A Bet On Humanity: Why Index Investing Works (Simply Explained)

Updated: August 13, 2026

No matter if you’ve only just started investing or have been in this game for a long time, we’re all investing in the hopes of growing our wealth – to get more money back than what we put in. However, if you’re like me, there will be times when you ask yourself “How does this all work?” and “Why do share prices go up and down?” and, especially in our FIRE community, “Why do prominent people in the community advocate Index investing? Why does the stock market go up over time?”

These are great questions. They are also questions I asked myself when I was starting to get my feet wet.

When I first started investing, it all just seemed random and super risky. This lack of understanding caused me to be uncertain, fearful, and it ultimately delayed my start on building my wealth.

Over the years, this is the explanation which made index investing click for me. I hope it can also give you the confidence to continue on this path.

This will also help me solidify my own understanding – the best way to learn something is to explain it, right?

TL;DR: The short answer is that a broad global index fund lets us own a tiny piece of thousands of real businesses without having to guess which ones will become the huge winners. Many of those businesses will muddle along and some will fail completely. But a small number may grow far more than anybody expected – and if we own the broad market, we have a much better chance of owning those companies too.

For the longer answer we’ll take it from first principles. I’ll start from the very basic concepts and then reason it up logically and walk you through to the more complex topics. In the end, you should have much better clarity on how and why Index investing works.

Ready? Here we go!

Buying shares of a company allows us to own a piece of a living, breathing business

Sometimes people forget this. A share of a company isn’t just a piece of paper. It represents your ownership of a company and all the value that comes with it.

Companies own assets, employ people, and produce products and services to sell to customers. Businesses generate real, tangible value in the marketplace – whether it be local or international.

With a share of a company, you are a part-owner of all this. Those shares give us a claim on the assets the company owns and the income it may generate in the future.

This is what gives shares their value. Yes, some companies pay dividends to their shareholders, which is valuable, but that’s not the only reason why they are valuable.

As a business grows and earns more, its shares should generally become more valuable over time – although what we paid for them still matters.

Companies compete with other companies in the market and better companies become more valuable

Companies don’t operate in a vacuum. They compete against other companies that are also out there trying to make money producing similar products and services.

So whichever company we choose to invest in must fight for survival against companies that other people invested in.

Customers of these companies vote with their wallet to determine which product or services best fits their needs.

Companies that are able to understand customer needs and cater to them while managing their costs well will create better products and services and prosper. They will capture a larger share of the market, make more revenue, have more opportunities. Companies that cannot will lose out and slowly stagnate and die.

This brings us to the next point.

In order to compete well, companies must invest in great people

Companies can’t produce great products and services without employing the best and brightest people to work for them.

People create new ideas, new products, come up with new ways to do things more efficiently. In order for businesses to survive, they must continue to invest in human capital. That’s why the biggest companies today boast about hiring only the best of the best.

In turn, as shareholders of these companies, you have these amazing people working for you – all working hard to ensure that their company is the best at what it does. Most of these people are way smarter and work way harder than I do – as they are working hard (in aggregate) to make the company – and thus us shareholders – richer.

I mean, who wouldn’t want people like great CEOs working to make us richer?

Great companies prosper and bad companies die out

However, given the fierce competition, some companies will win and some companies will lose.

If a company cannot compete in the market, either their competitors produce better products or customers no longer want what they produce. They will slowly die and fade away. Their value can go to zero – despite having smart people working for them.

On the other hand, companies that are able to understand the market and able to provide products and services that meet their customers’ needs will likely prosper and do well – giving them a leg up in continuing to invest in future products and services. This should increase the value of the business and the value of their shares.

This should mean that we should be golden if we just pick the best companies and ride off into the sunset as they generate more and more value, growing more and more quickly and make their investors filthy rich right?

Well, not so much.

Great companies aren’t guaranteed to remain great forever

History is filled with stories of once-great companies that fell from their dominant position and even some that went bankrupt – losing all of their value and shut down. Why?

