Great, index funds, another complicated investment term I don’t understand. At least, that’s how I felt when I first started learning about investing.
It’s hard to keep everything straight in your head. Index funds, mutual funds, stocks, bonds, Roth IRAs, 401ks, why are all these names so weird?
Well luckily, we’ve had a lot of great people go before you and me and figure all this stuff out for us. So today I’m going to share what I’ve learned about index funds from other people and why I think it’s the absolute best way for us to invest.
This is what I use, and it’s probably what you should too.
Let’s jump in.
Stock Market Index
Before you can understand what an index fund is, you have to understand what a stock market index is. Basically, an index is simply a collection or group of stocks that have been put together.
You may have heard of the S&P 500 index or the Dow and Jones Industrial Average. Both of these are examples of stock market indexes.
The S&P 500 is a group of the largest 500 companies in the U.S. and the Dow and Jones is a group of 30 large companies in the U.S.
Another major stock index is the Wilshire 5000 which is an index that attempts to include almost all of the publicly traded stocks in the U.S.
Other major stock indexes include the Russel 2000, the NASDAQ composite, and the NYSE composite. All of these indexes track a certain portion of the stock market based on company size or industry.
All you really need to understand is that a stock index is just a grouping of stocks together that tracks the performance of that group as a whole. If you ever hear someone say “the stock market’s down 10%!” they’re likely referring to one of the indexes. And more often than not, they’re talking about the S&P.
How Index Funds Work
An index fund is a special type of mutual fund. Rather than leave the stock choices up to an individual fund manager or firm, index funds simply track a specific index. They do it by buying a portfolio of stocks that aligns as closely as possible to that index.
For instance, both FUSEX and VFINX are index mutual funds that track the S&P 500. This means that they attempt to hold the exact same balance of each stock as the index weights it. These index funds are capitalization weighted (or market weighted). What does that mean you ask?
Good question, here’s an example.
Although there are 500 stocks int the S&P 500, each stock doesn’t account for 1/500 of the money in an S&P 500 index fund. Rather, each stock makes up the same percentage as it’s size relative to the other companies.
Let’s look at Apple.
Apple (AAPL) is the largest company in the country right now and as of Feb. 8, 2016 it makes up 3.19% of the entire S&P 500. That is considerably larger than if you took all 500 companies and evenly distributed them at 1/500 = 0.2%.
So if Apple makes up 3.19% of the S&P 500 and you invest $1,000 into VFINX (an S&P 500 index fund), that means 3.19% or $31.90 will be invested in Apple stock.
Similarly, Amazon (AMZN) makes up 1.33% of the S&P 500, so $13.30 of your $1,000 would be invested in Amazon stock. And then the rest of your $1,000 would be invested in the other 498 stocks according to their size as well.
Index funds are as boring as they sound. They just track along with the index. No fancy stock picking. No “TOP TEN HOTTEST STOCKS NOW!!!” Just plain old investing in the whole market. If the S&P 500 gains 7%, your money gains 7%. If it goes down %5 your money loses 5%.
But don’t worry, when it comes to investing, you want to be super boring, that’s how you win.
Let’s find out why.
Major Advantages of Index Funds
There are many advantages to index funds and they all center around three fundamental ideas:
- No one (or, at least less than 2% of people) can predictively and consistently beat the market after fees.
- The only thing you have control over when you’re investing is the fees you pay to invest.
- Keep it simple.
Index funds shine when compared to active management and stock picking. They require minimal effort, normally less than 1 hour per month (if that, in many cases). They rely on the stock market as a whole rather than someone trying to beat the market. And because they don’t have to pay managers to actively oversee and choose the investments, they are able to maintain extremely low fees.
Ultimately stock picking is a loser’s game even for the professionals. An article in the NY Times discusses a study conducted by S.&P. Dow Jones. This study looked at 2,862 broadly diversified, actively managed, domestic mutual funds operating between March 2009 through March 2010. It chose the top 25% of these funds and tracked their performance over the course of the next few years through March 2014.
The study looked to see which of those funds that started in the top 25% stayed in the top 25% for each of the four 12 month periods between March 2010 and March 2014. The answer: 2.
That’s right, 2 out of 2,862 funds invested in the same types of stocks were able to consistently outperform. That’s 0.07%.
So here’s the problem, if it’s THAT rare for mutual fund managers to consistently outperform, what makes you think you can choose the right mutual fund that will?
That’s right, you probably can’t. But that’s okay, I can’t either. That’s why I invest in index funds. That way I’m guaranteed the market return. If you’re investing over the long term (which you should be), indexes will beat the large majority of actively managed funds every time.
