For investing newbies, one question always surfaces: are index funds better than stocks? Index funds have been growing in popularity for several decades. They are low cost, diversified investments that offer steady returns. Because they represent the entire market, there’s little management required and acceptable risk. They simply generate returns on your investment.
What is an Index Fund?
An index fund is a collection of stocks that represent the market. There are many stock markets in the United States, but the big two are the New York Stock Exchange (NYSE) and Nasdaq. Every publicly traded company in the U.S. belongs to a market.
In addition to the NYSE and Nasdaq, there are market indexes as well. Market indexes track the stock of some of the largest companies in the entire stock market. The S&P 500 is a market index of 500 large, publicly traded companies in the US. The Dow Jones is a market index of the 30 largest publicly traded companies in the US. Companies like Apple, Wal-Mart, and Exxon Mobile are in both the S&P 500 and the Dow Jones.
Index funds are a collection of stocks across these various markets and/or indexes. For instance, the index fund I invest in, VFIAX, is an S&P 500 index fund. Therefore, it has stock from all 500 companies in the S&P 500 market index. In this way, the fund will do as well (or as poorly) as all 500 companies.
As investors, we want differentiated funds. Differentiated means our investment spans many companies across many industries. Hiccups in one industry do not affect others. If the tech industry incurs a shortage of silicon, it does not impact the restaurant industry. Or if cotton prices fall and generate higher profits for the clothing industry, it does not affect the financial industry.
Therefore, the downswings are less impactful. Similarly, gains in one industry do not create wild upswings. As a result, index funds are the best investment because they are medium risk, medium return on the investment volatility scale.
Investment Volatility Scale
The investment volatility scale defines both risk and return for each type of investment. Those that are lower on the spectrum are both lower risk and lower return. Those that are higher on the spectrum can generate higher returns for higher risk.
As investors, we want to get the best return for our money. We’re familiar with savings and checking accounts that earn little interest over time. We may even be familiar with CDs or bonds that yield slightly more. But we’re looking for bigger returns that come the further we move to the right on the spectrum. Move too far to the right though and the risk we embrace surpasses the likelihood of a return. Investors who win with high risk investments receive big payouts. But there are many more investors who lose a fortune instead of gaining one.
Great investors study the stock market, read company financial statements and analyze industrial trends. The knowledge acquired gives them a better chance at picking individual stocks that may yield great returns. Yet, The Simple Dollar collected data from the Dow Jones indicating fewer than 1 in 6 professional mutual fund managers beat the market. So if the experts can’t do it, it’s unwise for us amateur investors to think we can do it. Lucky for us, there are index funds.
Warren Buffett Endorses Investing Index Funds
Warren Buffett, the most successful investor of all time, made tons of money buying stocks. His big investments of Coca-Cola and Bank of America stock each netted him billions. While that’s the story we’d all like to have, Buffett shares this advice to us common investors:
Most investors, of course, have not made the study of business prospects a priority in their lives. If wise, they will conclude that they do not know enough about specific businesses to predict their future earning power.
I have good news for these non-professionals: The typical investor doesn’t need this skill. In aggregate, American business has done wonderfully over time and will continue to do so (though, most assuredly, in unpredictable fits and starts). In the 20th Century, the Dow Jones Industrials index advanced from 66 to 11,497, paying a rising stream of dividends to boot. The 21st Century will witness further gains, almost certain to be substantial. The goal of the non-professional should not be to pick winners – neither he nor his “helpers” can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.Warren Buffett
2013 Berkshire Hathaway letter to shareholders
Later in the same letter, Buffett details wealth management instructions for his estate:
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… 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
2013 Berkshire Hathaway letter to shareholders
So if you can’t take my word for it, listen to the best investor of all time when he says to invest in index funds. After all, he plans to put 90% of his wealth into an index fund when he passes.
Finally, we’ll talk about the administrative costs of index funds. All index funds have a fee associated by way of an expense ratio. Expense ratios are the fees you pay for fund management and administration. Since there is little buying and selling, they require little to no active management. Consequently, they have lower fees.
Index funds with higher expense ratios do not equate to better management or better returns. Look for expense ratios that are low, as this will be a reoccurring fee for the life of your investment. The same goes for any other type of investment with management fees. Look to keep your fees low to keep a bigger slice of your earnings.
So are index funds better than stocks? If you’re convinced it is the right investment for you, here’s how to start investing in index funds.