There are several ways that great companies can fail. Here are some examples:

1. Competition: Other companies who produce your product or service better, cheaper or more efficiently than you do. Think BlackBerry, Nokia and Microsoft. These guys were dominant in the smartphone market before Apple and Google came along with iOS and Android. They simply could not imagine better phones than their own products until another company stuck one in their face. Even then they were slow to realise that their days were numbered.
2. Market Shifts: Changes in the costs of components, raw materials or supporting commodities that affect the overall costs of ownership or cost of operating of a company’s products and services could shift the entire market in favour of your competitor’s products. Think American car manufacturers like Ford and GM. When the oil prices rose, American consumers shifted to buying more fuel-efficient and cheaper cars from Japan and thus significantly reduced the American car manufacturer’s market dominance.
3. Disruptive Innovation: New products and services appear that make their current offerings irrelevant. Think Kodak and Fujifilm – two companies built around photographic film which faced the same threat from digital photography. Kodak eventually filed for bankruptcy protection, while Fujifilm pushed aggressively into areas such as healthcare and electronics. The same disruption did not produce the same outcome because one company adapted more successfully than the other.
   

Given all the above possibilities, you can see why there is no guarantee that today’s great companies will remain great tomorrow. There are so many pitfalls and competitive pressure that, often, people running great companies get blindsided by changes in the marketplace that could end their dominant status.

It’s going to be very difficult to predict which companies will do well and which will do badly in the future and shift your investment strategy in time to take advantage of it. Most experts in the field would not have predicted the downfall of all the companies mentioned above at the time.

Well, if we can’t predict the ones that will do well, all we have to do is avoid the obvious duds right? If we just buy companies that are not bad, then we should be golden? There’s a problem with that too.

Bad companies don’t always remain bad and could become a massive turnaround story

Given all the things that could happen to kill off a company, at any given time, companies going through a bad phase could look like a horrible investment. However, this does not mean that the company would not be able to take drastic measures that end up turning it around.

Take a company like Apple. Before the iPod, iPhone and iPad the company was struggling. Most pundits at the time Steve Jobs made his return to the company was predicting that the company would never create great products again and go bankrupt within a year or two. However, they were all wrong and today Apple is one of the most valuable companies in the world. If you had believed the pundits, you’d have missed out on the astronomical growth that the company has made in the last 2 decades.

Similarly, Amazon is a trillion-dollar company today, but experts predicted that the company will never make a profit and will go the way of Pets.com when the dot-com bubble burst in 2001.

However, predicting which horrible company will be the next unicorn is fraught with danger.

It’s not possible to predict which company will make the kinds of astronomical returns

We also have to remember that for every Apple, Amazon, Google and Facebook there are hundreds and thousands of MySpace, Excite.com, Webvan, Pets.com, Theranos, the list goes on.

Which struggling company today will become the next Apple? Which exciting new business will become the next Amazon – and which will disappear like Pets.com or Webvan? Which dominant company will adapt to the next technological shift, and which will become the next BlackBerry?

We can come up with convincing stories for all of them.

Anybody who claims to know exactly which companies will dominate the next few decades is either delusional or lying through their teeth. At best, it is an educated guess. At worst, it is a gamble.

Remember, it’s a competitive market. If a company slips up, the competition is there to exploit it. This brings us to the next point.

Even if we somehow identify a great company, there is another problem: everybody else may already know it is great.

If the share price already assumes years of spectacular growth, the company may have to perform even better than those expectations for us to earn an exceptional return. A great company can still be a horrible investment if we pay far too much for it.

So we don’t just have to identify the right company. We also have to work out what its future is worth today.

Easy, right?

Why picking the winners is harder than it looks

It’s not possible to know, long term, which companies will be successful and which will fail. Regulations change, companies must adapt, competitors enter the market, new technologies could threaten to make the company obsolete. Companies either adapt, improve or die.

Given all the above, in order to be successful in investing in individual companies we would need to do a lot of things right:

1. Buy a good company at the right time, at the time when it’s struggling but is about to take off.
2. Sell the company at the right time, when the company is doing well but is about to screw up.

