Depending where you are on your financial journey the information in today’s post might seem obvious. But for every individual who knows the ins and outs of mutual funds and ETFs along with what the letters VTSAX stand for, there are just as many who are just getting started and are eager to learn. So, what is an index fund?
- Mutual Funds and Exchange Traded Funds (ETFs) can be thought of as a basket that holds pieces of other assets like stocks, bonds, and even other mutual funds or ETFs.
- Mutual Funds and ETFs make it much easier for investors to create a diversified portfolio.
- The best stock pickers and mutual fund managers often fail to do better than the overall stock market, and that’s their job. If they can’t beat the market, why do so many individual investors think that they can?
- Investing in Index Funds is a way of acknowledging that it’s extremely difficult to outperform the stock market and you are better off matching it’s performance instead.
What Goes in Your 401k?
When you got your first job with a 401k or 403b and made the choice to contribute a percentage of your paycheck you might have been confused when you next had to pick your investment allocation.
We don’t do a great job with financial education in the U.S. so thinking you were done after choosing to put money in your 401k is understandable. But the 401k is the just the account that holds your investments. Contributing is great, but choosing what investments to hold in your 401k is extremely important.
Nowadays some 401k/403b plans will auto invest individuals into a target date retirement fund, which is great. But what if this doesn’t apply to you? What types of investments should you hold in your 401k/403b or your IRA, Roth IRA or 457b for that matter? The answer to that varies based on your age and goals, but it should generally be a mix of stock and bond index funds. So what exactly are index funds?
An index fund is simply a type of mutual fund or Exchange Traded Fund (ETF) that tracks the movement of a particular index. In plain English that means it’s like a stock whose price goes up and down the same as the index it follows. Most index funds follow a specific stock or bond index.
So, if an index is just a basket of companies what makes an index fund so special and why should you choose to invest in them versus other funds, or individual stocks and bonds?
The Stock Market Generally Trends Up
Investing in stocks is one of the best ways to earn the higher returns needed for your portfolio to grow and provide for your future goals, such as retirement. Keeping your money in cash, which is attractive right now in October 2023 with savings accounts offering interest of 4% or more often fails to beat out inflation over the long haul.
Money invested in bonds will grow slowly, generally in the range of 3% – 5%. While the returns on the US stock market have generally been around 8% annually, depending on the date range you look at.
So, if we believe that the value of the stock market will continue to increase and investing in stocks is the best way to grow our wealth to prepare for the future, why are index funds the best way to do that? Shouldn’t we just find the next Amazon or Google and buy their stock instead?
Picking the Hot Stock
The problem with finding the next hot stock is finding the next hot stock. There are many very smart people who spend a ton of time and money trying to find the next Apple or guess when the next recession will hit.
You’ve likely heard of famous investors like Warren Buffett. That’s because it is incredible hard to pick successful stocks, or “beat the market” year in and year out. The people that can do this are justifiable famous.
If you have the skill to pick the best performing stocks and only buy those, that is definitely the way to go. The problem is that the vast majority of us are just as likely to pick the next pets.com as we are to find the next Amazon.
The Benefits of Diversification
If we acknowledge that we it’s hard to pick winners in the stock market what are our options? The solution is to purchase a variety of different stocks. Some stocks will do well and grow in value, and others will do poorly. By diversifying among a large number of stocks we decrease the chance that we’ll go bust and lose our entire investment. We choose to own the entire market, rather than trying to beat it.
With a diversified portfolio we settle for the opportunity for decent return, rather than risk an all or nothing bet on one single stock.
That’s where mutual funds and ETFs come in. These are single securities that act like a basket holding a slice of many different stocks. Instant diversification!
How About Paying Someone to Pick the Best Stocks?
Since there are smart people out there who know how to beat the market why don’t we pay them to pick the best stocks and beat the market for us? It turns out you can try to do this by buying “active” funds.
Active funds are mutual funds or ETFs made up of stocks or bonds that the fund manager chooses because they think they will do well and outperform the market. The problem is that just as with picking a quality individual stock, it is very hard to pick a quality active fund.
Maybe an active fund will outperform its benchmark for one year, but it’s very difficult for it to do better year after year. The S&P Dow Jones Indices releases their SPIVA® (S&P Indices Versus Active) reports each year. During the first half of 2023 59.7% of U.S. large-cap equity fund managers underperformed the S&P 500. If you look over a three-year period 79.8% underperformed.
It is just as hard for someone to select which active funds will outperform in a certain year as it is to select which stocks will do the same. So, if we can’t really pick which of the active funds will do well, why do we choose index funds instead? Reason 1: an index fund won’t outperform the market but it shouldn’t underperform either. Reason 2: index funds cost much less than active funds.
Index Funds are Cheaper Too
We’ve learned that the majority of active funds don’t do any better than their index, so they must cost less than an index fund that “just” tracks the index right? Nope!
That 0.56% difference in fees between an index fund and active fund may not seem like a lot. After all, 0.56% of a $10,000 is only $56 but it adds up over time. For a $500,000 portfolio growing at 6% per year, paying an extra 0.56% in fees would cost you $421,938 over a period of 30 years. That’s quite an impact!
The Best, Most Cost-Effective Option
All of these reasons: diversification, lower fees, the difficulty of picking winners are why index funds are the right choice for most investors. These benefits have led to a rise in popularity of index funds. Where before you could only find funds that tracked the largest stock markets, today you can find an index fund for almost anything.
Index funds are the best investment options for most investors for their workplace retirement accounts, IRAs and Roth IRAs, and taxable brokerage accounts. They provide a low cost way to track the stock market and diversify your portfolio versus trying to pick individual stocks or active mutual funds that you think will beat the market.