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5 Reasons to Choose Index Funds for Your Investment Portfolio

By in Investing, Money Management, Mutual Funds, Stocks | 23 comments

Stock Picking is Time Consuming & Destined for Underperformance

I haven’t always been an index fund investor. When I started investing, I was a value stock picker. I wanted to invest in companies stocks  that were selling below than their intrinsic value. I spent hours reviewing company annual reports, Securities and Exchange (SEC) documents and listening to company conference calls. During those years, there were some amazing wins – I bought Oracle priced in the teens and sold it for over $100 per share. There were also some losses. Nokia looked like at a bargain at $30 after falling 50 percent, but there was plenty of room to drop further. Ultimately, I sold the stock in the single digits. Overall, my record was good, some years I beat the S&P 500, while other years, a tad under. 

5 reasons to invest in index funds; low fees, simplify, nobel prize winners index, all money works for you

What changed, why did I become an index fund investor? 

After studying the investment research, I found out that over time, professional investors rarely beat the stock market indexes year in and year out. My research and study further led to a book on that same topic-Invest and Beat the Pros. Here is why it’s smart to invest the majority of your retirement money in index funds.

Bonus read; How are Your Investments Performing? Is a 10% Return Good or Bad? >>>

What is an Index Fund?

The Securities and Exchange Website defines an index funds as:

“A type of mutual fund whose investment objective typically is to achieve approximately the same return as a particular market index, such as the S&P 500 Composite Stock Price Index, the Russell 2000 Index or the Wilshire 5000 Total Market Index. An index fund will attempt to achieve its investment objective primarily by investing in the securities (stocks or bonds) of companies that are included in a selected index.”

Have you ever been presented with a list of mutual funds and been struck with total confusion? 

Maybe it occurred when you started a new job and the human resources representative presented you with the abundant investment choices for the company’s retirement account. Or maybe you visited an investment company website like Vanguard or Charles Schwab determined to start investing and found yourself overwhelmed. 

In this circumstance, it’s wise to narrow your list of investment choices to low-fee vanilla index funds.

Here’s Why to Invest in Broad Based Index Funds

1. Index Funds Are Proven Winners

Years of empirical investment research has proven that most actively managed mutual funds fail to beat the returns of passive index funds.

What does this mean? You can spend lots of time selecting a mutual fund managed by a star. His or her fund might outperform for a year or two. But…. over the long term, the index fund returns will beat those of the actively managed fund.

The Elements of Investing, by Malkiel and Ellis, share well documented research that  “over 10-year periods, broad stock market index funds have regularly outperformed two-thirds or more of the actively managed mutual funds.”

It is extremely difficult for an actively managed fund to beat the returns of an index fund over the long term.

2. Index Funds Streamline Investment Decisions

There are literally thousands of mutual funds to choose from. Pare down the choices by sticking with index funds. Make investing decisions faster.

Investing can be extremely complicated and overwhelming. I’ve witnessed many people eyes glaze over when faced with the idea of choosing a mutual fund.

If you realized that a mutual fund is just a basket of individual stocks and or bonds packaged and sold, would that help your fears?

By choosing a mutual fund which mirrors a popular stock market index, such as the Standard and Poor’s 500, you’re investing in the way that beats most active mutual fund managers.

By choosing to invest in index mutual funds, you simplify and leave more time in life for living!

3. Index Funds Lower Costs

Since index funds are passively managed, the investment decisions are straightforward. No need for a cadre of overpriced managers here! And lower fees mean less money going to management and more money in your pocket. That means, your active fund manager has to earn higher returns at the outset, just to overcome his or her higher fees.

Most actively managed funds charge upwards of one percent management fee per year. Index funds annual fees are much lower. Compound those fees over many years, and you are keeping more of your investment dollars invested! Just make certain to check the fees on your index fund. Some “index funds” offer a souped up index fund that charges higher fees and tries to ‘improve’ on a standard indexing approach.

4. Nobel Prize Winners and Financial Luminaries Support Index Fund Investing

Some of the top investing minds in the world recommend investing in index funds. Warren Buffett recently instructed his heirs to invest in index funds.

