In this article I will write about what are known as “Index Funds”. I will write about what they are, how they work, and why I like the concept of them as an investment vehicle. Nothing in this article should be considered financial advice. For that you should contact a registered financial advisor.
You may have heard of a mutual fund before. A “fund” is similar to a stock. Individuals purchase shares or units of a fund and hold or trade them similar to how stocks are traded on the stock market. An index fund is a mutual fund which holds all of the stocks of a particular stock market index, for example the S&P 500. I will now explain why I think index funds are a great investment vehicle.
The great thing about owning an index fund is diversification. Let’s say, for example, you own shares of an S&P 500 index fund. You plan to hold these shares for 25 years. In 25 years it may be possible that no one uses Facebook anymore. That’s not necessarily a problem for your index fund portfolio. Facebook was only 1 of the 500 companies in your portfolio. New companies will join the S&P 500 in the coming decades and others will no longer be included in it. Some have called owning an S&P 500 index fund the “bet on America” strategy. This is in reference to Warren Buffett’s idea of betting on the future prosperity of America. When you own these kinds of index funds, you are betting that the American economy overall will improve in the future. This is less risky than owning individual stocks.
Another benefit of index funds is that they are an investment that you do not have to think about on a daily basis. They are meant to be held for long periods of time. These funds are not as volatile as individual stocks. The stock market as a whole never doubles in a year, but some individual stocks do. Also, the whole stock market never drops by 100% in a year, but some individual stocks do. Some people are easily enticed by the idea of quick gains. These are active traders who want to buy low and sell high at the right times. Unfortunately these traders often get burned and lose money. If you want to read more about this, please read my article on the investing philosophy of John C. Bogle.
Another great thing about the nature of index funds is that they are a good passive investment. Because the best gains from these assets come from simply holding them, there is really nothing you have to do after buying the index fund. All you have to do is wait. Unlike speculative stocks where traders constantly have to watch the price, as an index fund investor, you do not have to worry about that. Historically, the overall US stock market has continued to rise over time, but many individual companies have come and gone. With an index fund, you don’t need to worry if you have picked the right company to invest in or not. You are investing your money across the entire stock market.
One of the best parts about passively managed index funds is that they generally have very low fees associated with holding them. Some passively managed index funds may charge an annual management fee of around 0.07% of the money you have invested. Many “actively managed” mutual funds can charge you 2% or more per year just to manage your money. What do these actively manage funds invest in? Most of the same stocks you would invest in if you were buying an S&P500 index fund. However the supposed benefit of these actively managed mutual funds is that they have smart money managers who actively buy and sell at just the right times. They try to make you more money than you could if you just bought an index fund. They rarely succeed at this.
Active vs passive funds
Historically, as John C. Bogle has pointed out brilliantly in his books, actively managed mutual funds tend to rarely beat the passively managed index funds they compete with. Why make a money manager rich when you could simply invest in low cost index funds yourself. A money manager does not add any value to the companies that you invest in via their mutual funds, so why support them? That 2% a year they take from your principal investment really adds up over time.
I like the idea of a low fee index fund, and I am not alone. Warren Buffett has said that he plans to leave 90% of his wealth for his family in an S&P 500 index fund when he passes away. If this is how one of the greatest investors of our time wants to invest his money, do we as individual investors really think we can outsmart Buffett with our stock picks? I believe that over time, a low cost index fund is one of the safest and most surefire ways you can invest and get returns on your money without taking on a lot of risk. Talk to your financial advisor about index funds, but do not let them talk you into buying high fee “actively managed” mutual funds. These actively managed funds generally benefit the money managers more than the individual investors who buy them.
If you would like to listen to an in depth discussion on this style of investing, please listen to this interview with John C. Bogle.
Thank you for taking the time to read this blog. Have a great day.
©2020 Richard Gillespie