Editor’s Note: Liz Peek is a financial columnist and the author of wowOwow’s Wall Street Weekly. Liz Peek’s SHEconomics series, herewith, is scheduled to become a book. Click here for your introduction.

Ladies: Isn’t it time to load up on Diamonds? I don’t mean those deliciously sparkly rocks that brighten up our fingers – though they are always appealing – I mean an ETF that tracks the Dow Jones Industrials. In this installment of SHEconomics we’re going to clue you in to why Diamonds may indeed be a girl’s best friend.

Let’s suppose for a minute that you’ve been inspired by our Sheconomics series to take financial matters into your own hands and you’ve developed an itch to bargain hunt in the stock market. While pessimists would tell you to reach for the calamine lotion, optimists would say bravo! You are emboldened by the massive and now bewildering catalog of government programs working to turn around the economy. You see the clouds clearing over the next 18 months, and are not worried about being a little early. You are in charge.

The question is: What do you do?

The easiest way to place a bet on a turning stock market is to buy the whole thing. That is, instead of trying to figure out which specific stocks will recover first, or conversely which are most likely to go bust, you are best off buying an index mutual fund or an exchange-traded fund (ETF) that tracks the whole market. In either case you get substantial diversification, which is the only real way to lower risk, and you can easily bail in case you get nervous. How does it work?

Index funds were the original means by which investors could mimic the activity of a particular stock-market barometer like the Standard & Poor’s 500, which is a fairly broad group of 500 large companies, or the Dow Jones Industrials which includes only 30 of the country’s largest firms. The fund either owns all the stocks in the index or has a representative sampling which has been proven to mirror the index’s results. 

Once a manager has bought the shares he needs to track a chosen index, he leaves it alone. Unless companies merge or go out of business, which then means some rejiggering of the portfolio, the manager has little to do. If new money flows into the fund, a computer generates buy orders that maintain the correct weightings. This is called passive management.

The whole notion of indexing created quite a furor when first introduced by John Bogle in 1975. Bogle founded a company called Vanguard, which soon transformed the money-management business and as of last May managed $1.3 trillion in assets. Bogle’s inspiration came from the mediocre results turned in by mutual funds in the 1960s and 1970s, and from a book written by Princeton economist Burton Malkiel in 1975 called A Random Walk Down Wall Street. (This is goddess information – try throwing this one into the conversation!)

Malkiel argued that everything that can be known about a stock at any point in time is already reflected in its price. Consequently, stock price moves in either direction were random events and completely unpredictable. In theory, then, no one – not even the savviest professional stock pickers – can foresee where shares will head or will outperform the market on a regular basis.

Those of us who spent our careers analyzing companies and trying to predict which stocks would outperform the market for our clients dislike and dispute this notion. I would like to think that by being cleverer than the next person, I could put together superior investment results. The success of someone like hedge-fund manager John Paulson who made billions of dollars last year betting against mortgage-related securities pushes back against random-walk theory. However, studies have shown that in certain periods, index funds have indeed outperformed mutual funds.