“My money, I should add, is where my mouth is: What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit. (I have to use cash for individual bequests, because all of my Berkshire shares will be fully distributed to certain philanthropic organizations over the ten years following the closing of my estate.) My advice to the trustee could not 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 in Berkskshire Hathaway 2013 Annual Report

Not only does Warren Buffett recommend index funds, but so does John Bogle, the founder of Vanguard Investments and Nobel Prize Winners Eugene Fama and Lars Peter Hansen trumpet the index fund investing approach. Are you smarter than a Nobel Prize winner? Probably not.  

5. With Index Funds – All Your Money is Working For You

Some active fund managers keep a cash position. It might be 5 to 10%. That means that all of the money invested in the fund isn’t working for you in the markets. It’s also tougher to track your actual asset allocation with actively managed funds. In an actively managed fund there may cash, there also may be hedging or other strategies. Thus, if you want to keep a specific asset allocation, it’s tougher to monitor those asset classes with an actively managed mutual fund.

Whether you’re a seasoned investor or a newbie, getting started with index fund investing makes your life richer and simpler. 

(A version of this article was previously published-comments remain)

What are your investing recommendations? Do you index or not?

    23 Comments

  1. Great post Barb! And the best of all, you don’t have to worry about losing all your money which is a possibility when you invest in individual companies! With index funds, you remain highly diversified.

    Moneycone

    April 11, 2011

  2. Most of my portfolio is in mutual funds because of diversification. I like Vanguard for their low expenses, but some of my prior/current 401K/403B accounts were with Fidelity or TIAA-CREF.

    krantcents

    April 11, 2011

  3. I couldn’t agree more with this post. While I do not exclusively use index funds, not do I use them for every asset class, they are a core element of all client portfolios. In addition to the reasons that you listed, here’s one more, index funds are generally style specific. If the main focus of the long-term investor is on asset allocation (as it should be) these low cost, style specific vehicles are hard to beat.

    Roger Wohlner

    April 11, 2011

  4. Most of our investment are also index funds. Index fund is easy and I know if we keep dollar cost averaging in, we’ll do well in the long run. We have some individual stock investment on the side, but it’s a small percentage of our portfolio.

    retirebyforty

    April 11, 2011

  5. I think that different times call for different investments. If your at a part in your life, where you want nothing to do with risk then invest in index funds. But if you can risk some money, than go for stocks or even commodities.

    jeff

    April 11, 2011

  6. Jeff your comment reveals what in my opinion is a common misconception about index funds, that being that they are in any way shape or form a lower risk investment. Just as with an active mutual fund the index fund is as risky (or low risk) as the underlying index. An index fund investing in a short-term bond index would certainly be a lower risk investment compared to an index fund trying to replicate a commodities based index. One area where the risk of an index fund might be less is that you do eliminate the risk inherent in an active fund manager trying to beat their benchmark index.

    Roger Wohlner

    April 11, 2011

  7. @Moneycone-You remain diversified as long as you invest in diversified index funds. Some “sector” index funds are not diversified.
    @Krantcents-Vanguard, Fidelity and TIAA CREF all offer a variety of index funds as well as a variety of many other funds, investments and services. (As I’m sure you know 🙂 )
    Being an ex CFO, I’m sure you are well diversified.
    @Retire-I have nothing to add as you are clearly on a sound path. I’m rooting for you to rb40.
    @Roger, I’m certain your clients benefit from your sound and thoughtful philosophy.
    @Jeff, As Roger so aptly stated, all investing entails a certain amount of risk.

    Barb Friedberg

    April 11, 2011

  8. I like commission-free ETFs (offered by Schwab, Vanguard, and a host of others) even more than index funds: they’re also passively managed, and the fees are even lower.

    Paula @ AffordAnything.org

    April 11, 2011

  9. Cost, cost, costs. You hit the nail on the head with this article Barb! I’ve been all about index funds since my early days in college. It just makes sense for the average investor. I don’t have time in the day to study individual stocks. If you take Cramer’s advice, one must spend upwards of ten hours a week studying an individual stock to win big by stock picking. No thanks! I’d rather take modest returns and call it a day.

    Jon | Free Money Wisdom

    April 12, 2011

  10. Not only do you save on costs, you eliminate company specific risks by buying the index. My RRSPs are all indexed but I have a portfolio for those special investments of mine:)

    BeatingTheIndex

    April 12, 2011

  11. @Paula-You are another example of how my readers ADD to the important personal finance information. Schwab is turning out to be quite a leader in the “low cost” arena with commission free etfs and low minimum requirements for investment accounts.
    @Jon-Well put! Individual stock investing is extremely time consuming.
    @Beating-Another GREAT point. Getting rid of company specific risk lowers the risk profile of your entire portfolio. And of course there’s nothing wrong with taking some of your funds for more speculative ventures (with money you can afford to lose).

