Why are index funds such a popular investing option?
Investing in index funds has long been considered one of the smartest investment moves you can make. Index funds are affordable, enable diversification, and tend to generate attractive returns over time. Historically, index funds outperform other types of funds that are actively managed by top investment firms.
Index funds are a popular choice for investors seeking a low-cost, diversified, and passive investment strategy. They are designed to replicate the performance of financial market indexes, like the S&P 500, and are ideal for long-term investing, such as in retirement accounts.
The growth of indexing has been driven by the inability of active managers, in aggregate, to outperform passive benchmarks. This is not a new development — it was first reported 90 years ago. The rise of passive management is the consequence of active performance shortfalls. — the skewness of stock returns.
Individual stocks may rise and fall, but indexes tend to rise over time. With index funds, you won't get bull returns during a bear market. But you won't lose cash in a single investment that sinks as the market turns skyward, either. And the S&P 500 has posted an average annual return of nearly 10% since 1928.
Benefits of investing in index funds
Since an index fund mimics its underlying benchmark, there is no need for an efficient team of research analysts to help fund managers pick the right stocks. Also, there is no active trading of stocks. All these factors lead to low managing cost of an index fund.
Index investing was introduced to the public with mutual funds in the 1970s. The strategy got a big boost in the 1990s with the rise of exchange-traded funds (ETFs), which can be bought and sold like shares of stock.
An S&P 500 index fund essentially lets investors diversify capital across many of the most influential companies in the world. Warren Buffett sees that diversity as a compelling reason to invest. He once described the S&P 500 as a "cross-section of businesses that in aggregate are bound to do well."
Index funds seek market-average returns, while active mutual funds try to outperform the market. Active mutual funds typically have higher fees than index funds. Index fund performance is relatively predictable; active mutual fund performance tends to be less so.
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
One of the main reasons is that some investors believe they can outperform the market by actively selecting individual stocks or actively managed funds. While this is possible, it is not easy, and many studies have shown that the majority of active investors fail to beat the market consistently over the long term.
Do billionaires invest in index funds?
Even the top investors put their money in index funds.
In fact, a number of billionaire investors count S&P 500 index funds among their top holdings. Among those are Buffett's Berkshire Hathaway, Dalio's Bridgewater, and Griffin's Citadel.
While indexes may be low cost and diversified, they prevent seizing opportunities elsewhere. Moreover, indexes do not provide protection from market corrections and crashes when an investor has a lot of exposure to stock index funds.
If you're new to investing, you can absolutely start off by buying index funds alone as you learn more about how to choose the right stocks. But as your knowledge grows, you may want to branch out and add different companies to your portfolio that you feel align well with your personal risk tolerance and goals.
At least once a year, funds must pass on any net gains they've realized. As a fund shareholder, you could be on the hook for taxes on gains even if you haven't sold any of your shares.
A primary benefit of index funds is their low cost. But when it comes to safety, index funds can be risky, safe, or anywhere in between. The particular index fund you choose determines how risky it is, and index funds are not substantially safer (or riskier) than actively managed funds.
Index funds offer lower fees and tax efficiency. Due to their passive nature, they often perform in line with market benchmarks, making them suitable for investors seeking broad market exposure at lower costs. On the other hand, active mutual funds aim to outperform the market by employing active management strategies.
But by examining historical data, we can make an educated guess. According to Standard and Poor's, the average annualized return of the S&P index, which later became the S&P 500, from 1926 to 2020 was 10%. 1 At 10%, you could double your initial investment every seven years (72 divided by 10).
The important thing to remember about index funds is that they should be long-term holds. This means that a short-term recession should not affect your investments.
The average stock market return is about 10% per year, as measured by the S&P 500 index, but that 10% average rate is reduced by inflation. Investors can expect to lose purchasing power of 2% to 3% every year due to inflation.
Warren Buffett recommends an S&P 500 index fund
That strategy spreads capital across many of the most influential businesses in the world -- companies Buffett says "are bound to do well" in aggregate over time -- and it requires almost no work.
What is the 90 10 rule in investing?
Warren Buffet's 2013 letter explains the 90/10 rule—put 90% of assets in S&P 500 index funds and the other 10% in short-term government bonds.
|Number of Shares Owned
|Value of Stake
|Bank of America (NYSE:BAC)
|American Express (NYSE:AXP)
It might actually lead to unwanted losses. Investors that only invest in the S&P 500 leave themselves exposed to numerous pitfalls: Investing only in the S&P 500 does not provide the broad diversification that minimizes risk. Economic downturns and bear markets can still deliver large losses.
Much of it, yes, but not entirely. In a broad-based sell-off of a market, the benchmark index will lose value accordingly. That means an index fund tied to the benchmark will also lose value.
Rowe Price U.S. Equity Research fund (ticker: PRCOX) is in this exclusive club, having bested—along with a team of about 30 research analysts—the S&P 500 index for the past five years on an annualized basis. U.S. Equity Research is a Morningstar five-star gold-medal fund.