Should You Invest in Index Funds?
Here, our friend Matt Becker, fee-only financial planner and founder of MomandDadMoney.com, breaks down everything you’d want to know about index fund investing and more. While index fund investing is considered a great place to start for beginners, it’s also a favorite of many seasoned investors, including Warren Buffet. The post is long enough to be considered a mini-ebook, but it’s well worth the read.
- It works better than just about everything else, and it’s easier than just about everything else.
Hard to beat that combo.
Index investing is the approach I use myself and it’s the approach I recommend whenever someone asks me for advice. It lies at the heart of pretty much everything I believe about investing. And today I want to give you a complete view of WHY it works so well and HOW you can get started with it.
We’re going to cover a lot of territory here, so pour your beverage of choice, grab a snack or two and make yourself comfortable.
Just a heads up: there’s a decent amount of background before I actually get into the reasons why I like index investing so much. The reason for the background is to highlight WHAT matters in investing so that it’s easier to understand WHY index investing works.
Here’s what we’ll cover:
- What are index funds?
- Some investing basics (the important things to know)
- Why index investing?
- Two variations on index investing (and the one I like better)
- Arguments against index investing
- Steps you can take to get started
What are index funds?
At its core, index investing is simply an investment strategy that makes use of index funds. So what’s an index fund? Well, I’m glad you asked!
First, index funds are just a type of mutual fund. And a mutual fund is simply a collection of investments (stocks, bonds, real estate, etc.) that you can buy as a package deal. If you’d like a little more detail, you can read this.
Second, an index fund is a mutual fund that tracks an index. An index is simply a representation of a part of a market (e.g. the stock market, bond market, real estate market, etc.). For example, one of the most well-known indexes is the S&P 500, which tracks the stocks of the 500 largest US companies. But there are many different indexes that track many different parts of many different markets.
Finally, index funds stand in contrast to actively managed funds. With an actively managed fund, there’s a manager who’s paid to try and pick the best investments to include in the mutual fund. The manager’s goal is to use his or her skill to generate a better return than you could find elsewhere. But an index fund doesn’t try to pick the best investments. Its sole goal is to mimic the return of the part of the market it is supposed to track. This is why these funds are often labeled as “passive”.
Some investing basics (the important things to know)
Before I can answer the question of WHY index investing works so well, we need to step back a little bit and understand WHAT matters in investing. So, here we go!
WHERE DO INVESTMENT RETURNS COME FROM?
When you invest, you’re doing it because you expect some kind of return, right? Well, if that’s the goal then it’s probably important to understand where that return will come from, so that you can create a strategy designed to actually capture some of it.
If you’d like to read some detail on this, you can check out this paper here. But I’ll break this down pretty simply.
Over 90% of your investment return will be determined by two factors alone:
- What the markets do as a whole, and
- The amount of money you have in those markets (i.e. your “asset allocation”, which we’ll talk about below).
Only 10% of your return is determined by the specific investments you choose.
What this really means is that the types of things you decide to invest in (e.g. stocks) matter a lot more than the specific investments you make (e.g. the specific stocks you pick). That is, if you have your money in ANY stocks, no matter which stocks they are, the return you get from those stocks will almost entirely depend on how the stock market as a whole performs. Your specific choices are only a minor factor.
WHAT IS INVESTMENT RISK AND HOW IS IT RELATED TO RETURNS?
A big part of investing is managing the level of risk you want to take on. But “risk” is kind of a strange word in the investment world.
When an investment is labeled as “risky”, what that really means is that there’s uncertainty about the return you’ll get from it.
As an example, stocks are deemed to be “risky” because you can never be sure what you’ll get from them. Some years they’re up huge. Other years they’re down big. There’s a lot of uncertainty involved.
At the other end of the spectrum is a savings account. Yes, interest rates change over time. But basically you know exactly what will be in your account from day to day. That’s as certain as it gets.
And there are two big points to understand here.