You’d have to be right both times and be pretty lucky to be able to make the timing just right. Often, when the price drops you’ll never know if it will ever come back up again. Or if the company is doing well, that something won’t cause the price to drop before you have the chance to sell it.

If you made a mistake, that could wipe out all of your returns or worse. So what can we do?

Just buy them all – own all the companies!

Wait what?

OK listen. Remember that roulette table?

What if I told you that there’s a roulette table that has a 1 in 37 odds of winning if you bet on a single number but would pay out 5% of your bets each time that you bet on the entire table? You’d choose the sure 5% return right?

Well the stock market is sort of like this weird roulette table. Let me explain.

The market is self-cleansing

Bad companies can only lose a maximum of 100% of their value – they go to 0 and go bankrupt and get removed from the market.

Of course, the index does not magically refund our money when a company fails. We still suffer the loss as its value falls. The difference is that it is one company within a portfolio of thousands, rather than one giant bet which can wipe us out.

At the same time, when companies do well, there is no limit in how much upside there is. They could grow 100%, 500%, 1,000% or, like Apple, Amazon and Google, more than 10,000%. The winners become larger parts of a market-weighted index as they grow.

New eligible companies can enter, fading companies shrink and eventually some disappear – without us having to predict each change ourselves.

As bad companies go bankrupt and get removed from the market, new companies enter and great companies grow to multiple times their value. This creates an upward bias to the market over the long term.

This matters because stock-market wealth creation is incredibly concentrated. A study covering more than 64,000 global stocks found that the top-performing 2.4% accounted for all net global stock-market wealth creation between 1990 and 2020.

The problem, of course, is knowing which 2.4% they will be before they become the winners. By owning the broad market, we don’t have to make that prediction ourselves.

“But hang on!” you might say, “If I own all the companies and they are all competing in the market, isn’t that a zero-sum game? Won’t that mean there will be a net 0 in gain overall?”

Great question! There’s a reason why our global markets are NOT a zero-sum game: “Productivity Growth.”

The driver of wealth creation: “Productivity Growth”

Imagine if we own 2 companies. First, a company that produces screws and sells the screws to the second company. The second company uses the screws to build machines that can produce screws and sells that machine to the first company. In this scenario, it seems like overall, our wealth won’t increase as the net gain is 0.

Now imagine that the company that produces the machine to manufacture screws invented a new way to build the machine that requires less time to build and less labour. The machine can now be produced at half the cost. The company can either earn more from every machine it sells, lower its prices to win more customers, or do a bit of both.

What if the machine is also more efficient in producing screws so the screw manufacturing company can produce screws twice as fast with the same effort or materials?

Now you can see that our total value produced by the 2 companies has increased without any change in the number of participants. This is Productivity Growth.

This is how innovation and technological progress inject value into the system.

Hundreds of years ago, most humans around the world must spend their time growing and producing food in order to have enough food to eat. However, as we made innovation around agriculture, we got more productive.

Today only a small fraction of the world’s population needs to work in order to produce enough food to feed the entire world. Machinery and automation allow humans to get more done for less labour.

This makes food cheaper, more accessible and frees up time for the population to work on and create other products and services.

The total value of the system increases in this manner in all industries over time. As time progresses, we as a species and as a market become more efficient – creating more value with the same effort – which leads to the total value of the whole system to increase.

Additional material on this concept: NPR has an amazing Planet Money Podcast episode precisely on this topic (Productivity & Getting Lit), I highly recommend giving it a listen to better get an intuitive grasp of productivity growth.

Companies that create the innovations can capture much of the gain

This brings us back to which companies succeed. Companies that find newer, faster or more effective ways to provide products and services can capture much of the value created by those innovations. That success may snowball until they become dominant in their markets – at least until the next innovation comes along.

Again, it’s not possible to know which company will create the innovation and that the innovation will actually make a difference. The only way to optimally capture all of the countless attempts of innovation and creation of Productivity Growth in the market, is to own as many and all of the companies available.

