"Index Investing and Investing for Income"

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You may be aware of the controversy that's been going on in the investment world regarding investing in stock indexes and index investments.

Indexing is the Logical Way to Invest if You Value Price Increases Instead of Income

Years ago, Burton Malkiel wrote a milestone book called A Random Walk Down Wall Street. This basically claimed that stock prices for individual companies and the market as a whole were random, and therefore unpredictable.

You might as well choose your investments by throwing darts at a list of companies as send away for annual reports, study earnings and sales, and so on.

Indeed, the Wall Street Journal has sometimes done exactly that -- chosen a portfolio at the beginning of the year by throwing darts at a list of stocks. They then track portfolio recommendations by professional investing experts.

At the end of that year, they compare performances.

Quite often, the dart wins

And by now, many people know that in the long run, few actively managed mutual funds beat the Standard & Poor's 500 index.

According to Malkiel, the few mutual fund or pension portfolio managers who can beat the market over the long run are simply extremely lucky.

Yes, the big names from Peter Lynch to Warren Buffett to John Templeton are . . . simply the lucky few.

You Can't Beat the Market Long Term

His advice to us individual investors -- put our money into an index fund of the S&P 500 or similar broad stock market index such as the Wilshire 5000. Our returns will therefore match the overall rise of the market. The market will rise over the long run because capitalism creates overall wealth, whether individual companies fail or succeed.

Dr. Jeremy J. Siegel's first book, Stocks for the Long Run, published in the early 1990s, is often cited to support this advice

He published a now-famous chart comparing the returns of various investments from 1804 to 1990. The dollar falls (our modern dollar is worth about 7 cents in 1804 money). Gold was steady but has been falling since 1980. Various bonds and notes increase in value over the years.

But the obvious big winner is the stock market.

So his advice was to buy a broad amount of stocks and hold on to them.

But in his latest book The Future for Investors Dr. Siegel is not so favorable on indexing investments

Indexing Has Its Flaws

He did a study comparing investor results in an S & P 500 index fund to those investors who continued to hold the ORIGINAL S and P 500 companies.

See, the S&P 500 changes over time. Companies are taken off, new companies are put on.

He found that the Growth Trap operated in the S&P 500 index -- the new companies underperformed the old companies.

This phenomenon is increased by the way Standard & Poors makes changes to their index fund. They announce additions in advance, so that traders buy up the shares of companies that are going to be added, because they know that soon index funds are going to HAVE to buy -- at any price.

Dr. Siegel describes how he was quite distressed to see this happen when Yahoo! was added to the S and P 500. He considered it already overvalued -- and after Standard and Poors announced it was going to be added to the list of 500, it became even more overvalued.

So Dr. Siegel discovered that the original S & P 500 beat the changed S and P 500 because the companies taken out of the S and P 500 list had lower investor expectations. And therefore, were relatively cheaper.

In his book What Works on Wall Street, James P. O'Shaughnessy discovered a number of strategies that beat the S and P 500

His analysis is that the S&P 500 does do well because it's obviously made up of successful, large companies. So it should do well.

But that doesn't mean you can't target your investments to do even better than the overall market, however.

His studies found techniques which allowed different classes of stocks to beat the market over the long run

And usually the opposite of those techniques picked stocks which dramatically UNDERperformed the market in the long run.

For example, choosing companies with low P/E ratios beats the market. Buying companies with high P/E ratios ensures that you'll do worse than the overall market.

Good examples of this occurred after the publication of his book -- the dot com boom, when many otherwise sane people bought dot com stocks with P/E ratios in the hundreds.

My conclusion for income investors

If you put your money into an index fund, that's far better than putting it into almost all equity mutual funds.

But for income you're stuck with the low overall yield of the S and P 500, and with many companies that pay no dividends whatsoever.

Instead, look for low P/E, high dividend yield companies.

Especially boring utility and consumer staple companies.

One real value in duplicating a market index is to escape from the greatest risk to investors

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