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Investment Philosophies: Successful Strategies and the Investors Who Made Them Work, 2nd Edition by Aswath Damodaran

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CHAPTER 13

Ready to Give Up? The Allure of Indexing

Many investors begin life as active investors, convinced that they can beat the market, and end up conceding failure in this quest. For such investors and for those who never believed that they had a chance of beating the market, the most practical alternative is investing in an index fund. An index fund is designed to mimic an index and generate returns that are equal to the index (and not beat it). While we give up the chance of ever beating the market with an index fund, we do gain some significant benefits. First, there are almost no trading costs since there is little portfolio turnover, other than adding new stocks to the index and shedding those that leave. Second, their low turnover makes index funds more tax efficient than other funds.

Index funds were created in the early 1970s and have swiftly caught on as an investment alternative. Ironically, the performance of active investors and money managers provides the best endorsement for index funds. The returns earned by active money managers have trailed the return on the S&P 500 index for much of the past few decades. In addition, the market timing abilities of money managers seem to be limited. Under such circumstances, you can and should ask whether it makes sense to pay active money managers to lose money for you.

THE MECHANICS OF INDEXING

How do you go about creating an index fund, and once created, how do you maintain it? Note than for an index fund to mimic an index, ...

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