Reasons Index Funds Might Be a Better Choice for the Average Investor
Most New Investors Don't Have the Knowledge to Pick Individual Stocks
I've spent years praising the low-cost index fund despite its inherent flaws, including the quiet methodology changes that have been pushed through for things such as the S&P 500 index fund that make it effectively an entirely different, less attractive product than it has been in past generations to the issue of embedded capital gains, which should cause any investor with at least a seven-figure net worth to seriously contemplate building an individually managed account, instead, as they could get hit with someone else's tax bill even if they, themselves, experience a loss; risks that many small investors genuinely don't know exist because they seem so unfair.
Why the praise for this particular financial product in light of its shortcomings? If you are an ordinary investor without the ability to read a balance sheet, income statement, or cash flow statement, and you lack the funds necessary to hire one of the few white-glove, well-heeled private asset management companies catering to the rich and their multiple-generation family estate plans, an index fund is going to give you a lot of convenience at a relatively cheap price. It is, in other words, "good enough" to get the job done; a major accomplishment when you consider that one Morningstar research paper found investors earned something like a pathetic 3% return over periods when their underlying investments generated 9% returns because they were so inept at building a portfolio.
Put bluntly, 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. If you aren't particularly fond of using direct stock purchase plans and dividend reinvestment plans -- a great strategy if you have the discipline to stick to it and one that has minted many, many secret millionaires such as the minimum-wage earning janitor Ronald Read, who accumulated $8,000,000 -- index funds are a decent mechanism to harness the same formula.
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 additional 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, if you can even get in the door, which is highly unlikely absent a family connection (most have minimum opening balance requirements for clients ranging from $500,000 to $10,000,000).
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.)
With a low-cost index fund, in contrast, you can often invest for as little as $500 through a retirement account or $3,000 through a regular brokerage account.
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. Of course, you are experiencing these things -- they are very, very real and you own individual stocks, you've arranged your affairs in a way you don't see them on a line-by-line basis unless you purposely pull the index fund's regulatory filings -- but you can remain purposely ignorant to them, assuming you're willing to take the risk of having faith the methodology employed is still reasonable. That has tremendous advantages for certain types of psychology profiles, going straight to the heart of behavioral economics.