Why do most personal finance snobs invest in index funds? The Physician Philosopher could probably think of 20. Instead, he gives us 6 reasons index funds rock and, ultimately, why it's important to set it and forget it. More on that here in a bit.
I’ve written before that I think investing in individual stocks is for losers. If I don’t believe in investing in individual stocks, what in the world do I use to create our wealth when we invest? The answer can be summed up in just two words: Index Funds. In fact, it doesn’t take long when someone asks me about investing for me to mention passive index funds. The fact is that as an investment choice, they are extremely hard to beat. Here are some reasons why Index Funds remain king.
1. Better Performance
The first place many people begin to invest their money is in a 401K or 403B offered by their employer. These usually consist of a few different options, including Target Date Funds (discussed below), actively managed mutual funds, and index funds. This can be broken down into active and passive management because most target-date funds are actively managed.
An index fund buys every stock in a specific indices and promises to give you the average market return. Nothing more. Nothing less. For example, the Total Stock Market Index Fund is designed to mirror the entire U.S. market. When the U.S. market goes up 5%, so does the Total Stock Market Index Fund.
Actively managed funds are funds where there is a manager who is paid to outperform the market. In other words, they charge you a fee (captured by the expense ratio of the fund) to pick winning stocks.
This begs the question, how often does a mutual fund manager beat their respective index fund that simply mirrors the market? According to the SPIVA scorecard, which keeps track of this information, 80-90% of actively managed funds fail to outperform the market.
Don’t let me put words in their mouth, this is what the SPIVA report says,
…over the 15-year investment horizon, 92.43% of large-cap managers, 95.13% of mid-cap managers, and 97.70% of small-cap managers failed to outperform [their respective index] on a relative basis.
In other words, index funds have an >90% chance of outperforming managers who are paid to beat the index. Who wants to pay for something that does worse than a less expensive product? Not this guy.
A successful investing portfolio adapts to market turmoil. When one part of your portfolio zigs, you want the other to hopefully zag. This happens through diversification, which is one of the key ingredients to successful investing. If you don’t believe me, go and find the closest Enron employee who had all of their retirement in company stock.
Depending on how simple you want to make it, you can get pretty complete equity diversification with only three index funds. It’s called the Three Fund Portfolio. It consists of the Total Stock Market Index Fund (U.S.), Total International Stock Market Index Fund, and Total Bond Market Index Fund (U.S.). These funds mirror the entire U.S. economy, international economy, and U.S. bond market; respectively.
It doesn’t get much more diversified than that, and it only takes three funds! The truth is that there are multiple ways to create very good index fund portfolios with excellent diversification.
3. Low Cost
One of the easiest ways to lose money in the market is to invest in assets that cost a lot of money to own and manage. When it comes to investing in mutual funds, the easiest way to look at how much it will cost you to invest in a given fund is to look at an expense ratio. The expense ratio captures the cost of fund management, advertising, and much more.
For many of the target retirement date funds, the expense ratio can be found around 0.5%. For every $10,000 that you invest, this will cost you $50. The industry standard expense ratio for actively managed funds is somewhere between 1 and 2%. For the same $10,000 this will cost you around $100-$200.
For those that are curious… the most expensive actively managed fund I could find was on Morningstar was AMREX. This fund charges a mind-blowing 15.2% expense ratio…. and comes with a nice 5.75% load (i.e. commission) for the financial advisor that talks you into it.
That doesn’t seem like a lot until you look at the typical expense ratio charged by an index fund, which has an industry-standard of <0.1%. In other words, it costs you less than $10 (and often less than $5) to invest $10,000 in an index fund.
If you combine this fact with point number 1 above, you’ll realize that those who invest in actively managed funds are choosing to pay more for a fund that will not beat the market returns captured by index funds.
As crazy as that sounds, people still buy actively managed funds. And conflicted financial advisors still recommend them. Though, these advisors don’t tell you they probably get a commission from putting you into the fund. That’s why you should find advisors who meet the gold-standard of financial advising.
4. Set it and Forget It
You know how often I make changes to my portfolio? Once per year at the end of July. Why? Because I know that my index fund portfolio is going to capture the market average. So, I don’t sweat looking at individual stocks or tracking performance.
A passive index fund portfolio is low maintenance. If I have the S&P 500 index fund, I know that it is going to consistently carry the 500 largest capitalization companies in the U.S. economy. I don’t have to worry about picking which ones to buy and sell. And it certainly doesn’t require me to do any research.
And based on what I told you earlier about the inability of hedge fund managers (who are paid to pick winning stocks) to beat the market… what makes me think I could do any better picking stocks on the side?
Investing in index funds is low key.
5. No Crystal Ball Required
“Hey, Jimmy, have you seen what the market is doing? It’s crazy!?!?!?”
“Nope. I sure haven’t. I rarely look at what the market is doing.”
This conversation blows people’s minds every time. How can someone who reads and writes about personal finance constantly have complete disregard for the market?
The answer is that I intentionally ignore market shifts and changes, because sticking to the plan is the most important aspect of successful investing. I know that I cannot time the market, and while index funds consisting of equities (i.e. stocks) are still risky investments, knowing market history is key.
Just stay the course. These are likely the four most important words in all of investing. If you don’t believe me, take it from Jack Bogle, the inventor of the index fund and founder of Vanguard.
If a simple index fund portfolio is boring and makes it more likely for us to stay the course, then it is likely best overall. It requires no crystal ball for market timing, and allows you to simply sit back and enjoy the ride.
6. It Makes Hard Stuff Easy
The most important reason that index funds are king is that they are easy. Any good retirement account offers them. You can purchase them in your backdoor Roth IRA (click here for a backdoor Roth IRA tutorial). Heck, you can even by them in a good ol’ fashioned taxable account.
What I am saying is that they are easily accessible. And I’ve already pointed out that they make staying the course easy, too.
In addition to all of this, index funds make all of the hard stuff easy. You don’t have to research companies, CEO’s, P/E ratios, or the latest hot stock tips. You also don’t have to listen to your buddy in the physicians lounge who thinks they’ve found the next Apple, Microsoft, or Facebook.
Index funds allow you to cheaply diversify your investments while making the hard things (staying the course, picking stocks, etc) easy. The only thing you have to worry about after you realize how great index funds are is your asset allocation (stocks/bonds; american/international, etc).
Don’t make these complicated. Keep it simple. This is definitely part of the 20% of personal finance you need to know to get 80% of the results!
Do you invest in index funds? Why or why not? Leave a comment below.