First, if you want a strategy with higher expected returns, you have to accept a higher level of risk (i.e. a lower level of certainty). If someone is telling you about a way to get higher returns for less risk, then they’re selling you something that doesn’t exist (unless they’re talking about diversification, which I’ll get to below). I tell you this because there are a lot of salesmen who will try to convince you otherwise. Don’t be tempted.
But the other big point that’s often overlooked is that certainty brings its own set of risks. This is why I say that the word “risk” is strange when it’s used in the context of investing. Going back to our savings account example, while you can be certain of your balance from day to day, you’re also running the very high risk that the value of your money will be lost to inflation. Over short time periods this isn’t a big deal. But over long periods of time it matters a lot. This is the biggest reason why people suggest that long-term investors put their money into “riskier” investments. It’s because there’s actually risk on both ends of the spectrum.
So, the two big takeaways here are these:
- If you want the possibility of higher returns, you have to accept more uncertainty about whether you’ll get them. There’s really no way around it.
- Over the long-term, there actually IS risk involved with even “low risk” investments. Yes, it’s confusing. But it’s true.
THE IMPORTANCE OF ASSET ALLOCATION
For example, one person might have an asset allocation of 50% stocks and 50% bonds. Another person might be 60% stocks, 30% bonds and 10% real estate. There are an infinite number of ways to do it, but in the end it simply describes at a high level what types of things you’re investing in.
And your asset allocation is the single biggest investment decision you’ll make for two reasons:
First, remember we said above that your asset allocation is one of the two factors that determine over 90% of your investment return. The other is the return of the markets as a whole, which you can’t control. But you CAN control your asset allocation. So simply by deciding on an asset allocation, you’ve done 90% of the work of determining what returns you’ll get. Pretty sweet!
Second, your asset allocation is the primary way in which you can control the risk level of your investment strategy, and therefore the expected return. The more money you put into “riskier” investments, the higher return you can expect but the more uncertainty you’ll have.
Basically, your asset allocation is one of the few factors that is BOTH directly under your control AND has a significant impact on the returns you end up getting. Makes sense to focus on it.
THE IMPORTANCE OF COST
Costs matter in investing. A lot.
I’m not going to get into a ton of detail here. You can read this article I wrote if you want the nitty gritty.
But the topic can be summed up with two simple points:
- Cost is the single best predictor of future investment returns.
- Lower costs predict better returns.
You better have a VERY good reason to pay more for an investment than you could pay elsewhere. Keeping your costs low is one of the single most powerful things you can do to improve your returns.
THE IMPORTANCE OF DIVERSIFICATION
Diversification is simply the process of spreading your money across a lot of different types of investments.
For example, instead of putting all of your money into just a few stocks, you spread it across a lot of them. Or instead of investing only in stocks, you also invest in bonds.
Diversification matters because it’s the ONE way in which you can decrease your risk without decreasing your expected return. It gives you something for nothing. This is why it’s often referred to as the one free lunch in investing.
The logic is pretty simple. If you only own a few stocks, then your return is highly dependent on the performance of those few stocks. But if you own the stocks of thousands of companies, then no single company can have too big an impact on your returns. You can expect the same level of return, but without the risk that one bad choice can ruin your portfolio. And in case you’re wondering, yes there’s plenty of math backing up the logic.
Unless you’re Warren Buffett, you should be using diversification to your advantage.
So, why index investing?
Whew! That was a lot of background info. Thanks for sticking with me.
But now that we’re armed with all of that information about the things that actually matter in investing, we’re ready to answer the question of WHY index investing is such a good strategy.
Let’s get to it!
ACTIVE INVESTING DOESN’T WORK
Remember above we said that 90% of your returns will come from just two factors: the returns of the overall markets and the amount of money you put into those markets (your asset allocation).
That still leaves 10% of your return that will come from your specific investment choices. Or in other words, your active management.
But here’s the problem with that 10%: all of the data we have says that even the experts are bad at picking investments. You can read more detail about it here, but the research can basically be summed up in two points:
- Year after year, across all different markets and sub-markets, the majority of professional investors UNDERPERFORM the index they’re measured against.
