Here’s Why You Should Invest in Index Funds

Investing Basics, Retirement & Investing
on January 9, 2015
Stock Investing: Why You Should Invest in Index Funds
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In this world of choices, it can be difficult to decide where to invest that hard-earned money. The interest rates of savings accounts are laughably low and the stock market can seem scary. But it doesn’t have to be that hard. What if Warren Buffett himself were to tell you there’s an easy and reliable way to make money in the stock market?

Here’s something you should know: Warren Buffett plans to put 90 percent of his estate in index funds. Index funds are highly accessible to even the most casual investor, and they’re probably a small investor’s best bet at making money in the stock market. Here’s why.

DIVERSIFICATION

Stock values go up and down all the time. This is what makes investing in stocks so interesting in the first place; you can profit by buying low and selling high. However, there’s a risk that you may actually end up buying high and selling low.

While the movements of individual stocks can be erratic and unpredictable, the movements of the market as a whole are relatively more stable. If one company’s stocks plummet, other stocks in the market may remain stable or gain value, softening the impact of that one company’s stocks on the market.

Following this logic, you can lower your risk by distributing your investment between many different companies’ stocks instead of just one or two companies. This is called diversification. In other words, diversification is about not putting all your eggs in one basket.

An index fund is a diversified stock portfolio that contains stocks from a large number of companies in order to replicate the movements of the market. For example, the popular S&P 500 index contains the stocks of 500 large companies. So when you invest in an S&P 500 index fund, your stock portfolio enjoys instant diversification and lowered risk.

LOW COST

If you haven’t heard of index funds before, it’s probably because banks tend to hide them at the bottom of their list of mutual funds. Banks don’t go out of their way to promote index funds because they don’t make the banks much money.

When you invest in a mutual fund, you have to pay a management fee to the people who make decisions for the fund. Some types of funds require the manager to make many active decisions, using up more resources in the process. An index fund, which simply mirrors the market instead of trying to beat the market, doesn’t take up too much of the fund manager’s time or effort.

If you take a close look at your bank’s mutual funds list, you’ll most likely see that the index funds have the lowest management fees.

 

LONG-TERM RESULTS

Okay, so index funds are cheap—surely that means they don’t perform very well, right? Not at all.

Managers of active funds do try to do better than the market, but they rarely succeed, despite the high fees investors pay them. Historically, about 80 percent of actively managed funds perform worse than the market.

While the stock market has its ups and downs, its value grows in the long term. Over the last 10 years, the S&P 500 index has grown by 7.84 percent per year on average. So why not pay less for an investment product that will likely perform better? Your banker certainly has an incentive for recommending actively managed funds to you, but you don’t have to take his advice.

LOW MAINTENANCE

Index funds perform well if you invest for the long term. Yes, there may be economic crises or market crashes in the next 10 or 20 years, but it’s best to let your investment in index funds weather through those events and recover on their own.

The stock market is more robust than people think; it has always bounced back after economic downturns. The best thing you can do as an index fund investor is to leave your investment alone.

People often don’t behave in a rational way when it comes to investing in the stock market. They know they have to buy low and sell high to make money. But in reality, when the market does well, they’re tempted to buy, even if the prices are high. And when the market crashes, they rush to sell, out of fear that prices will drop even further.

By passively investing in index funds, you can avoid succumbing to this kind of behavior. This is another great thing about index funds: they’re perfect for lazy investors.

Looking for more? Visit NomadWallet.com and follow along as Deia B. offers regular advice and resources spending, saving and investing wisely.

  • Great introductory article Deia. To learn more about index fund investing, I recommend this book from the founder of Vanguard Funds (USA) which is I believe the largest provider of index-based mutual funds. It is of course available on Amazon.com and other book shops.
    The Bogleheads’ Guide to Investing

    If you are investing for retirement in a 401K plan in the US for example, the availability of index funds choices is dependent upon your employer. However if you plan to open up an investment account to fund your future (like saving for a trip around the world or retiring abroad), you can decide between active and passive mutual funds. The Vanguard.com website also has informative videos and hosts webinars to help you make your own best decisions about your financial future.

    -Scott, VacationCounts – Take More Vacation Time Off

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