What if we buy just the S&P 500 or only American companies? Surely that’s enough?

Sure, that’s definitely not a horrible choice. America, after World War II, has gone through a phase of unrivalled growth and has become the biggest economy in the world. Their companies have built up a mountain of innovation, patents, brands and trademarks that give them an edge over their competition – an edge that is likely to continue far into the future.

Given that a large number of these companies are also multinational – have business operations in other countries – is there still a need to buy shares of non-American companies?

Well, I think so. Yes, America may be the dominant economy and American companies may be the dominant players now, but they are not guaranteed to remain dominant forever. Who’s to say that America will not run into the same economic stagnation similar to Japan? Who’s to say that China won’t overtake America in innovation and technology?

Remember, it’s not possible to predict the future nor where the next massive growth opportunity will arise, so our investment strategy should take this into account. Since I have no idea where the next massive growth opportunity will arise, I would rather spread my investments across markets than make another prediction about which country will win.

This is why my portfolio does not only hold American companies but also companies from the developed and emerging markets.

And then there are costs

There is also one much more boring reason why broad index funds work so well: they tend to be cheap.

A 1% annual fee may not sound like much, but paying it every year for decades makes a huge difference.

Imagine two people each invest $100,000 for 30 years (the currency does not matter here). One earns 7% a year after costs and ends with about $761,000. The other loses an additional percentage point to fees each year, earns 6%, and ends with about $574,000.

That one percentage point costs nearly $187,000.

There is a simple reason for this. As William Sharpe explained decades ago, before costs, the average actively managed dollar in a defined market must earn the same return as the average passively managed dollar. After costs, the group paying more must earn less on average.

Since I already cannot predict what return the market will give me, I would rather not make things harder by paying away a larger part of that return in fees.

The word “index” by itself does not make a fund sensible. Some index funds track one narrow theme or market and can still be surprisingly expensive. I am talking here about broad, diversified and low-cost index funds.

Still, despite diversification and holding as many companies as we can to capture the value-creation and the means of production, it does not mean that our investments will always go up.

There will still be bubbles, crashes and recessions!

Owning thousands of companies does not mean we cannot lose money. We absolutely can.

There will still be bubbles, crashes and recessions. Wars, pandemics and political shocks can send prices down as well. Sometimes the businesses are still doing fine, but investors suddenly expect lower profits or are no longer willing to pay the same price for them.

When times are good, it becomes very easy to believe that prices can only go higher. We see everybody else making money, become afraid of missing out and convince ourselves that paying a little more is perfectly reasonable because somebody else will surely pay even more later.

Then the story changes. Maybe earnings disappoint, interest rates rise or one frightening event makes everybody less confident about the future. Investors who were previously afraid of missing the gains suddenly become afraid of being the last person left holding the shares. Selling creates more fear, which creates more selling.

Share prices are estimates of an uncertain future, and new information can genuinely change what a business is worth. The journey between optimism and fear can be extremely violent.

The falls can be massive. From October 2007 to March 2009, the MSCI All Country World Index fell 58.38% from peak to trough.

Imagine watching more than half of your portfolio disappear while every headline says things could get even worse. It is extremely difficult to stay calm when that happens.

So what are we supposed to do when it happens?

First, we have to understand that crashes are normal. They are not some strange failure of the stock market. Stock-market returns can remain disappointing, or below a previous peak, for years. That has always been part of owning stocks.

This is also why time matters so much. Looking at almost a century of US-market history, the frequency of positive returns increased as the holding period stretched from one year to five years and then ten years.

The longer we stay invested, the more time we give the businesses we own to grow through the temporary crises. If we are also investing regularly, our money goes into the market at many different prices. Sometimes we will buy near a peak. Sometimes we will buy after a crash. Over the years, all those purchases average together.

Ironically, falling prices can be useful while we are still accumulating. The same monthly investment buys us more shares than it did before the fall. But we only benefit from that if we actually keep investing when the headlines are terrifying.