- The professionals who outperform over one time period are less likely than chance to outperform again over the next time period. This makes it almost impossible to tell which professionals are actually good and which are just lucky.
That has two big implications for you as an individual investor:
- Attempts to beat the market are much more likely to fail than to succeed, and
- If you want the fully capture the return of a given market, finding a way to mimic that market as closely as possible is going to be the most efficient way to do it (since that would remove all active management, which again is more likely to be harmful than anything else).
Which brings us to…
INDEX FUNDS MIMIC THE MARKET
If you want to mimic a market, an index fund is going to be the best way to do it. After all, that’s exactly what they’re designed to do.
A good, low-cost index fund will come as close as possible to giving you the full return of whatever market you want to invest in.
INDEX FUNDS MAINTAIN A CONSISTENT STYLE
We said above that your asset allocation is one of the most important decisions you’ll make. What that means in real life is that your first decision will likely be the asset allocation you want, and your next decision will be the specific mutual funds that get you to that allocation. Which means that you’ll need to know exactly what each mutual fund you choose actually invests in. Otherwise, it would be pretty difficult to actually match the asset allocation you want.
One of the really nice things about an index fund is that you KNOW what it’s going to invest in. An index fund tracking the US stock market isn’t suddenly going to start including international stocks as well. If an index fund fits your asset allocation when you choose it, it’s going to continue to fit your asset allocation unless YOU decide you want something different.
On the other hand, one problem with actively managed funds is that the manager might start out investing one way but eventually start investing in a different way. And if he or she changes course, your asset allocation might suddenly be thrown off track. Which means you’ll be left figuring out what adjustments you have to make to get things back in line, which might involve choosing new investments and selling some of your old ones. Not only could all of that be a huge hassle, but actually making those trades could cost you a lot of money (in the form of taxes and trading fees).
The consistency of an index fund makes your job a lot easier and potentially saves you a lot of money.
INDEX FUNDS MAKE DIVERSIFICATION EASY
If you own an index fund that mimics the entire stock market, you’re diversified within stocks. If you add another on that mimics the entire bond market, now you’re diversified within bonds too. And you’re also diversified across two different markets. See how easy that was!
Now I will say that a lot of actively managed funds are diversified as well. For example, most actively managed stock funds hold enough stocks that they aren’t too sensitive to the downfalls of any particular company. BUT there are a few reasons why this is less beneficial with an active fund than an index fund:
- Active funds usually cost more (see the next point), so the diversification doesn’t come as cheap.
- Active funds have less consistency (see above), so you can’t always be sure that you’ll have the same level of diversification from one year to the next.
- If you REALLY wanted to pay someone for their stock-picking skill, you would actually want them to be UN-diversified. You’d want them to put most of their money into their best ideas, because if they were truly skilled then that would be the best way to get the highest returns. Warren Buffett explains this really well here:
So if you want the free lunch of diversification, index funds are the best way to get it.
INDEX FUNDS ARE LOW COST (AT LEAST THE GOOD ONES ARE)
There are some bad, high-cost index funds out there. You need to watch out for them.
But the best index funds are extremely low cost. And it makes sense, because they’re not paying anyone to try and beat the market. It’s simply easier and less costly to mimic the market than to try and beat it.
And since cost is the single best predictor of future returns, this is a pretty big argument in favor of index investing.
IT’S EASIER TO KNOW A GOOD INDEX FUND FROM A BAD ONE
A good index fund is simply one that tracks its market well. Basically, you want the fund to deliver the full return of its index, less any fees.
As an example, let’s say that the stock market as a whole returns 10% for the year, and you’re looking at an index fund that costs 0.2% per year to own. In an ideal world, the return for that index fund would be 9.8% for the year. You got the 10% return of the stock market, less the 0.2% fee.
