset" classes -- specifickindsof stocks and bonds. Asset classes can be represented by indexes, many of which have a corresponding indexfund.Loosely, you can think of "asset class" and "index" as different ways of saying the same thing.

Index versus non-index

Many investment professionals call conventional funds "actively managed" and refer to index funds as "passively managed." I'm not going to do that. "Passive" implies something negative -- people sitting on their hands. On the contrary, index funds require expert management to minimize costs and make sure they stay close to the indexes they represent. Since both types of funds require active management, I call the conventional funds "non-index" funds.

ONWARD AND UPWARD

Index funds held by individual investors have been growing at a remarkable clip. There are now more than 150 publicly available index funds. Rex Sinequefield, Chairman of Dimensional Fund Advisors, summed up the situation as follows:

Indexing has grown...from essentially nothing in 1973 to well over $1 trillion now, and indexing has invaded nearly every asset class....[Pensions & Investments,9/30/96]

Some of these gains can be attributed to publicity in financial and business publications, even though the coverage is often less than it should be. These publications depend on advertisers advertising non-index funds and brokerage operations. You can't expect them to go to the wall for index funds. But there are exceptions. One was the August 1995 issue ofMoney.The Executive Editor's page proclaims:

Bogle wins: Index funds should be the core of most portfolios today.

("Bogle" refers to John Bogle, chairman of The Vanguard Group.) The headline for the cover story states: "The New Way to Make More Money in Funds." This article was an act of courage and integrity.Money,take a bow.

A LETTER THAT WAS NEVER SENT

There are no guarantees in the stock and corporate bond markets; almost anything can happen. But the inherent advantages of index funds put the wind at your back. We're going to spend the rest of part one of this book establishing the truth of that statement. In the meantime, here's a way to think about the difference between index funds and non-index funds:

Dear Investor:

We are pleased to inform you that the Ajax Fund grew by 20 percent over the past twelve months. We are proud of this achievement.

However, the fund did not outperform its relevant index, the S&P 500. Funds based on this index grew by 23 percent during the same time period. This means, of course, that you would have earned higher gains in one of the S&P 500 index funds. (Fortunately, Ajax is a no-load fund, or you would have fared even worse.)

Since the only purpose of an actively managed fund is to outperform a relevant index fund, we enclose our check for $11,372 to compensate you for the following items:

* $1,400 to cover our higher administrative, management, and transaction costs. (Index funds commonly operate at one-seventh to one-tenth of the cost of actively managed funds.)

* $8,432 to cover the difference between what you earned in our fund and what you would have earned in an S&P 500 index fund.

* $1,540 to cover the extra taxes you will have to pay because the Ajax fund made hundreds of transactions last year, thus generating capital gains distributions, which, in an index fund, would have been deferred.

We sincerely hope that you choose to leave your money in the Ajax Fund, in the hope of better relative performance during the next twelve months. At the same time, we are obliged to report that the Ajax Fund -- along with thousands of other large company growth funds -- has failed to outperform an S&P 500 index fund over the most recent ten-year period.

We are most grateful for your confidence in the Ajax Fund and wish you the best of luck in the years ahead.

Sincerely,

J. Winthrop Ajax

President

THE RIGHT PROMISE

This bit of fantasy makes a valid point. You give a fund family a good part of your life savings, and they charge you an average of 1.5 percent (plus .5 percent for transaction fees) to invest your money -- assuming there's no sales charge. What you get in return is a service. The fund managers, using their vast resources and legendary skills, promise to try to make your money grow as much as possible, consistent with the fund's rules and objectives.

Now here's the problem:That's the wrong promise.What the fund managers should promise is that they will try to beat a specified, relevant index fund. As stated in the letter:

The only purpose ofnon-index funds is to outperform relevant index funds.

Because if they don't, who needs them? Who needs to go through all the work (and anxiety) of trying to select a non-index fund that will do wellin the future?Why pay operating expenses that are seven to ten times those of an index fund? Why pay extra capital gains taxes because your fund made so many buy/sell transactions?The existence of a broad variety of index funds changes the investor's basic perspective.Now, when you're choosing a mutual fund, you shouldn't ask, "Will this fund make money for me?" You shouldn't even ask, "Will it do better than similar funds?" The right question is,"Will this fund outperform a relevant index fund?"

There's another basic change wrought by indexfunds(as opposed to indexes). They provide an objective benchmark that is also a practical investment vehicle. It's like the idea of par in golf. It provides an exact, numerical goal representing what a good playershouldachieve. Not everybody agrees with using indexes -- or index funds -- as a benchmark. Michael Lipper, president of Lipper Analytical Services, the New York City fund research company, was quoted inMoneyas saying, "It makes much more sense to compare funds to other funds that have a similar investment style and offer the same services."

