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The Basis for Why Index Investing Works (VIDEO)

Here is a market prediction for 2015: investing will be a zero-sum game. Okay, that isn’t much of a prediction because the concept of markets as zero-sum is not new and it applies at all times. Still, understanding this concept can help you make better investment decisions in the new year and beyond.

Essentially, investing is a zero-sum game in that a particular market is made up of the holdings of all investors in that market. Therefore, if one investor outperforms, then another investor must underperform. You can think of it like a poker tournament – for a player to win a hand, other players must lose the hand.

As a whole, the dollar-weighted return of all investors, both winners and losers, in a particular market is equal to the overall return of the market.

What does that mean to you? Investors have to pay costs, which reduce returns and effectively put the collective return of all investors below that of the overall market. In other words, the more you pay in investment costs, the more likely you will underperform the market. On the other hand, by reducing costs you increase your chances of outperforming investors paying higher costs.

This is an essential argument for index investing. Index funds, on average, are lower in cost than active funds. Additionally, since index funds by design seek to replicate a particular market’s performance, you are not placing bets against other investors that you will beat the market.

You have the ability to control costs and choose not to gamble your money against other investors. Sure, it’s not a new or sexy investment strategy. But when it comes to investing, the best way to start off a new year is rely on timeless fundamentals.

For additional information on how the zero-sum game concept works, watch this segment from our webinar “Why Index Investing Makes Sense in All Market Conditions.” Tony Watson, Chief Investment Officer at Portfolio Solutions®, presents a detailed illustration on this important concept and how it affects investors.