If the index fund’s actual return was significantly higher or lower than 9.8%, you might start to wonder whether it’s actually doing a good job of tracking its index. If not, then it’s probably not a good fund to own because you can’t be exactly sure of what you’re getting.
The point here is that it’s a pretty simple process to determine whether an index fund is “good”. It will largely come down to cost, as a lower cost index fund will naturally be able to give you more of the total return than a higher cost index fund tracking the same index. But regardless, it’s just a matter of looking at the numbers.
This is in direct contrast to actively managed funds. While there are definitely good funds and good managers out there, there’s almost no way to know whether you’ve picked one of the few good ones or one of the many bad ones. Like we said above, you’re better off flipping a coin when trying to pick an active fund than you are looking at past performance.
I would much rather be able to know for sure that I’ve picked a good fund.
INDEX INVESTING ACTUALLY WORKS
All of the factors above are important, but none of them would matter if we couldn’t show that index investing actually works in real life.
The data at the very top of this section shows that active managers lose to the indexes. But the problem with that research is that no one can actually invest directly in an index. They have to invest in an actual fund that tracks the index. So while it shows us that active investing doesn’t work well, it doesn’t show us that the alternative DOES.
Luckily, we have some research that solves that problem.
You can read the details here, but in 2013 Rick Ferri and Alex Benke showed that someone who had invested in just a few simple, real life index funds over the past 16 years would have gotten better returns than over 80% of other investors. And in some cases better than 90%.
This research was incredibly important because it showed that index investing was more than just a theory. It was something that could actually be applied in real life by real people to get better results with less effort.
Hard to argue with that.
IT’S SIMPLY EASIER
The big “downside” of index investing, if you could even call it that, is that you remove the possibility of crazy high investment returns. You can’t get returns like Warren Buffett investing in index funds.
BUT, if you pick a solid index investment strategy and stick with it, you will guarantee yourself two things:
- You WILL get market returns. Over the past 100+ years, those returns have been really good. There’s really no NEED to do better.
- You will get them with minimal effort. Most of those people who lose to index funds in the studies I talked about above? They spend a lot of time and effort trying to do better. And they fail. Why would you put all of that effort into something that’s likely to fail when there’s an alternative that’s not only better but easier? Really. Why?
Two variations on index investing (and the one I like better)
People love to tinker, and over the years we’ve come up with different ways to actually implement an index investing strategy. Now there are two basic approaches, both of which can be done well. In this section I just want to briefly describe the two approaches and explain why I personally like one better.
The most basic type is what I’ll call “total market” index investing. Basically, if you want to invest in US stocks, you’d pick an index fund that represents the entire US stock market. Same for bonds, international stocks, real estate, and anything else you might choose to invest in.
The alternative is commonly called a “slice and dice” approach. There are a million different ways to do it, but basically it’s an effort to split each market up into different sub-markets, each with different risk/return expectations, and to invest in those sub-markets instead of the whole thing. A simple example would be splitting US stocks in big, medium and small companies.
When it’s done right, there is some really good evidence behind certain slice and dice approaches and I would never argue with someone who wanted to go that route. But when it’s done wrong, it really just becomes another form of active investing where people are trying to guess which part of the market will do best.
Personally, I prefer a total market approach for a few reasons:
- It’s easier for people to understand, which means they’re more likely to stick with it. If you think that’s a silly reason, just read this (one of my all-time favorites): Why Your Problem Is Not Your Funds.
- It’s simpler to implement and maintain and it still gets great results. Might there be something “better”? Maybe, maybe not. But do you really need something better to reach your goals? And if not, why introduce unnecessary complexity?
- The more you “slice and dice”, the less sure you can be of getting market returns. In other words, you’re introducing more uncertainty than what already naturally exists in the markets.
What are the arguments against index investing?
There are plenty of people who will argue that index investing is the wrong approach. Here are some of the most common arguments I’ve heard against index investing, and my response to each of them.
INDEX INVESTING IS LAZY
Actually, there is a TON of academic research backing it up. A lot of really smart people have spent a lot of time and energy studying this stuff and found index investing to be incredibly successful.