I do not lightly disagree with a person of his stature, but I do disagree. The two methods of comparing are not mutually exclusive. You can do both, which is exactly the way golf scores are counted -- the number of strokes a player has taken,andthe number of strokes above or below par for the course. Golfers adopted this approach to deal with the possibility thatallthe players turn in a lousy score. In that case, comparing one with another would give you an incomplete picture, which a comparison with par would correct. It's the same with mutual funds -- all well and good to compare a fund with its peers, but unless you also compare it with a relevant index fund, you're missing a vital fact.

SLEEP BETTER

Anything can happen to an individual company. You could not only lose, but lose big. If you decide that's not for you, and turn to non-index mutual funds, you've still got problems. There are more than 7,000 separate mutual funds out there. How do you know which ones will suit your needs and beat the average? The quick answer is, "You don't." You'll see why as we move along.

Contrast that with index funds, where you deal with a relatively small number of important asset classes (such as big-company stocks, real estate stocks, long-term bonds). Yes, they fluctuate in market value. But here's the point:

With index funds, youknowyour money will always equal its relevant index (minus low operating expenses and a small tracking error) --guaranteed.

This is inherently more comforting than having to worry about your non-index funds underperforming their relevant index. Also, index funds relieve you of the burden of trying to time the market. By their nature, index funds are long-term investments, not appropriate for trading in and out. Index funds give you less to think about, less to worry about, less to do. Which brings up a useful idea.

DEMOCRACY COMES TO INVESTING

Index fundssimplifyinvesting. You don't have to confront the forbidding task of choosing from thousands of stocks and bonds or thousands of mutual funds. You don't have to belong to that elite club known as "active investors," trying to find needles in a haystack. Equally important, you don't have to hire somebody else to do it for you. That's good, because the average professional has rarely matched the long-term performance of a relevant index fund, yet charges a significant fee. The wall of mystique that Wall Street has erected in front of you is no longer an obstacle. You just walk around it. Index funds have brought democracy to investing.

A NEW WAY OF THINKING

Wall Street has been afraid to recognize the obvious: Index funds have ushered in a new approach to investing, a new paradigm. To make that clear, let's look at a quick sketch of the history of investing. I've divided it into five basic approaches:

1. Buy individual stocks and bonds from brokerage firms (from the 1890s)

Stock brokerage firms peddled securities directly to individual investors, many of whom hoped to make a killing in the market. The panic of 1929-1930 showed that the killing could cut both ways. In the fifties and sixties, brokerage firms hired security analysts to bring professional discipline to the analysis of stocks and bonds. Paradoxically, this did not necessarily make the firms' recommendations more useful. Competing security analysts made the markets more sensitive and competitive, which tended to offset the potential benefits of improved analysis.

2. Supplement stocks and bonds with mutual funds offered by salespeople (from the 1950s)

Mutual funds were a great leap forward. They enabled individual investors of modest means to diversify their investments and get professional management. That was important, because diversification lowers risk. Mutual funds also brought a useful simplicity to the process of investing. It became easy to invest every month, and monthly statements recorded your progress.

3. Buy no-load mutual funds directly from a mutual fund company (from the 1970s)

Gradually, some mutual fund companies began offering to invest people's money directly, dispensing with the need for a salesperson -- and a sales commission. Some people argued that load funds must be better because they charge more. But they weren't (and aren't). Nearly all the sales commission goes to the salesperson or into advertising the funds. The "load" contributes little or nothing to hiring better managers, building better software, or doing better research.

4. Buy mutual funds where you work through a tax-deferred savings plan (from the late 1970s)

In 1978 Congress passed a law allowing individuals to accumulate savings and investments on a tax-deferred basis, provided they were enrolled in a "defined contribution plan." For employees of profit-making companies, the plan is called a 401(k) (referring to a section of the law). For nonprofit employees, it's a 403(b). And for government workers, it's a 457. In some organizations, employers add to the employee's contribution to enhance loyalty. Defined contribution plans have become a major form of individual investing. ("Defined contribution" means the amount you contribute is specified; what you take out is not.) You may not think of yourself as an investor, but if you're in a defined contribution plan, you may have many thousands of dollars invested in the stock and bond markets.

5. Buy no-loadindexmutual funds instead of individual securities or non-index funds (mainly from the early 1990s)

This is the new paradigm for investing by individuals. Index funds have been around since the early 1970s, when professional investors started using them for pension programs. One of the first champions of indexing was my co-author, Burton G. Malkiel. In his best-selling book,A Random Walk Down Wall Street,he states:

What we need is a no-load, minimum-management-fee mutual fund that simply buys the hundreds of stocks making up the broad stock market averages and does no trading from security to security in an attempt to catch the winners. Whenever below-average performance on the part of any mutual fund is noticed, fund spokesmen are quick to point out, "You can't buy the averages." It's time the public could.

