6 Reasons to Investing in Index Funds

If you sift through enough personal finance books on investing, you’ll eventually realize that the best course of action for the vast majority of people is to invest in low-cost, diversified index funds. While this form of investing may not be as exciting as trying to pick individual stocks that could turn into lottery winners, it is the best way to invest your money and receive good returns over the long term.

This isn’t just conjecture or opinion, though. There are many reasons that index funds outperform actively managed mutual funds and your colleague who is telling you about the most recent tech stocks that they believer are going through the roof. Let’s talk about 6 of the reasons that index funds are the way to go when it comes to investing for retirement.

1. Better Performance

The first place many people begin to invest their money is in a 401K or 403B offered by their employer.  These funds usually consist of a few different options, including Target Date Funds (discussed below), actively managed mutual funds, and index funds. When it comes to mutual funds versus index funds, a simple way to break this down is to know that most mutual funds in these accounts are actively managed while index funds are passively managed.

An index fund buys every stock in a specific index and aims 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. This is why it is called “passive” investing. The fund simply follows the index. It is not trying to pick “winners” or “losers.”

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 a >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 me.

2. Diversification

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 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, made famous by Bogleheads.  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 index 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 around 1%.  For the same $10,000 this will cost you around $100.

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 $100 (and often less than $5) to invest $100,000 in an index fund while the actively managed mutual fund with an expense ratio of 1% would cost you $1,000. The larger the investment, the more profound the difference becomes.

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. A lot more. Over a 30-year investing period, this could be a seven-figure difference in your account total when you get to retirement.

As crazy as that sounds, people still buy actively managed funds usually do to anecdotal evidence that they’ve made investments that beat the market. However, this fails to realize that just because you beat it one year (or even five years) doesn’t mean you will continue to do so. The SPIVA scorecard mentioned above shows that.

4. Set it and Forget It

A low-cost, diversified index fund portfolio needs to be rebalanced. There are multiple ways to do this, but the simplest is to simply rebalance once each year. There is a really important reason for why this is helpful. It is called myopic loss aversion.

Myopic loss aversion – a term created by Thaler, Khanamen, and Tversky – is the psychological phenomenon where people pay more attention to their investments, are more likely to see it go down, and then are more likely to sell their assets in a down market. This is a big financial mistake. Said differently, the less often you look at your portfolio, the more likely you are to do well over the long term.

You want to be able to set it and forget it when it comes to investing.

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 was said above about the inability of hedge fund managers (who are paid to pick winning stocks) to beat the market… what makes you think you could do any better picking stocks on the side?

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. This is the best way to avoid myopic loss aversion. 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.

Jack Bogle – the founder of Vanguard – once said that staying the course is the most important part of investing.

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 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.

Take Home

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!