Reasons Index Funds Might Be a Better Choice for the Average Investor
A low-cost and effective way to make money over the long term.
Many people don't understand that successful investing is most often about avoiding major mistakes. You need to acquire a diversified collection of great assets at good prices, hold them in a tax-efficient way for long periods (often spanning 25 years or more), and let time do the rest. Index funds are an excellent mechanism to harness the same formula.
Index funds are designed to track a specific index or the overall performance of the stock market. Because there are no active managers trying to "beat the market," they can often bring strong returns at a very low cost.
1. You Can Save Money By Investing in Low-Cost Index Funds
When you invest in low-cost index funds, the management fee or expense ratio can be as low as 0.10% of assets per year compared to 1% or 2% for other types of mutual funds. In practical terms, that means for every $100,000 you had in a Roth IRA or 401(k), you'd indirectly pay $100 in fees to the money management company compared to paying $2,000 with a more expensive actively managed fund. That is an extra $1,900 per year in your pocket. Over long periods of time, that is hundreds of thousands, or even millions, of dollars in additional wealth.
There are times when this trade-off is not worth it. For example, in many situations, a registered investment advisor or private wealth management firm offers substantial added value in terms of tax strategy, risk control, and generational transfer assistance (such as using family limited partnerships and liquidity discounts to get around gift tax limits), to name a few cases. In those scenarios, I'd be wary of paying more than 1.5% per annum in management fees. If you're an office worker with $80,000 in investable assets living in Des Moines, Iowa, it's not necessarily worth the trouble or expense of hiring someone like that.
An index fund is going to be your best alternative.
2. Low-Cost Index Funds Provide Widespread Diversification at a Fraction of the Cost
If you are a small investor who wanted to replicate the S&P 500 by buying shares of each of the 500 stocks directly, you'd need to spend thousands of dollars in commissions and invest millions of dollars. (This isn't true for larger investors, who pay a mere half-a-penny per share in transaction costs in many cases with the rebalancing or other adjustment transactions being handled by a software program.)
Many discount brokerages have started offering index funds with small or even no minimum investment requirements. In 2018, Fidelity Investment made headlines when it began offering four index funds with no minimum investment and no transaction fees.
3. Low-Cost Index Funds Exist for Multiple Asset Classes, Investing Strategies, Market Capitalization, and More
Low-cost index funds have become so popular that there are now mutual funds that cover nearly any investing mandate or asset allocation you could have. Want to only invest in small-cap value stocks? Consumer staples? Energy stocks? International pharmaceuticals? There is an index that tracks it that would allow you to invest in a basket of the stocks at reasonable expense levels.
4. Low-Cost Index Funds Can Be As Simple or Advanced As You Desire
There are index funds that are completely inappropriate for new investors, such as those that hold assets in foreign currencies. For all intents and purposes, an index fund is no more safe or unsafe than the underlying investments that it holds. If you put 100% of your net worth in an index fund specializing in junk bonds, you aren't diversified, you just own a lot of different securities within the junk bond asset class. An index fund is nothing more than a type of mutual fund. It is not a specific type of investment.
5. Passive Investing in Low-Cost Index Funds Means Not Having to Think Much About Individual Investments
When you own a passive index fund, you are investing in individual stocks, bonds, REITs, and other securities but you don't have to think about individual stocks.
Once you've found the index fund that meets your needs and risk tolerance, the idea is to buy it, so you don't have to spend your free time deciding whether Procter & Gamble is worth more than Colgate-Palmolive or whether U.S. Bancorp is cheaper than Wells Fargo & Company. You don't have to see your oil stocks down 50% due to a glut in the commodity markets or your airline stocks going bankrupt following an event such as the attacks of September 11th, 2001. That has tremendous advantages for certain types of psychological profiles, going straight to the heart of behavioral economics.