The indexing approach to investing accounts for over half of US equity investments in 2025. Compare that to the 1970s, when it was almost non-existent.
Among many investors and their advisors, indexing has become conventional wisdom. There are good reasons for indexing’s growth.
The case for indexing is strong, and we will review that case.
But there’s also a significant case against indexing, and we will review that case also.
The Origin of Index Investing – The Desire to Avoid Failure
The indexed approach to investing seems to have its origins at least partly in the desire to avoid failure. This motive explicitly was the title of an influential book, Winning the Loser’s Game, published in 1985.[1]
But the name of Vanguard’s founder, John Bogle, is most closely associated with the rise of index investing. Bogle was born in 1929, and by 1955 had graduated from Princeton and was working at the investment management firm Wellington Management.
Bogle, a tough, intelligent, and hard charger, rose rapidly at Wellington. His career there, however, came to a screeching halt after a merger that he championed. Wellington’s flagship fund was (and still is) an actively managed “balanced” fund. The word “balanced” in this case means that the fund owns both equities and fixed income (i.e. stocks and bonds).
Bogle drove the merger of Wellington Management with the Boston investment firm Thorndike, Doran, Paine & Lewis. At the time of the merger, 1966, Wellington was many times larger than Thorndike.
Many people have had the experience of making an investment decision that seemed like a good decision at the time, and watching that decision turn out to have a poor outcome. And if it turns out we missed something obvious, we might reflect in wonder at how we made such a mistake.
Yet the terms of the Wellington “merger” with Thorndike seem to have been disadvantageous from the outset. The New York Times reported in 1971 that the deal was seen as “a case of the minnow swallowing the whale.”[2]
The deal worked out very poorly for Wellington. So poorly such that by 1974, Wellington’s board fired Bogle.
In Bogle’s words, “If I hadn’t been fired in January 1974, I would not have had the opportunity to start Vanguard in September 1974.”[3]
Bogle was scarred, as most people would be, by the experience of great success followed by great failure.
Index Funds
An index fund, as you may know, is a fund that is designed to be a “passive” investor in an index.
Vanguard is best known for its leadership in index funds. But Vanguard has always offered actively managed funds.
However, Bogle became an increasingly outspoken advocate for index funds.
What is an Investment Index?
An investment index is a single number that attempts to measure the market value, or change in market value, of a specified set of securities. An example is the S&P 500 index (which doesn’t necessarily even contain exactly 500 stocks).
Today, it is common to discuss “the index” and identify that index with “the market.” For example, in the US, when people say “the stock market” they frequently mean the S&P 500, or less frequently, the Dow Jones Industrial Average.
In practice, this speech shorthand is usually reasonably accurate. Over long periods, the performance of the S&P 500 has closely matched that of the Dow Jones Industrial Average.
However, the identification of “the market” with “the index” is not necessarily free from potential problems, largely because there is no provably correct definition of “the market.”
A Brief History of Indexes
The idea of representing a complex set of facts – such as the results of investing in hundreds or thousands of companies – by a single number has its origins in the economics of index numbers.
It is difficult to pinpoint the first index. Chance[4] traces the origin all the way back to 1675. The relatively famous (among economists) Francis Y. Edgeworth wrote in 1925, “It would be too much to ask economists… to think it possible that they might be mistaken. Each maker of index-numbers is free to retain his conviction that his own plan is the very best. I only ask him to think it possible that others may not be entirely mistaken.”[5] (Emphasis added.)
I have a slightly different view than Edgeworth. It’s not so much that this or that index is “mistaken,” but rather that an index is inherently a biased representation of what William James described as “blooming, buzzing confusion,” which is real markets (or the life of an infant in James’ reference).
An index is an attempt to capture that blooming, buzzing confusion and represent it in a single number.
But despite the obvious theoretical deficiencies of indexes, the economics profession embraced the idea. Irving Fisher, probably the most influential American economist of the first half of the 20th century, published an entire book on indexes in 1922. The book was titled The Making of Index Numbers.
Indexes Are at Best Approximations
An index can only approximate what it intends to measure. For example, the Consumer Price Index is an attempt to represent “the price level” in a single number. I have written extensively about the impossibility of there being a single, objectively correct price level in my book Politicians Spend, We Pay. One ineradicable issue is that the set of goods and services that you consume is personal to you, and even your next-door neighbor has a different set. Furthermore, even your personal set is likely to change from year to year.
A similar inherent problem afflicts the idea of representing “the market,” any market, by an index. Which exact investment possibilities are available to you? Which are applicable to you? Is that set the same from everyone? Almost certainly not.
Despite these issues, there is a good case to be made for indexes and index investing.
Next steps
Now that you have a background on WHAT index investing is, the next post will look at the case FOR index investing.
Did you enjoy this blog post? If so, reply to this email and let us know.
If you are an established advisor who serves the high-net-worth market, and you’re seeking to grow AUM and value of your practice, you owe it to yourself to give us a call. Call us at 703-437-9720—or email us back to set up a time to talk. Or, click here to request an advisor guide.
[1] Charles D. Ellis, McGraw Hill, 1985. Ellis was an “investment counselor” who started Greenwich Associates in 1972. The thesis of the book was that you “win” by not trying to “beat the market.” In other words, just invest in the index.
[2] https://www.nytimes.com/1971/04/25/archives/wellingtons-new-look-boston-link-contributes-capital-and-expertise.html
[3] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1690710
[4] W. A. Chance, A Note on the Origin of Index Numbers, The Review of Economics and Statistics, Vol. 48, No. 1 (Feb., 1966), pp. 108-110
[5] Edgeworth, Francis. 1925. “The Plurality of Index-Numbers.” The Economic Journal 35, no. 139: 379–88
Leave a Reply