Successful investing usually depends on 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 way for investors to harness this approach.
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 provide strong returns at a very low cost.
Save Money by Investing in Low-Cost Index Funds
In practical terms, for every $100,000 you have in a Roth IRA or 401(k), you would indirectly potentially pay around $100 in fees to the money management company; in contrast, you might pay $2,000 in fees if you had a more actively managed fund. Simply put, you could save an extra $1,900 per year. Over a longer time period, savings can accumulate to hundreds of thousands, or even millions, of dollars.
When you invest in low-cost index funds, the management fee or expense ratio can be as low as 0-0.1% of assets per year compared to 1-2% for other types of mutual funds.
At times, this trade-off is not worthwhile. For example, in many situations, a registered investment advisor or private wealth management firm offers substantial added value in terms of, among other things, tax strategy, risk control, and generational transfer assistance (e.g., use of family limited partnerships and liquidity discounts to get around gift tax limits). But, in such scenarios, you should be wary of paying around 1% or more per year in management fees.
Gain Diversification at a Fraction of the Cost
If you are a small investor who wants to replicate the S&P 500 by directly buying shares of each of the 500 stocks, you would need to spend thousands of dollars in commissions and invest millions of dollars. This is not true for larger investors who typically pay half-a-penny per share in transaction costs due to rebalancing or other adjustment transactions that are 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.
Low-Cost Index Funds Exist for All Asset Classes
Low-cost index funds have become so popular that there are now funds that cover all types of investment mandates and asset allocations. You can invest in an index that tracks, among other things, small-cap value stocks, consumer staples, energy stocks, and international pharmaceuticals. The expense levels for these funds are reasonable.
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 are not diversified, since you just own different securities within the same asset class.
When you own a passive index fund, you are investing in individual stocks, bonds, REITs, and other securities, but you do not have to think about them as individual investments.
Allow Passive Investing
Once you find the index fund that meets your needs and risk tolerance, the idea is to buy it so that you do not 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. You do not have to see your oil stocks go down 50% due to a glut in the commodity markets or your airline stocks go bankrupt following a paradigm shifting event, like the September 11 attacks.
The ability to not worry over every individual investment has tremendous advantages.