Why you Should Invest in Index Funds

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Investing can be quite confusing, and even scary, to new and “experienced” investors alike, due to the overwhelming number of investment options. Many investors will ask themselves which stocks, mutual funds, and other securities to invest in. Should you invest in the hottest companies that everyone is talking about or the mutual funds that have achieved the best performance in recent years? Unfortunately last year’s winners are often times this year’s losers.

As you can tell by the title of this post, my answer is to invest in index funds. If you’re new to investing, you may not know what index funds are or why you should consider investing in them.

Below I’ll go over some of the options when investing, specifically in stocks, and why I feel index funds are a wise choice for your hard earned money.

Individual Stocks

Many of us have fantasies about buying stocks from one or more companies at a really cheap price and then watching the investments grow at a meteoric rate, making us a millionaire in the process.

While investing in individual stocks can be exciting and could make you rich, if you’re only investing in a handful of individual companies you’re essentially just gambling. Even some of the largest companies could be just one scandal away from going under and taking your investment dollars with them. For this reason, I’d recommend against investing anything more than a small percentage of your portfolio in any one individual company.

Even most new investors have probably heard that it’s extremely important to diversify your portfolio. The main reason you want to diversify is that you don’t want the failure of any one company, sector, or even asset class to wipe out your portfolio.

If your entire portfolio is invested in a single stock and that company goes under, your entire portfolio will be lost as well. If that company happens to be the company that you also work for, then compound the loss of your portfolio with a potential job loss or reduction in income. Even if your portfolio is evenly invested amongst, say, ten different companies, if any one of those companies goes under then you will lose 10% of your portfolio.

If you’re investing only in individual stocks, I’d recommend a minimum of twenty different companies as anything less puts too large a percentage of your portfolio in each company. Investing in more than twenty companies will help to diversify even further. Unfortunately, building a portfolio of many individual stocks can also get expensive when accounting for trading fees and can require quite a bit of your time between researching companies, deciding when to buy, and constantly monitoring your investments.

Actively Managed Mutual Funds

Mutual funds allow you to invest in a basket of different stocks (as well as bonds or other securities) that can contain hundreds or even thousands of different companies. The immediate benefit of investing in mutual funds, whether they’re actively managed or not, is diversification. With a single mutual fund you have the ability to get a diversified portfolio containing stocks from companies of all sizes, across every industry, that are located all around the world.

With actively managed mutual funds there’s a (typically highly paid) manager that makes decisions about which stocks and other assets to buy and sell, as well as when to buy and sell them. One of the problems with some actively managed funds is that fees can be quite high for you the investor. Another problem is that it’s almost impossible for any manager to consistently beat, or even match, the performance of the market as a whole. Below are some more details on each of these problems.

Fees

Fees can be charged in a number of different ways. Some mutual funds are called load funds and come with a sales fee or commission that you the investor must pay when purchasing. This is referred to as a front-end load, though there are also back-end load funds that charge the fee when you sell. This fee is typically something like 5% of the investment amount and is used to compensate the broker, investment advisor or other sales intermediary. So if you’re investing $1,000 into a front-end load fund with a 5% load, you immediately lose $50 to these load fees and only $950 gets invested.

This is probably a separate conversation but In my opinion, there’s typically too much of a conflict of interest when a broker or investment advisor recommends these types of load funds to his or her clients. What incentive does an advisor have to recommend investments with no commissions over those that pay a commission? The answer is none.

Simply stated, don’t buy load funds! These fees are too high and there’s no reason to ever pay them.

Mutual funds also have another fee that’s called an expense ratio, which is used to cover administrative and management expenses as well as other ongoing expenses. The expense ratio is charged as a percentage of the fund assets to cover these fees and lowers the return that you as the investor will achieve. For example, if the fund’s investments would have made 10% over the course of the year but it charges a 1% expense ratio, the overall return is 9%.

The higher the expense ratio of a fund, the more it will eat into the returns of the investors of the fund. While the 1% example may seem insignificant at first glance, it’s important to know that you are paying that 1% every single year. If you calculate out your returns over the course of decades of investing (which is what most people do when investing in a 401(k) or other retirement account), the amount you lose to fees is staggering.

Consider the following example. If you make a one-time $10,000 investment that you don’t touch for 40 years and it earns 9% on an annual basis, it will be worth $314,094.20 after 40 years. If the same investment earned 10% every year, it would be worth $452,592.56. That’s an additional $138,498.36 just by earning an additional 1% per year.