If it’s lazy to take all of the best objective research we have and apply it in a way that gets top-notch results with minimal effort, well then I guess I misunderstand the definition of the word.
INDEX INVESTING WILL ONLY GET YOU “AVERAGE” RETURNS
I hear people always say things like “well sure, if you just want average returns then index investing is okay I guess.”
My answer: The research shows that index investing beats active investing over 80% of the time. Winning 80% of the time is not average.
BUT THE MARKET LOOKS X RIGHT NOW. I REALLY THINK YOU SHOULD DO Y!
Everyone’s got an opinion about what the market’s about to do. And a lot of those opinions can sound really convincing. Sometimes, it can honestly be hard to argue with the logic.
But here’s the thing. What evidence do you have that the person giving you this opinion has consistently been right? Do you know about all of their opinions, including the ones that didn’t work out? Are you able to track how they’ve performed over time? Is their opinion founded on decades of research that’s also been proven in the real world?
Anyone can have an opinion, and some people are really good at making them sound very convincing. But again, the cold hard numbers we actually have say that those opinions aren’t likely to be worth much.
THIS GUY HAS A GREAT TRACK RECORD!
It’s very tempting to trust your money with the guy who’s had a great last couple of years. But the data shows that past performance is less useful than a coin flip in predicting future performance. What someone has done in the past has very little bearing on what they’ll do going forward.
I LIKE TO BE MORE IN CONTROL OF MY MONEY
A lot of people say they pick their own stocks because they like to be in control of their money. They say that no one has more interest in your money than you do, so why not take charge and pick your own investments?
Honestly, I get that sentiment. But I would look again at the data showing just how bad even the experts are at beating the market. If you really want to try, by all means give it a shot. Just go in with your eyes wide open to the probabilities.
NOT ALL INDEX FUNDS ARE GOOD
This one is actually true. There are plenty of bad index funds. Whether they’re high cost, track too small a market, or whatever, the fact that something is an index fund doesn’t make it good.
But the catch here is that it’s pretty easy to identify a good index fund. So no, please don’t blindly go around picking index funds. There are plenty of bad apples out there. But since the good apples are pretty easy to find, the fact that bad ones exist doesn’t mean the strategy itself is faulty.
INDEX INVESTING IS BORING
I actually have no rebuttal for this one. It is pretty boring. But are you investing because you want excitement or because you want results? I know my answer.
Still on the fence?
The most important thing you can do is find a strategy you believe in and stick with it, whatever that strategy is.
But before you decide to choose any investment strategy, ask yourself one simple question:
How confident am I that this strategy is good enough to get me to my goals?
One of the biggest reasons I like index investing is because I know it works. It probably won’t end up being the “best” out of everything I could have done, but if I stick with it then it will almost definitely be good enough to get me to my goals.
I haven’t found anything yet that gives me the same odds.
How you can get started with index investing
Here are some simple ways you can get started.
Quick note: For in-depth, step-by-step guidance on creating your personal investing plan, check out my book: Smart Investing for Your 20s and 30s.
CHOOSE AN ASSET ALLOCATION
First, know this: while your asset allocation is important, it’s not something you should agonize over TOO much. It’s an imprecise science, and there’s no such thing as finding the “perfect” asset allocation. It’s really a matter of finding something “good enough” and sticking with it.
The biggest decision you’ll make is how much of your money to put into stocks. A very basic rule of thumb is to make sure you’re comfortable losing 50% of the money you have in stocks in any given year without bailing on your plan. So if you put 70% of your money into the stock market, you shouldn’t be surprised if in any given year your investments drop by 35%.
Beyond that, just keep things simple. A good way start is to focus only on US stocks, international stocks and US bonds. Only branch out from there if you have a good reason to do so.
If you want some examples of different asset allocations you could try, check out this resource from bogleheads.org.
FIND SOME GOOD FUNDS
Once you’ve got your asset allocation, you should try to find one good index fund to represent each piece of your strategy. That link above from bogleheads.org includes some good fund recommendations as well.
