Index Investing 'Wins' the Nobel Prize

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.

Even a 20% weighting for a sector, as financials had during the middle of the last decade, is at the very least a flashing yellow light.

Another warning sign would be an inverted yield curve where short-term rates are higher than long-term rates.

Banks borrow at short-term rates and lend at long-term rates, but if the yield curve is inverted then that lending model is unprofitable and banks stop lending, which is recessionary.

An important point, however, is that individual investors should not be focused on beating the market. What really matters to individuals is whether they have enough money when they need it, typically when they retire.

A person's savings rate likely will be a larger determinant of whether he or she has enough for retirement. An investor who beats the market every year but only puts away $1,000 each year is far less likely to have enough money for retirement than the investor who lags the market but saves $25,000 each year.

There's another thing that savvy investors do. They avoid succumbing to behavioral biases at the wrong time.

Investor prone to panic selling probably should not build portfolios with index funds, because these investors are likely to sell when markets are slumping, taking sharp losses.

Famed investor James Montier from GMO has talked about the danger of permanently impairing capital. Investors who sell at the lows and never come back have permanently impaired their capital and damaged, if not ruined, their financial plan.

This subject is too broad for just one brief article, but the bottom line is this: Investors need to choose strategies that gives them a reasonable chance of accumulating enough money for their goals while avoiding doing the wrong things at the wrong times (i.e., panic selling)

Indexing will be the right answer for some investors, but no single strategy can be the best for everybody.

At the time of publication, Nusbaum had no positions in securities mentioned.

This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.

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