One of the most beneficial items I discovered when I started reshaping my investing philosophy has been index funds. For most of my investing life, I believed that the only true way to invest was to buy and sell individual stocks. It didn’t help that I was overconfident that since I was an accountant by trade, I could easily analyze annual reports. Once I was introduced to the world of index funds, everything I was discovering just made sense. Index funds offered diversification that I just couldn’t match in my taxable account.
So what are index funds? Well, according to Investopedia, “‘Indexing’ is a passive form of fund management that has been successful in outperforming most actively managed mutual funds.” So an index fund is a mutual fund or ETF (exchange-traded fund) that is built to track a specific index, like the S&P 500 or Russell 2000. So instead of investing in a single individual company, if you invest in an index fund, you will be investing in a much larger pool of companies. For example, if you invest in a S&P 500 index fund, you will be buying a small portion of the companies that comprise the S&P 500. This diversifies you into many different industries and can help off set losses that occur in others.
Advantages of Index Funds
- Cost – One of the main advantages of using index funds is that since they are passively managed, their expenses are normally
much lower than actively managed funds. The lower the cost, the more investment is left to compound over the
years. Actively managed funds normally will have many transactions during a year which will lead to higher fees, thus lowering your annual return. Many actively managed funds can have expense ratios north of 1% while many index funds are around 0.20% or lower (especially Vanguard funds which are normally some of the lowest in the industry).
- Regularly Beat Actively Managed Funds – According to “The Case For Index Fund Portfolios“, a whitepaper by Portfolio Solutions and Betterment, passively managed index funds outperformed comparable actively managed portfolios 82%-90% of the time over the period of 1997-2012. The study also found that the longer investors held those investments, the better the change of beating the actively managed funds. Index funds hold the advantage of being able to hold onto investments for the long-term and are able to take advantage of compound interest.
Disadvantages of Index Funds
- No Big Winners – Since you are investing in specific indexes, you won’t be hitting those big winners on individual stocks. A big gain in one stock may not move the needle on your investment since you will be invested in a larger amount of stocks. Investing in index funds means passing up those large potential gains (or losses) for lower, steady gains.
- Under Performance – Since index funds have costs, those costs will go against your gains, leading to a slightly lower return that the specific index your fund is targeting. This under performance can be managed by searching our for lower cost funds, but you will always incur some sort of cost.
As you can see, index funds should be an important part of any portfolio. With their ability to keep costs low so expenses don’t cut into your gains long term, you are better able to take advantage of compound interest and keep more of your gains. I used to think that the best way to invest was by picking individual stocks, but I am realizing that using index funds is the more practical avenue to help grow my wealth.
Do you use index funds? How do you incorporate them into your overall investment strategy?
Photo Source: Sujin Jetkasettakorn