This is the part which I think many people underestimate. It is easy to say we are long-term investors while markets are rising. The real test comes when our portfolio has fallen by 30% or 40% and every sensible-sounding reason tells us to wait until things feel safer.

The problem is that “safer” often arrives only after prices have already recovered. If we panic and sell during the crash, we then have to make another impossible decision about when to get back in.

Meet Bob, the world’s worst market timer

One of my favourite examples of this comes from Ben Carlson’s story of Bob, the world’s worst market timer.

Bob is a fictional investor who somehow managed to invest his savings at four of the worst possible moments in US-market history.

He invested at the end of 1972, immediately before the market fell by almost 50%. He waited until August 1987 to invest again, just before another fall of more than 30%. His next investment came at the end of 1999, right before the dot-com crash. His final purchase was in October 2007, just before the Global Financial Crisis.

Honestly, it is difficult to imagine worse timing without access to a time machine.

But Bob did one extremely important thing right: he never sold.

Across those four spectacularly ill-timed purchases, Bob invested a total of US$184,000. He held through every crash and gave his investments decades to recover and compound. Despite investing only at market peaks, Bob still retired at the end of 2013 with about US$1.1 million.

And here is the really interesting part. If Bob had simply invested his savings regularly instead of letting the cash pile up while waiting for each market peak, he would have ended up with more than US$2.3 million.

Bob’s story does not tell us to wait around and invest only before crashes (please don’t!). It shows us that consistently saving, staying invested and giving compounding enough time can matter far more than finding the perfect moment to buy.

Ben later turned the story into a short animated video on YouTube, which is well worth watching if you prefer the visual version.

Morgan Housel explains this beautifully in Fees vs. Fines, an idea he also explores in The Psychology of Money. We tend to treat volatility as a fine – evidence that we did something wrong. It is better to think of it as a fee: the price of admission for the stock market’s long-term returns.

The market does not collect this fee neatly in dollars and cents. We pay it through uncertainty, frightening headlines and occasionally watching years of gains disappear from the screen.

This is the deal. We do not get the long-term returns without living through the crashes along the way.

If we already know that we will panic and sell the next time markets collapse, it may honestly be better not to start investing in stocks at all. We have to believe in the reason we invested before the crash arrives, and be prepared to keep going when it does.

I’ve invested through the 2018 decline, the COVID crash, the 2022 bear market and several other panics which felt horrible at the time. None of them felt like an obvious buying opportunity while they were happening. During COVID, I wrote about how I was continuing to invest despite having no clue what would happen next.

Staying invested and continuing to buy worked out for me through those periods. More importantly, they taught me that I do not need to know when the next recovery will arrive. I just need to keep investing, rain or shine, and give the investment thesis enough time to work.

Crashes are not evidence that index investing has stopped working. They are part of the price we have to be prepared to pay.

So how optimistic are you about humanity and innovation?

So should we invest in index funds? Well, after reading my explanations above, I hope that it’s clearer why the question can be rephrased as “Do you believe that we, as a human race, will continue to make technological progress in the long term?”

For me, this is really easy. The answer is an undeniable YES.

I believe people will continue trying to solve problems, create better products and find more productive ways to make the things we need. By owning the broad market, I don’t have to know beforehand who will succeed. I can own a small piece of as many of those attempts as possible.

If that turns out not to be true – if the world ends and devolves into a hunter-gatherer society, or a world war wipes us all out – then the performance of my index fund will probably be the last thing on my mind anyway.

That is the bet I am making. A bet on humanity.

If you’d like to see how this approach has worked out for me in real life, I’ve documented my journey from $0 to more than $4 million in ten years – including the decisions, mistakes and lucky breaks along the way.

If you’re completely new here, my Start Here page will point you towards the other articles and tools which I found useful on my own FIRE path.

I’d love to know whether this helped you get your head around index investing, so leave your questions or comments below, drop me an email or message me at @firepathlion.

Until next time!

FPL