Index funds are the perfect choice if you prefer an easy way to invest in a large portion of the stock market and avoid paying someone to try and “outsmart” the market. They are generally much simpler, cost less, and have historically provided a better return on your investment over time. That’s the big picture; now let’s look at why.
Some people love the concept of mutual funds because they provide an instant way to diversify your investment by purchasing a bucket of stocks, rather than one or two stocks. Kind of smart, right? It is; however, one of the major problems with traditional mutual fund investments is that they usually charge investors higher mutual fund fees and pay the fund manager to attempt to select the “best” investments.
Now here’s the irony — the investment strategy of selecting “best” investments by the fund manager doesn’t consistently outperform the market as a whole. That is where index funds shine.
What is an Index Fund?
An index fund is a mutual fund but instead of having an active manager, it has a passive manager. While still operated by a professional money manager and pooling funds from various investors, an index fund lowers the expense of investing and generates consistently higher overall returns than active fund managers.
Rather than trying to outperform the stock market or any particular stock, an index fund tries to reproduce what is happening in the stock market.
If the stock market goes up then so do We (the fund).
If the market goes down then So do we (the fund).
No huge amounts of money spent on stock picking or constantly trying to find the next hot stock.
Instead, we simply invest in a broad variety of stocks while tracking only one set of stocks (the index).
You may be surprised to know that over long time periods, most actively managed mutual funds underperform compared to the market when you take expenses into account.
If you cannot always count on beating the market, how do you invest? That is how index investing was developed. Instead of spending money for someone’s guess as to what stock will be the best next year, you buy everything in the desired stock market(s) and wait until each stock rises or falls with the market. This is a very boring way to invest. But being boring in investing can often lead to positive results.
A Big Deal About the Fee Diff
We’re going to talk about the money you can’t see coming out of your account.
Actively-managed mutual funds have higher expense ratios because the fund manager continually researches, analyzes and makes trades. The cost gets passed on to you, the investor/investors.
However, with an index fund you do not have to continually make decisions. It is simply a fund that uses an index (.i.e., S & P 500) to drive its investments. As a result, the operational expenses will be much lower and therefore, the investor/investors have more of his/her money to keep investing.
Over long periods of time, even a small percentage difference in fees can amount to thousands of dollars.
And as a bonus, you are often getting a lot more of your money for a lot less than if you went with an actively-managed fund and primarily underperformed the market relative to an index-based fund.
The Popularity Of Index Funds Didn’t Happen By Chance
Index Funds have dramatically increased in popularity over the past 10 years due to mathematical evaluation.
Investors have realized two things with their investments:
1) The cost you pay for an investment is crucial,
2) Simplicity works, and
3) Long-Term investments will outperform short-term, random guesses
After people understood that, it became easier for them to change their behaviours.
But, isn’t picking stocks through Active Management a better way to invest?
It makes sense, if you have someone managing your money who has a better than 50% chance of picking “winning” stocks to invest in then in theory you should do better than someone investing through only passive funds.
However in practice, you typically cannot predict which stocks are going to do the best; the markets price in information very quickly; and managers who can outperform year after year are the extreme minority.
So rather than taking a chance on finding that one superstar manager who can beat the odds you are going to find many investors who take the approach of investing in a passive way and allow time to do all the heavy lifting.
The ability to create diversification without having to go through the hassle of making allocation decisions is another advantage to index funds.
When you invest in an entire stock market index through an index fund you are not only relying on the performance of one particular company (stock), but you are getting exposure to hundreds or thousands of other companies at the very same time.
Therefore if a stock drops significantly, it will have virtually no effect on the overall market portfolio, meaning it creates diversification in an amount that is virtually impossible to replicate if you are only making stock selections on your own.
An index fund (a type of mutual fund) is set up to mimic a particular part of the markets, as opposed to trying to outperform it.
It does not aim to be the fastest runner but to finish the entire distance.
And, most of the time, this strategy seems to end up winning — especially when you include the cost aspect.
Who Should Use Index Funds:
Index funds are the ideal investment vehicle for:
- Individuals seeking to invest for long-term growth.
- Those who wish to minimize investment costs and fees.
- Individuals that prefer not to like look at their investments regularly or obstructively examine the markets.
- Those who believe in the power of compound interest to accumulate wealth over time.
Index Funds are NOT too exciting and won’t give you bragging rights around the cocktail party about “your hot pick stock,” but they will provide you with what is more important: the benefits of a consistent investment return.
The Secret to Success for Beginners
Many new investors fail to consider how much they will be affected by emotions.
Active investing may elicit a reaction to newspaper or magazine headlines, a reaction to the news about something on the market going down, or an attempt to find the next “hot” stock.
Investing via index funds encourages you to take the long view. You are not trying to second-guess what will happen in short-term time frames when the economic cycle will change.
You are investing in the theory that, over years and decades the economy (from the bottom up) will continue to expand and grow.
Historically, the economy (from the bottom up) has continued to expand and grow.
Long-term success can typically be found in 3 areas:
- Lower Fees
- Broad Diversification
- Fewer Emotionally-Driven Decisions
These factors combined create a large obstacle for high-fee, actively managed strategies to outperform index funds over an extended length of time (20-30 years).
If you are seeking the advantages of mutual fund diversification without all of the accompanying costs and complexity, index funds will provide you with a simple and easy-to-understand means of investing.
Unlike many mutual funds, index funds do not guarantee returns above an index or benchmark; rather, they guarantee returns equal to that benchmark or index.
In investing, achieving equivalent market returns at low expenses can be significantly more desirable than trying to achieve superior market returns at high expenses.
The best way to invest may not be by attempting to out-think yourself or other investors; rather, it may be best to invest through a method that allows you to go about your life while still receiving your desired level of return.
