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Index Fund: The Optimum Investment Strategy

Written by Leonardo Hadi · 2 min read >
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Key Points:
  • A Nobel Prize Theory – Efficient Market Hypothesis is the basis for Index Fund creation.
  • S&P 500 Index Fund has gained 10% annual return in average since 1926.
  • Warren Buffett said “If you don’t know much about stock market, buy index fund”
Efficient Market Hypothesis

Efficient Market Hypothesis (EMH) – published in 1970 by Eugene F. Fama, Finance Professor at the University of Chicago Booth School of Business, Illinois – argued that it was nearly impossible to consistently outperform the overall market return in the long-term because the market is efficient. 

The current asset price always reflects all the available information. The asset price movements always occur efficiently, and stocks always trade at fair value because any new information will be quickly incorporated into the asset price by many buyers and sellers. It is difficult to get the information ahead of time to outperform the market without speculation as the asset price moves only when new information becomes available to the public.

Even though some people gain superior returns, on average, the excess return does not exceed the cost of winning it (i.e., trading fee and information cost). The only way to outperform the market is by taking a much greater risk or when the anomalies occur. In 2013, Professor Eugene F. Fama received a Nobel Prize in Economics because of his work in the Efficient Market Hypothesis, which became the foundation for creating the index funds in 1976.

Market Return and Volatility
Center of Research in Security Prices – The University of Chicago

Based on the 1926-2020 market return data from the Center for Research in Security Prices (CRSP), US S&P 500 Total Return Index gained a 10% compounded annual return.

If $1,000 was invested in January 1926, the fund worth $6.4 Million in 2020. It is important to note that during the 94 years period, there was the great depression of 1929, the great recession of 2008, 15 recessions, 2 World Wars, Atomic Nuclear Bombings of Hiroshima and Nagasaki, Cold Wars, Gulf Wars, the Oil Crisis, Indochina Wars, 9/11, many people thought that the world was going to end at some point. Still, the US economy kept growing and achieved a 641,133% total gain. Now the questions are:

  • What is the best portfolio strategy if you want to retire comfortably?
  • Why should we pay a high fee for professional fund managers if the return is equal to or less than the index fund?
  • Why should we spend precious spare time to day trade, pay high trading fees, gain a 20% return on a single year but risk losing all on a single trade, and not able to consistently outperformed the index for a very long time?

It is important to remember that keeping an investment return is similar to keeping score in professional golf. Not just keeping score of the good shots, but also keep score of all the bad strokes.

Investment Strategy for Retirement

The optimum investment strategy for retirement is to invest in low-cost index funds very early. On the retirement day, all the funds in Treasury Bills can be invested to generate risk-free cash flow forever.

The table above shows the potential cash flow at retirement when investing in index funds with an investment duration of 35 years. For an illustration, if $2,000 per month is consistently invested in the Index Fund, $6.5 Million will be earned after 35 years.

During retirement, the $6.5 Million funds can be invested in Treasury Bills to earn a cash flow of approximately $188,000 per year or $15,700 per month as retirement income. 


Reference

Fama, Eugene F. (1970). Efficient Capital Market: A Review of Theory and Empirical Work. Journal of Finance. Retrieved from here.

Weisbenner, Scott (2018). MBA Lecture: Investments. University of Illinois at Urbana-Champaign

Investment Illustrated (2018). The Big Picture Chart. Center for Research in Security Prices. The University of Chicago Booth School of Business. Retrieved from here.

Corporate Finance Institute (2018.) Efficient Market Hypothesis. Retrieved from here.

Buffett, Warren (2018). Annual Shareholder Report. Retrieved from here.


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Written by Leonardo Hadi
MBA from the University of Illinois at Urbana-Champaign. Quantitative Fund Investor. Professional Engineer. Operations Professional. Profile

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