In the example above, by investing in a fund that returns 1% less every year (9% instead of 10%) due to higher fees, the final investment is worth 30% less. This should make it obvious how much even a 1% fee can impact your returns over the course of many years.  The higher the fees, the more it will eat into your returns.

The expense ratio can vary quite a bit from fund to fund but it’s common for some actively managed funds to charge as much as 1.5 – 2%. While you might think that buying a fund with a higher expense ratio will somehow get you a better product with better returns, every study that has been done shows that this is not the case. According to investopedia.com, even the U.S. Securities and Exchange Commission website states:

“Higher expense funds do not, on average, perform better than lower expense funds.”

Personally, I probably wouldn’t invest in a fund that charges over 0.5% and I definitely wouldn’t invest in a fund that charges over 1%.

Performance

If you look at the data that’s been published, even mutual fund managers with the best performance track record fail to beat the market over the long term. While they may have years where they outperform by a large margin, they also have years where they underperform the market by a large margin. Overall, studies have shown that there are essentially no mutual fund managers who can consistently outperform their market benchmark.

If the so called “experts” are unable to consistently beat the market, the odds are really stacked against the individual investor being able to select mutual funds and other investments that outperform the market.

Index Funds

For those that are new to investing or not familiar with what index funds are, an index fund is a type of mutual fund or ETF (exchange-traded fund) that passively tracks some market index. The index may be based on asset class (stock or bonds), geographic location, size, value, etc. such as the S&P 500, the total US stock market, an international stock index such as the MSCI, or US small cap value stocks. For example, an S&P 500 index fund is made up of approximately the largest 500 US companies by market capitalization.

Index funds typically have very low cost fees, are tax efficient, and allow broad market diversification. While many actively managed funds have fees approaching 1% and higher, there are index funds with fees as low as about .05% (or even .035% for some institutional class funds that may be available through your employer’s retirement plan).

Index funds have become quite popular and can now be found at many of the large investment companies such as Fidelity, Vanguard, Charles Schwab, etc. but Vanguard is the company known for some of the lowest cost funds in the industry. Personally I own Fidelity and Vanguard index funds in different investing accounts and have some great funds with rock bottom fees.

Investing in a fund such as the Vanguard Total Stock Market Index (VTSAX, or VTI for the ETF version) allows you to own a piece of every publicly traded company in the US at a very low cost of .05%. Adding an international stock index fund gives your portfolio exposure to even more additional companies around the world.

There are also all-in-one index funds that allow you to buy a single fund and get exposure to US stocks, international stocks, as well as US & international bonds, etc. The amount of diversification you can get with just one, two, or three funds is remarkable.

In addition to the great diversification you can get with index funds, you can sleep well at night knowing that if you buy and hold (as opposed to constantly selling and trying to time the market) you will achieve returns equal to what the market as a whole returns. This can be a great peace of mind vs. investing in individual stocks or mutual funds that try to beat the market, and are often times unsuccessful.

Money Gato sleeps well at night knowing investments are in index funds.
Money Gato sleeps well at night knowing investments are in index funds.

Another advantage of index funds is that they are incredibly tax efficient.  Index funds tend to distribute less in capital gains throughout the year vs. actively managed funds, which distribute more due to higher turnover.  If you are investing in a taxable account, this means that you’ll owe less in taxes at the end of the year.

Conclusion

While I obviously favor investing in index funds, the choice to invest in index funds vs. individual stocks or actively managed mutual funds does not have to be an all or nothing choice.

You could invest the majority of your portfolio in low cost passive index funds and invest a small percentage in some individual stocks or actively managed mutual funds that you feel give you a chance of earning even better returns. I’d recommend that you just think of this part of your portfolio as “fun” money or a bet that if you lose, will not break you. I personally wouldn’t want to allocate any more than 5-10% of my total portfolio to individual stocks.

For many investors, the ability to put your money in investments that will achieve market returns without the need to constantly research individual companies or worry about under-performing should be reason enough to invest in index funds.

If my argument for investing in index funds is still not convincing, then consider the fact that in Warren Buffett’s will to his wife he has recommended that the trustees place the majority of the cash proceeds in low cost index funds.

“My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.”

-Warren Buffett

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