5 Reasons to Choose Index Funds for Your Investment Portfolio
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.
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.
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?