    Barb

    April 12, 2011

  12. Although I enjoy trading options, I believe that index funds should form the core of a retirement portfolio. Coupling index funds with regular investments to take advantage of dollar cost averaging is one of the foundations of a secure long term financial plan.

    optionsdude

    April 12, 2011

  13. I mostly invest in index funds. However, I have a couple dividend stocks I invest in also.

    Part of the reason I went with index funds is because when I did invest in individual stocks, my emotions got the best of me at times and I traded too frequently. Indexing has worked out well for me so far because I know my shortfalls.

    Everyday Tips

    April 12, 2011

  14. This doesnt surprise me at all… actively managed funds are at a detriment, and that’s somebody thinking they can beat the market.

    MoneyIsTheRoot

    April 12, 2011

  15. Thanks for the information Barb. For my b’day, I told my husband that I wanted my bike tuned up and to finally start a mutual fund (so boring, I know. 😉 ) I’m going to take your advice and select an index fund to start with.

    Little House

    April 12, 2011

  16. Great post! I like one of your reasons to invest in index funds: live more time in life for living. Nobody thought of that.

    The chart is great too; showing how investors are getting wiser.

    Investment Fiduciary

    April 12, 2011

  17. @Optons dude-Pleased to discover that you are not a “risk junky.” Thanks for weighing in.
    @Everyday-Very wise; acting within your own personal comfort level and style.
    @Little House-Happy Birthday, both gifts will pay long term dividends 🙂
    @Money-You and the finance researchers are both in the same camp.Wise!
    @Investment-We all tend to get wrapped up and forget to “smell the roses”.

    Barb

    April 13, 2011

  18. Hi DT-You are absolutely right, research shows that excessive trading leads to subpar returns.

    Barb

    April 13, 2011

  19. Sign me up also on Index Funds. They are my favorites. I can say since I have learned about them and their benefits, it’s been such a relief not having to track down the next hot investment, anymore. Index Funds are tried and true and an intelligent choice to use as an investment.

    Dave@50plusfinance

    April 14, 2011

  20. Love, love, love index funds too,Barb. Along with dollar cost averaging and low expenses. With all the evidence that exists out there about index funds, why do you think so many people invest in managed funds?

    Julie @ The Family CEO

    April 15, 2011

  21. @Dave & Julie -I like how you allude to the ease of index funds. It’s now as if they don’t go up and down, it’s just that you know over the long term you will closely match the respective index. Dave, Lots of time and aggravation saved by avoiding the hunt for the “next big one.” Julie, Many think they can “beat” the index! Others get “sold” by advisors on managed high fee funds!

    Barb

    April 16, 2011

  22. I have a web site where I give advise on penny stocks and stocks under five dollars. I have many years of experience with these type of stocks. If their is anyone that is interested in these type of stocks you can check out my web site by just clicking my name. I would like to comment about index funds. The question that I have for investors is this their are now hundreds of exchange traded funds and closed end fund available to investors. Why would any investor buy a broad based index fund like the standard & poors 500 index when you can pick from dozens of single country funds some of which are down by 80% from their highs of a few years ago or exchange traded funds that are concentrated in a very narrow sector like uranium maritime shipping that may be great bargains in the future. Anyone of which could be a spectacular bargain at some point in time that is if one is patient enough some of these single country funds and narrow sector focused funds will become spectacular bargains. Why buy a broad based index fund and get a mediocre return when say the first ireland fund is down by almost 75 percent from its high of two or three years ago a great buying opportunity. This is just one example. simply put if one can buy a diversified porfolio of narrow sector funds and single country funds when they are down by 70 80 or even 90 percent from their highs why bother with broadly diversified index funds.

    james moylan

    May 23, 2011

  23. James, The answer to why buy a broad based fund versus a single sector/country fund which has hallen in price is this: Many individuals are not interested in spending extensive time on portfolio management and prefer to do other activities with their time. The average return of the s & P over the long term is about 7-9%, I don’t consider that mediocre.

    Barb Friedberg

    May 23, 2011

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