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Index Funds: why they work
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Written by Wei-Jing Zhu
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Thursday, 14 December 2006
The SF magazine article on "Investment Tips given to Googlers" basically re-emphasized the amazing result of index funds over actively managed funds. Here is my interpretation of the effect.
Index funds essentially follow the market, on say a monthly basis, readjusting their portfolio at the end of every month, and buying stocks that has gone up, selling stocks that has gone down, proportionate to the market cap of the company (which makes up the index.)
In this way, Index Fund Strategy can be considered "Trend-following", but on a monthly scale, rather than the daily scale that the term commonly connotates.
Alternatively, since investors change the stock prices by their monetary votes, the Index Fund Strategy can also be considered as basically the "Web 2.0" strategy, of using what everyone thinks should go up or down.
Mathematically, I have mentioned that this strategy is also the MaxEnt solution, that when you have no special knowledge about which stock will rise, this is the most uniform way to spread your bets and maximize your profit based on no extra knowledge.
How can you beat this strategy then?
- Forerunning the Index Fund themselves. This is what some hedge funds do.
- Have advance knowledge and use that edge.
Otherwise, for common investors, stick with index funds.
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