The first place you’ll probably want to look is your 401(k), especially if your employer is matching some of your contribution. Hopefully it has at least one good index fund, but even if not you’ll still want to put at least enough money in there to get the full match.
Beyond that, my default advice is always to start with Vanguard. They basically invented index investing and they’re still crushing it. I use them personally for all of my investments.
If you’re looking at established companies (like the ones mentioned here), just make sure that you’re not paying a lot more for one fund than you could pay elsewhere.
Just get started! More than anything, simply starting those contributions is the most important thing you can do. If you need some help or encouragement, here are two articles for you:
And oh yeah, don’t forget to put those contributions on auto-pilot. That tip alone will do more to grow your investments than just about anything else.
REBALANCE FROM TIME TO TIME
You picked your asset allocation for a reason, right? It represents the level of risk and return you want from your investments.
Well, over time the natural market movements will cause your investments to shift away from that asset allocation. As an example, a good year for stocks can cause your portfolio to become overly weighted to stocks, simply because they’ve returned more than the other parts.
Which means that if you want to keep your strategy on track, you’ll have to do a little maintenance from time to time. This is called “rebalancing”, and you can read more about it here.
STAY CONSISTENT. DON’T REACT TO THE MARKETS
The hardest thing to do in investing is stay consistent with your strategy. Whether the economy is up or down, there will ALWAYS be another strategy you hear about that sounds tempting.
I can’t possibly stress how important it is to pick a strategy and just stick with it. The investors who have success are the ones who do the same things over and over again, without fail. They don’t jump from fad to fad. Constantly changing your approach is a surefire way to disappointment.
This is hard. It really is. But you have to do it if you want to do well. Here are a couple of articles to help encourage you:
CAN YOU DO ALL THIS WITH A SINGLE FUND?
Why yes. Yes you can!
Two good examples are Vanguard’s Target Retirement funds (which you can use for any purpose, not just retirement) and their LifeStrategy funds, though again plenty of other companies have their own versions. In both cases they’re “funds of funds”, which just means that they’re mutual funds that are actually a collection of other mutual funds. You could choose one of those funds and have instant diversification across both US and international stocks and US and international bonds.
But you do need to be careful here because not all companies that offer these “funds of funds” have your best interests at heart. You need to be especially wary of fees, as some of them will charge you for the underlying funds IN ADDITION to the fund itself.
But if you can find one that’s low-cost and fits your investment style, this can be a really good option.
WHAT ABOUT ETF’S?
ETFs are very similar to index funds, but have some slight differences. Rather than getting into them here, I’ll simply point you to this article that does a good job of summarizing them: How to Choose an Exchange-Traded Fund (ETF).
What I will say is that pretty much everything I’ve said here about index funds applies to ETFs as well. So if you would rather build your portfolio using ETFs, the information here will still be a good guide.
AN EXAMPLE: MY PERSONAL PLAN
If you’d like to see an example of how someone thinks through an investment strategy and puts it into place, you can read all about my personal investment plan right here.
Please know that this isn’t meant to be advice for how YOU should invest. You’ll have to take your own situation and preferences into account when making your own strategy. My only hope is that it will be helpful to see how someone else went through the thought process.
What are your thoughts?
I’m a big fan of index investing mostly because it works. Plain and simple. The fact that it’s ALSO easy to implement is really just an added bonus.
But what about you? Have you had any experience with index investing, positive or negative? Do you have a different strategy you like better? If so, why? I’d love to hear your thoughts in the comments below.
If you found this article helpful, please Like, Tweet and share!
This article originally appeared (with the title “The Beginner’s Guide to Index Investing”) at MomandDadMoney.com. Reprinted with permission.
Matt Becker is a fee-only financial planner, founder of MomandDadMoney.com and author of the free ebook, The New Family Financial Road Map. You can connect with him at his blog, Mom and Dad Money, or on Twitter @MomandDadMoney.