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Index Investing 'Wins' the Nobel Prize

Stocks in this article: SPY SCHB TDC

NEW YORK ( TheStreet) -- Yesterday we got the news that the 2013 Nobel Prize in Economics was awarded to Robert Shiller, Lars Peter Hansen and Eugene Fama.

Fama has long been a well-regarded proponent of the efficient-market hypothesis and investing in index funds.

The short version of this idea is that because asset markets are efficient, it is impossible for individuals to beat them. If it is impossible to beat the equity market's efficiency, then picking individual stocks is futile, so investors should simply use broad-based index funds to construct their portfolios.

People who argue against this thesis typically cite the many professional investors who have indeed beaten the market routinely -- folks like George Soros, George Soros, Stanley Druckenmiller and David Tepper. (Tepper was the guest host on CNBC's "Squawk Box" program Tuesday morning.)

Nevertheless, many individual investors choose to build their portfolios with index funds. These investors will get the returns of the markets the funds track, minus expenses charged by the funds.

But because these funds are not actively managed, they typically have the cheapest expense ratios.

One popular index fund, the SPDR S&P 500 (SPY) has an expense ratio of only 0.09% while the Schwab U.S. Broad Market ETF (SCHB) charges only 0.04% and is commission-free for Schwab (SCHW) customers.

A portfolio that holds only index funds won't have significant exposure to single-stock selloffs, such as the one suffered Tuesday by Teradata (TDC). Shares are down 14% because the company lowered its earnings outlook.

Index investing is a valid strategy, but it has its drawbacks, and markets are not always efficient. There were plenty of signs/warnings of excessive valuations leading up to the tech wreck in 2000 and the financial crisis in 2007, but markets kept going up until they imploded. Of course, index funds felt the full brunt of those implosions, because they are the market.

One thing savvy investors should watch is the sector weightings of the S&P 500. When a sector grows to be 30% of the S&P 500, as technology did in 2000, or as energy did in the early 1980s, then it's usually a warning sign.

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