Problem
In the previous chapter, you learned how mutual funds allow professionals to manage money on behalf of investors. While this solves many problems, it introduces a new question.
If professionals are managing money, why do many funds still struggle to consistently beat the market?
Over time, studies across many countries have shown a surprising result. A large number of actively managed funds fail to outperform the overall market after costs are considered.
This observation led to a simple idea: What if, instead of trying to beat the market, an investor simply followed the market?
Index funds and exchange-traded funds (ETFs) were created around this idea. They aim to deliver market returns at very low cost, without frequent decision-making.
This chapter explains how index funds and ETFs work, why they are called passive investments, and why cost plays such an important role in long-term results.
Question
If beating the market is difficult, is it better to just match it?
Can low-cost, simple strategies outperform complex ones over long periods?
To answer this, we need to understand what index funds and ETFs are designed to do.
Concept
What Is an Index?
An index is a collection of investments that represents a market or a part of a market.
For example:
- An index may track the largest companies in a country
- Another index may track a specific sector or group
An index does not try to choose winners. It simply represents the market as it exists.
What Is an Index Fund?
An index fund is a type of mutual fund that aims to replicate an index.
Instead of selecting investments actively, it:
- Buys the same assets as the index
- Maintains similar proportions
- Makes minimal changes
The goal is not to outperform, but to match the index's performance.
Because decisions are limited, costs are usually low.
What Is an ETF?
An ETF works similarly to an index fund but trades on exchanges like a stock.
Key features:
- Tracks an index
- Low operating costs
- Can be bought or sold during market hours
From a purpose perspective, index funds and ETFs are very similar. The main difference is how they are bought and sold.
Why Passive Investing Works
Passive investing works because:
- Markets grow over long periods
- Costs compound just like returns
- Avoiding mistakes matters more than chasing extra returns
By minimizing activity and costs, passive funds allow investors to keep more of what markets deliver.
Walkthrough
Imagine two investors: Person A and Person B.
Person A: Active Strategy
Person A invests in actively managed funds.
Each fund:
- Charges higher fees
- Tries to outperform the market
- Makes frequent changes
Some years are good. Some are disappointing.
Person B: Passive Strategy
Person B invests in an index fund.
The fund:
- Tracks the market
- Charges low fees
- Changes only when the index changes
Over many years, Person B's returns are close to market returns.
The key difference is cost.
Even a small difference in annual cost compounds into a large gap over decades.
Lower costs mean more money stays invested and compounds for the investor.
Impact
Index funds and ETFs change how people think about investing:
Simplicity over complexity Fewer decisions reduce errors.
Lower costs improve outcomes Small fee differences matter over long periods.
Market returns become acceptable Matching the market is often enough.
Discipline becomes easier Passive strategies reduce emotional reactions.
These strategies are especially suitable for long-term goals and beginners who want clarity and consistency.
Let's Do It
Do this simple exercise:
- Accept that you do not need to beat the market
- Understand that consistency matters more than cleverness
- Focus on long-term participation, not short-term performance
At this stage, your job is not to choose specific funds. Your job is to understand why low-cost, passive strategies work.
Takeaways
- Index funds track a market index
- ETFs work similarly but trade like stocks
- Passive investing aims to match market returns
- Lower costs compound into better results
- Simplicity reduces mistakes and stress
What's Next
Now that you understand low-cost passive investing, the next step is learning about direct ownership.
In the next chapter, we will explore stocks for long-term investors—how owning shares in companies works, what risks are involved, and how to think about stocks as a beginner.