Quite independently, John Bogle, Chairman of The Vanguard Group, came to the same conclusion. He started an S&P 500 index fund for individual investors in 1976. It often beat the average performance of diversified stock funds, but not many people took notice until the mid-nineties, when the funddoubledin market value. Critics like to say that indexing is "settling for mediocrity." "Go for a home run," they urge. So much for that argument.

The recent success of this and other index funds has led the business press to give index funds more attention. Today you can use index funds to invest in a wide range of stock and bond asset classes -- from the huge stocks in the Dow all the way down to funds that mirror the Russell 2,000 index of small capitalization stocks.

Another important development in the nineties was the birth of the mutual fund supermarket, a central source from which you can buy any of thousands of mutual funds and be treated like a single customer. Charles Schwab & Co. launched the first one in 1992. They soon had major competition from Fidelity, Jack White, and others.

WHAT ABOUT INDIVIDUAL STOCKS AND BONDS?

You don't need them. For the average person, mutual funds are a better alternative -- especially index mutual funds. Think of the problems with individual stocks and bonds:

* Most people can't afford to buy cost-efficient amounts of enough different stocks for adequate diversification. If you try to get around this problem by buying a little of this and a little of that, the commissions can kill you.

* You have to make at least four hard decisions: Which securities to buy, which to sell, when to buy, and when to sell. It would be a mistake to minimize the difficulty of any of these decisions. There is a common notion that you're home free when you buy a stock that goes up. Not so.You don't pocket a gain until you sell the security.Knowing the best time to do that is something most people are not equipped to determine. Keep in mind, also, that you have to make all those decisions for every stock or bond you own. With index funds, you don't have to choose securities, and you don't have to time the markets.

* In making those four decisions, you compete with highly informed professionals who have access to data and software that mere mortals like you and I can't even imagine. In the vast majority of cases, by the time you and I actually buy or sell a security, the news we acted on is already reflected in the price.

* You pay high commissions to buy and sell individual stocks and bonds. At a big discount broker, the cost of buying or selling $10,000 worth of stock is $110. That's 1.1 percent when you buy, and 1.1 percent when you sell. A total of 2.2 percent. (The commission rate on small amounts may be even higher.) Compare that with investing in a no-load S&P 500 index fund, where the cost can be less than one-fifth of one percent a year, 25 percent of which is deducted from dividend income every quarter. In the fund, you start out with the entire $10,000 working for you. At the broker, you start out with $9,890.

* It's hard to manage individual stocks and bonds. It takes a lot of time, effort, and knowledge to stay on top of a portfolio, and at tax time, it can be a horror. Fund families, on the other hand, give you a single statement that reflects your total situation, including the percent of your money in stocks, bonds, and cash, plus the amount of your total return that is currently taxable.

* We live in a period of accelerating change. More and more, as time goes on, if you're going to buy or sell a stock, you have to do itfast.The average person -- even the average active investor -- is simply not equipped to respond to kaleidoscopic markets.

* Brokerage firms are glad to offer recommendations about which stocks and bonds to buy. In effect, you pay commissions to trade, but get the advice free. This is less wonderful than it may seem. Every recommendation is essentially a prediction of future events. The last time I checked, human beings were somewhat deficient in that area. Think about it. If broker recommendations were the road to riches, a lot more people would be rich. The same applies to the predictions by people who write for publications and newsletters.

* Studies have shown that up to 92 percent of the return on a diversified portfolio can come not from picking hot stocks, but from "asset allocation." This is a major concept we'll discuss later. For now, know that asset allocation refers primarily to the percentage of stocks, bonds, and cash in your portfolio. The term also refers to thetypesof securities you hold within the broad categories of stocks, bonds, and cash.

A FEW SAMPLES OF WHAT YOU'LL LEARN

As mentioned, this book is divided into two parts. The first part documents the fact that index funds are almost always a better way to invest than conventional mutual funds, especially on an after-tax basis. The second part, "The Five Giant Steps to Wealth," explains how you can use what you've learned to make more money. Here are some of the subjects we'll cover:

* Why index funds are likely to continue outperforming the average non-index fund

* How index funds simplify investing

* Why index funds provide morereliableinvestment results

* Why up to 92 percent of your investment return may come from a single investment decision

* The crucial importance of financial and investment planning

* How to combine different kinds of index funds to maximize return and minimize risk

* How to choose which funds to put in your portfolio

BEGINNERS OR EXPERTS

You can profit from this book even if you don't know much about investing and don't think of yourself as an investor. I will show you how index funds can give you higher returns than the average non-index fund, along with more peace of mind. On the other hand, if you're an active, informed investor, you'll learn how you could become more successful than ever before. In fact:

If you think of all the professional money managers as "Wall Street," the odds are that index funds will enable you to "beat the Street," which means you're likely to get better returns than most fund managers, even before adjusting for sales charges, risk, and taxes.

