Why Should I Invest in Index Funds?

Be honest: Are you intiminated by stocks? Does the idea of having to pick one type of mutual fund or ETF over another scare you into avoiding decisions about investing altogether?

Thankfully, whether you’re trying to build up your retirement nest egg or simply invest for growth, there’s one thing you can do that will take all of the guesswork out of the equation and make your life a whole easier: Choosing to invest in index funds.

Index funds have been consistently proven to be a radically simple way for the common investor to capture the average returns of the stock market without having to research individual stocks or have deep knowledge of the market in general. In fact, this strategy has become so popular that it is now backed by big-name stock-pickers like Warren Buffett.

Sounds good, right? But what exactly are index funds? And why do they come so highly recommended?

What is an Index Fund?

Index funds are really nothing more than a select group of investments that people use to determine how the whole market is behaving. Because other stocks and funds are often compared to them, you’ll hear people refer to them as “benchmarks”.

The first well-known index is the Dow Jones Industrial Average created back in 1896 by legendary businessman Charles Dow. Instead of trying to keep track of how every stock in the market was doing, Dow reasoned that he could get an “average” of the daily performance by looking at the top 12 companies.

People liked the simplicity of this idea, and newspapers began to report it as a way of communicating overall stock market performance. Today, the financial industry now has dozens of unique indices for all different types of asset classes: stocks, bonds, precious metals, etc.

For large-cap stocks, the most widely used benchmark is the S&P 500 index. These are the 500 top-performing and largest companies in the U.S.

Why Are Index Funds Such Great Investment Opportunities?

Though the original usage of index funds was to gauge market performance, it wasn’t until the mid-1900’s that some academics realized they might have other useful benefits too; particularly as potential investment vehicles.

Outperforming the Pros

For years, investors had been putting a lot of time and effort into trying to pick the best companies to put their money into. But what they didn’t realize is that the companies already listed in an index fund are the best of the best. The question then became: How can the common investor buy the stocks of all 500 companies in the S&P 500 in an efficient manner?

This is where opportunity came knocking. Vanguard founder Jack Bogle recognized the benefits of index investing and offered the world the first publicly available index fund in 1975. At the time, it was mocked by Wall Street media and nicknamed “Bogle’s folly”.  But over time, Bogle was the one who had the last laugh. Vanguard’s mission continued to attract and retain clients, and today the company stands as the largest provider of mutual funds in the world.

Since being introduced, the idea of index fund investing continues to be explored and praised by many financial enthusiasts. Paper after paper and book after book demonstrate examples where most typical actively mutual funds cannot beat the benchmarks they compare against. 

Even Jack Bogle has been quoted as saying Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks.”

Lower Cost Fees

One of the major contributors of index funds having better performance is the fact that most active funds cost significantly more than passively managed index funds.  Higher fees eat away at net returns, and as this cycle compounds over time, the results can be huge.

How huge? In this article comparing actively managed funds to index funds, you can see how much damage a few percentage points of fees can do.

Consider a portfolio of $10,000 invested every year for 30 years with 7 percent average returns. With an index fund such as the Vanguard 500 Index Fund Admiral Shares which carries an expense ratio of just 0.04%, the fees add up to just $6,771.

However, actively managed funds carry fees that are quite higher. At the industry average expense ratio of 1.25%, they totaled up to a staggering $187,963!

As you can see, the difference in fees makes quite the difference!

Better Diversification

Index funds also offer the average investor a convenient way to diversify their portfolio and capture the market as a whole. This is in sharp contrast to other funds or investment options that may be too rigid or specific to a certain sector of companies.

For instance, some funds may invest heavily in technology stocks for big-name companies like Apple, Facebook, Amazon, Google, or others. While these businesses may have experienced unbelievable growth over the past decade and posted impressive returns, a turn in the market could potentially cause them to lose above-average share price value. That poses a risk to investors who are unprepared for such a turn of events.

By comparison, the S&P 500 encompasses 11 economic sectors including information technology as well as industrials, financial, information technology, health care, etc. Therefore, the risk is better to spread out among the top performers from each industry. That will result in better stability and overall returns with minimal effort on the part of the investor.

How to Invest in an Index Fund

If you’re interested in putting your money into an index fund, you don’t have to look too far. Nearly every major financial broker now carries some version of an index fund as either a mutual fund, ETF, or both. Most retirement plans also offer this as one of their investment options.

Here are a few of the most popular ones to try:

  • Vanguard 500 Index
  • Fidelity ZERO Large Cap Index
  • SPDR S&P 500 ETF Trust
  • iShares Core S&P 500 ETF
  • Schwab S&P 500 Index Fund

If you’d like one quick and easy place to see how all of your investments are performing, then try using Buxfer’s Investments feature. Investments will effortlessly import real-time data from the retirement and brokerage accounts you connect to Buxfer. You’ll then be able to monitor your entire portfolio’s performance while gaining valuable insights about your holdings such as price, quantity, sector type, etc.

Click here to find out more about the Buxfer Investments feature.

Image credit: Unsplash

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