An index fund is simply a security that seeks to track 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. An index can be pretty much anything. The Dow Jones Index is an index made up of 30 companies picked by the Dow Jones company. The S&P 500 is an index made up of the 500 largest public companies in the US. The Russell 2000 is an index of 2000 smaller public companies in the US. 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 anything else that’s out there?
The Stock Market Generally Trends Up
Investing in stocks is seen as the best way for most people to invest for retirement because it offers the best possibility for the higher returns needed. Money invested in savings accounts will work hard just to beat inflation. 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 what date range you look at. Why has the stock market continued to climb? New ideas, new products, more productivity, more efficient ways of doing things, more people entering the workforce, more people entering the consumer pool, and on and on. Will the stock market continue to go up? I tend to think so, and of course we will continue to experience economic setbacks like in 1929, 1987, 2000 and 2008, but nothing in life is certain. I think Warren Buffett said it best in this quote from 2016:
“For 240 years it’s been a terrible mistake to bet against America, and now is no time to start. America’s golden goose of commerce and innovation will continue to lay more and larger eggs. America’s social security promises will be honored and perhaps made more generous. And, yes, America’s kids will live far better than their parents did.”
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 invest with them?
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 no doubt heard of some of the most famous investors like Warren Buffett or Benjamin Graham. 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 in their field.
The Benefits of Diversification
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 solution is to purchase a basket of different stocks like in an index fund. 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.
Active Funds vs Index Funds
Since there are smart people out there who know how to beat the market why don’t we pay them to beat the market for us? It turns out you can try to do this by buying “active” funds. These are mutual funds or ETFs made up of stocks that a manager chooses because he/she thinks they will do well and outperform the market. Just as with index funds there are many varieties to choose from as well. There are funds and managers that specialize in certain countries or certain industries or types of companies and on and on. 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. According to their year-end 2017 report over 80% of US Equity funds did worse than the market. Source: https://www.aei.org/publication/more-evidence-that-its-very-hard-to-beat-the-market-over-time-95-of-financial-professionals-cant-do-it/
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? The answer comes down to the one thing that we can control in the situation. Cost.
It Turns Out You Don’t Get What You Pay For
When comparing an index fund that seeks to track the S&P 500 (the largest 500 US companies, remember) and an active fund that seeks to select the best performing large US companies, we cannot predict which one will come out on top. We can look at the past performance of both funds and see which has done better over the past 3, 5, or 10 years. But as we discussed above, that gives us no indication of how they will do in the future.
The one thing we can contrast between the two and be certain of is their respective costs. With the index fund there is a cost associated with bundling the basket of stocks together and selling you a slice. An active fund has additional costs for the fund manager, research and more. Because you don’t have to pay the additional “active” costs with an index fund it will typically be the cheaper option.
The average expense ratio for an active equity fund in 2018 was 0.76% and the average for an index equity fund was 0.20%. source: https://www.napa-net.org/news-info/daily-news/mutual-fund-expense-ratios-continue-descent
That 0.56% difference in fees between an index and active fund may not seem like a lot, but it definitely adds up over time. On a $500,000 portfolio earning 6% annually, by paying an extra 0.56% in fees you would lose out on additional $421,938 over a period of 30 years. Looking at it this way you can understand how much of an effect fund fees have on your portfolio’s performance.
Cheaper than the Alternative and Just as Good
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 whereas before you could only find funds that tracked the largest stock markets, today you can find an index fund for almost anything.If you are interested in learning more about how to put together a portfolio of index funds that is right for you, I recommend talking to a fee-only financial planner. They can take the time to understand your goals and time horizon and put together a financial plan that fits your situation. And if you would like to speak to us at Steady Climb Financial Planning reach out today, we have open availability to take on new clients.