But what about the hypothetical Great Predictor we met at the start of this chapter? Surely you couldn't have done better than his scorching, five-year gain of 21 percent a year? Yes, you could. He runs what's called a "Small Cap Value Fund." His relevant index is the "Value" portion of the Russell 2,000 index, which grew by 23 percent during the same time period. If you were in a Russell 2,000 Value index fund, you would have beaten him. No problem.

WHY INDEX FUNDS ARE JUST CATCHING ON

Despite recent fast growth and good press, the money invested in index funds is still just a splash compared with the ocean of money in non-index funds. How can that be? If index funds are all that good, why aren't they a bigger part of the investment picture? Four answers come to mind:

1. Human nature

People want to believe in Santa Claus -- even smart, sophisticated people. They want to believe there are gifted gurus who can reliably outperform the markets.

2. Publicity about non-index fund performance

You can't help reading and hearing about funds that have beaten the markets by a wide margin. The noise level is deafening. You see headlines like, "SuperTech Fund gains a sizzling 43 percent in first half." You'd have to be less than human not to be affected by all the trumpets and drum beats.

3. Greed and fear

For mutual fund companies and brokerage firms, no-load index funds are a lot less profitable than non-index funds. Investors typically pay five to seven times more for a so-called actively managed fund than for an index fund. The sobering truth is, there's a big, powerful industry out there that depends on investors not fully appreciating the advantages of indexing. Indexing threatens a lot of mortgage payments in places like Fairfield County, Connecticut, and Orange County, California. The people who pay those mortgages are not likely to run around promoting investments that could drive them out of their castles.

4. Just plain ignorance

Most people don't know much about index funds. A common response when I tell people about this book is, "What's an index fund?" They've heard about them, but they're not familiar with them. They don't know the record of index funds versus conventional funds. They don't know you can buy index funds in a wide range of asset classes.

WHY BOTHER?

Skim through this book, and you'll see that it covers a lot of ground. Your response could be one or both of the following:

Look. I appreciate what you're trying to do, but I just don't have the time. I'm putting in sixty hours a week on the job, and when I get home, investing is not exactly on the top of my list.

I know I should read this book, but I'm just not that interested in investing. To tell you the truth, it bores me. I know that's not smart, but that's how I feel.

Fair enough. But give me a minute, if you would. Acting on those sentiments, you're likely to do whatever's easiest. Maybe you just delegate the whole thing to a friend or relative who's in the business and forget about it. Why not do that? For a couple of reasons:

One is that we're talking about your life savings, whether they're currently thousands or millions. And it's not just the money. It's what kind of college your kids will go to. It's what kind of home you'll live in. It's how well you can retire.

Another reason is the issue of what your friend or relative will actually do. He or she will probably handle your money according to generally accepted practices, such as:

* Investing all your money in stocks and bonds or in non-index funds

* Selecting funds largely on the basis of their published track records

* Trying to time the markets by trading (buying and selling) the different funds you own

* Earning his or her income by charging a commission on the trades

* Trying to diversify by buying different funds or stocks and bonds in the same asset class

All these generally accepted practices have one thing in common:They are all wrong.They are against your best interests. Your Uncle Charley may do well by following these practices, especially during roaring bull markets. But however well he does, the odds are that you will do even better by using the approach this book recommends.

SUMMARY

* Stock index funds in a variety of asset classes have outperformed the average, diversified non-index fund over many different time periods. Bond index funds have a similar record.

* The only purpose of non-index funds is to beat a relevant index fund. Managers who fail to do that don't earn their compensation.

* Non-index fund performance may not be as good as it seems. For one thing, it has to be measured against a relevant index. In addition, you need to consider the effect of taxes, sales charges, expenses, and the amount of risk taken to achieve the return.

* Index funds are the new paradigm for individual and institutional investors.

* Index funds simplify investing. Instead of having to choose from among thousands of securities or thousands of mutual funds, you can choose from a small number of important asset classes.

* People don't need individual stocks or bonds, which generate avoidable costs and other problems. For the vast majority of people, index funds are a better alternative.

* When judging a non-index fund, it's vital to compare its record not only with similar funds, but also with a relevant index.

Welcome to the new world of investing. Things will never be the same.

Excerpted from The Index Fund Solution: A Step-by-Step Investor's Guide by Richard E. Evans, Burton Gordon Malkiel
All rights reserved by the original copyright owners. Excerpts are provided for display purposes only and may not be reproduced, reprinted or distributed without the written permission of the publisher.