When it comes to investing you have very little real control. The market is huge and unless you’re a billionaire, you probably don’t own enough stock in one company to make any influential decisions. But despite your lack of control when it comes to the performance of your investments, you have a large amount of control over what you pay for those investments.
If you invest through a normal brokerage account with any major brokerage you’re going to pay a transaction cost every time you buy or sell shares of stocks or mutual funds. These costs can range from $5 to $50 to even more depending on what you’re trading and where.
Not only will you have to pay transactional fees, if you’re investing in actively managed mutual funds you will have yearly account management fees that typically range between 1 – 2%.
Compare this to trading index funds through a broker like Vanguard or Fidelity where trading their index funds is free for transactions and they have some of the lowest yearly fees around (typically less than 0.20%). That 1% yearly maintenance fees means that your active manager has to beat the market return by at least 1% just to break even with the market.
To compare this consider investing $10,000 in a mutual fund for 20 years at 10% with an expense ratio of 1.5%. At the end of 20 years, the fund would be worth $49,725. But if instead you invested in an index fund that had only a 0.5% expense ratio, the money would have grown to $60,858. Just a 1% difference in expenses made an $11,000 difference over the entire investment.
The bottom line is that you have no guaranteed control over long-term performance, but you do have control over what you pay for that performance. Obviously, you want to keep that payment as low as possible, and index funds do that.
Lastly, the other major advantage of index funds is how simple they make your investing life. Once you get a balanced portfolio of a few index funds it becomes extremely easy to consistently invest without spending much time researching stocks. If you’re anything like me, you don’t have 10 – 15 hours a day to spend studying the stock market and trying to choose the best stocks.
I’d much rather spend <1 hr a month making sure things are still on track and then have all of that extra time to spend doing things I’d rather be doing.
Index funds allow you to be a hands-off investor. Or, as Mike Piper would say, an Oblivious Investor.
Of course, there are many other reasons to invest in index funds, and I won’t dive into them all. But here’s just a few:
- No sales commissions
- Less risky than typical funds
- Index funds are highly diversified
- Many index funds are tax efficient
- Operating expenses are extremely low
- It doesn’t matter who manages the fund
- You don’t have to hire a money manager or investment advisor
- Allows for peace of mind and simplicity
Disadvantages of Index Funds
Obviously by now, you know I’m a huge fan of index funds. But it wouldn’t be fair to talk about all of the good things and not mention any of the bad. After all, there’s always pros and cons. Really though, when it comes to investing, index funds have very few cons. But let’s take a look anyways.
Index fund managers are bound by the rules of the agreements for their fund to stick to a certain asset allocation regardless of what the market is doing. This means that there isn’t really any room for human intuition, knowledge, or skill to play into the investing. For example, if a particular index is declining rapidly the index fund manager has little room to change the situation. Whereas an active fund manager has the ability to change strategies at any given moment.
However, this all depends on your outlook. Personally, I see this not as a bad thing because I’d rather bet on the entire stock market than one manager’ ability to choose the right thing. But, regardless of how you look at it, flexibility is a bit of a disadvantage.
No Room for Big Gains
Because index funds are used to track specific indexes you’re not going to see any major outperformance compared to the market. You won’t experience the news-worthy stories about a stock doing 200% in one year while the market only does 7%. You’re just going to see that 7%.
The top-performing actively managed fund will outperform the top-performing index fund. That’s just the way it is.
But again, it’s risk vs reward because that top actively managed fund is likely not going to be the same one next year or the next. And it could just as likely significantly underperform the market as much as it could outperform. So always keep that in mind.
Why You Should Use Index Funds
You can’t beat the market, I can’t beat the market, and no one else can either, and they especially can’t do it net of fees. So why try?
Don’t waste your time and money. Everywhere in life, I would argue that you should try and be better than average. In your career, in sports, in games, in relationships, don’t settle for average. But when it comes to investing, you’re better off just aiming for the average market return and spending your time elsewhere.
Professional investment advisers and managers can’t consistently beat the market over time. So by investing in index funds over the long term, you’ll actually be above average as compared to the rest of people who invest.
If I told you that you can spend less than 1 hour a month investing, keep your risk low, and perform above average over the long term, wouldn’t you be happy with that?
I am. And for the majority of us, including you, this is the way to go.
If you found this article helpful I’d love for you to click the share buttons below or just leave a comment and let me know what you thought! Have you invested in index funds? What was your experience?