Let me first say I’m a big fan of index funds. I think every investor should have index funds as a part if not the entirety of their portfolio. However as I read some the comments I read in regards MyMoneyBlog’s contemplation of having a speculative portion of his portfolio, I can’t but think that some index fundies go too far. I agree with them on the most part, but I also believe it’s also possible to extend the argument too far. The inherent greatness of index funds is really a question of cost and easy diversification rather than any performance metric. A index fund by it’s nature has average performance. It will never beat the market nor will it under perform the market.

One of the core principlals of Vanguard Fundies, is that the market is efficient or at least that there is no way for an individual investor to recognize inefficiencies if they exist. There is a whole set of arguments to why the market may or may not be efficient. I’m agnostic on this. I don’t know if the market is efficient or not. Is it rational? The 2000-2002 Nasdaq Bubble would indicate otherwise. A market can be both efficient and irrational. Efficiency simply implies that market responds “instantly” to new information. How the market reacts is another matter - it can be rational or irrational. However, the crux of my argument against a slavish devotion to index funds is more fundamental and does not require a conviction that the market is inefficient or irational.

In some ways taking the plunge into individual stock investing is like Pascal’s Wager. Even if the market is perfectly efficient, and there is no way to pick a bad stock from a good stock, an investor who is properly diversified does not take a performance hit by investing in individual stocks versus investing in an index fund. He or she is just as likely to do better or worse than the market just as the index fund is apt to perform better or worse than an individually selected basket of stocks. For someone who fundamentally believes the efficacy of index funds to argue otherwise would be self-defeating. If individually picked stocks somehow always perform worse than the market then implicitly there’s some method to picking stocks. You can’t pick bad stocks without picking good ones. An individually chosen basket of stocks should merely perform differently from the index, but still have an expected return equivalent to the index.

So even if we believe that there’s no way to beat the index, and that any basket of stocks individually chosen stocks should perform as well as the index, why wouldn’t you invest in individual stocks? It’s like betting on God, if he doesn’t exist nothing has changed, and if he does Heaven awaits the true believer. The risk with an individually selected basket of stocks is a question of diversification. An improperly diversified portfolio will be more risky than the index. It will have wilder swings.

All said, I still believe index funds are the way to go for most individuals. They are cheapest and quickest way to diversify. Most people don’t have the time to do research and buy individual stocks. Transaction costs can quickly add up. Index funds are by far the easiest and safest way to get into the market, and ultimately that’s what’s important - investing in the growing economy. I only make the argument against because I find some people who only push index funds a little too dogmatic in their approach.

It’s hard to argue with Vanguard Fundie because I agree with them and they are right on the most part. It’s just at times I think the Vanguard Fundies take too much of a hard line sometimes.