benefits of index funds

The Benefits and Risks of Investing in Index Funds

Erik Financial Education, Markets, Thoughts of a Mastermind 14 Comments

THIS POST MAY CONTAIN PAID AND/OR AFFILIATE LINKS.

Disclaimer: I’m not a licensed investment professional. All investments come with risk. Please do your own due diligence before investing in any product and investing in index funds.

“V-T-S-A-X, V-T-S-A-X, V-T-S-A-X!”

If investing had rallies, I’d imagine Vanguard nation members would have be chanting about VTSAX, an extremely low fee index fund.

What is index fund investing, and why is it so great? Simply put, index funds allow you to own thousands of positions and capture the general stock market trends at an extremely low cost. I like index funds for these reasons: they are supposedly lower risk because they are highly diversified, and the fees are nearly 0. Comparing this to actively managed funds with fees of 1-2% or more, you get much more bang for your buck!

Investors and traders ask many of the following questions each year: what stock do you think will perform best this year? Is there a sector that will see success in the next 2-3 years? What companies’ have the best outlook?

For the everyday person, many of these questions are not worth asking, or answering. I personally own thousands of companies, and I never think about those questions. With so little time to devote to financial statements and investment research, it’s just not worth looking for the next Amazon or Apple.

How do I own thousands of companies? It’s quite simple! Index funds!

In this post, I will be sharing with you the benefits and risks of index fund investing, why I own thousands of companies through index fund investing, and how you can own thousands of companies too. I’m also going to touch on why index fund investing works, and the problem with passive index fund investing.

What are Index Funds and the Benefits of Index Fund Investing?

What are index funds?

Index funds are essentially a collection of assets which, as a whole, look to replicate the performance of some market or sector.

For example, a stock market index fund would be a collection of many stocks, such that the performance of the index fund would mirror the performance of the general market.

There are many index funds you can buy through different brokerage accounts. To give you a better idea of some examples of index funds, looking at my 401(k) account, I have access to the following index funds:

  • General Equity Market Index Fund
  • Large Cap Index Fund
  • Small Cap Index Fund
  • Dividend Index Fund
  • Bond Index Fund
  • International Equity Index Fund
  • And the list goes on and on

There are hundreds of funds out there for many different sectors, asset classes, and industries.

What are the Benefits of Index Fund Investing?

“A very low-cost index is going to beat a majority of the amateur-managed money or professionally-managed money.” – Warren Buffet

Warren Buffett, John Bogle and many of the other great investors believe investors like us should invest in index funds. There are a few benefits to index fund investing vs. investing in individual securities.

One such benefit of index funds is diversification. It’s unfortunate, but it’s a fact that some companies will fail. It’s also a fact that some companies will outperform others. Humans don’t have crystal balls, and to be able to select which ones will fail and which ones will perform well is nearly impossible.

Instead, with index funds, we can own a piece of many companies, and if some fail, it is fine because others are likely doing well and can help make up for that difference – meaning we will also own the winners! On average, we will be able to replicate the general market.

Over time, the stock market typically has trended up, and as a result, index funds allow us to able to capture a piece of this trend.

Another benefit of index fund investing is a combination of lower fees and out-performance when compared to actively managed funds. Vanguard’s equity index funds average a 0.12% expense ratio vs. 0.62% for actively managed funds. In addition, these index funds have outperformed actively managed funds for many years!

Why pay more for less? Index funds are superior when considering fees and performance over time. In addition, if done passively (i.e. set and forget), your taxes and transaction fees are greatly reduced.

Why does Index Fund Investing work?

In the previous section, we talked about the benefits of index fund investing. Those reasons are contributing, but not exactly why index fund investing works.

Index fund investing works because the market is supposedly “efficient”.

The Efficient Market Hypothesis is a fundamental concept in portfolio management theory, and simply states the prices in the market reflect all information out there on a company. It’s a hypothesis, though it makes sense. (I don’t know if I’m completely on board with it, but that’s a discussion for another day.)

Under this theory, how does the market stay efficient?

Theoretically, active investors are constantly looking to determine if the price of assets is in line with expectations or not, and should be buying or selling to “close the gap” between the price and supposed expectation.

Index fund investing works because it follows the stock market trends, and also takes advantage of these active investors who are doing the heavy lifting of price discovery.

How You Can Own Thousands of Companies

I don’t have time to research the entire market for the best companies and stocks, and even if I did, my predictions would most likely be wrong.

I’m guessing you don’t have time to research and look over financial statements. If you are looking to invest passively, take a look at index funds.

With minimal fees, and the ability to own thousands of companies, properties, and bonds, you can capture the general trend of the market and reduce risk through diversification.

This may sound like a boring strategy to wealth, but it’s a time tested winning strategy for financial success.

Index funds are not exclusive to only high net worth individuals. Beginners and experienced investors alike can invest in index funds with little involvement and effort up front.

To own thousands of companies and get invested in the general market all that is required is to open up a brokerage account, do your due diligence and figure out which index fund is appropriate for your risk tolerance and financial situation, and boom! You’re invested!

Many people like Vanguard index funds. I know many personal finance bloggers who swear by these funds and will always invest in them!

Set and forget! Stay consistent with your investing, continue to learn more about finance and saving, and you will be on your way to financial success. Over time, you might be able to become a stock market millionaire!

However, with all investing, there is risk. For index funds, there are a few risks you need to consider.

What if Everyone Decided to Invest in Index Funds?

Something I like to do is think about different scenarios, take things to the extreme (if necessary), and think about the outcomes (otherwise known as a thought experiment).

Here’s something to ponder: what if everyone decided to invest passively in index funds – what would the outcome look like?

One of the common recommendations for investing in index funds is to dollar cost average (aka buy a little each month), and not touch the nest egg for 20-30 years.

At some point though, if everyone decided to invest in index funds, dollar cost average, and never touch their nest egg, wouldn’t the price of assets just keep rising (without care for the underlying fundamentals?)?

Would this be (dare I say) the beginnings of a Ponzi-like scenario and scheme?

While yes, at some point, people probably will start selling down their assets, the market can’t always go up. Otherwise, it’s not a market.

Index fund investing works because you have active money managers who supposedly “keep the market efficient”, but if those players went away, the market would certainly not be efficient.

The Problem and Risks of Index Fund Investing

Here’s the problem with passive index fund investing: with more people doing it, the less “efficient” the market will be, and this exposes you to a concept known as “the herd mentality”.

What do I mean? If everyone is always buying, regardless of price or the underlying value, then your expected returns will be less than prescribed. In addition, The Earth and economy is closed and there is a ceiling to everything.

Buying and buying and buying will just lead to boom, bust, and ruin at some point. It’s basic physics.

Don’t Be a Turkey when Investing

One of my favorite authors is Nassim Taleb. He is an author, philosopher, mathematician, former trader, and all around thought provoking individual. In one of his books, The Black Swan, he talks about the turkey problem:

“Consider a turkey that is fed every day,” Taleb writes. “Every single feeding will firm up the bird’s belief that it is the general rule of life to be fed every day by friendly members of the human race ‘looking out for its best interests,’ as a politician would say.

“On the afternoon of the Wednesday before Thanksgiving, something unexpected will happen to the turkey. It will incur a revision of belief.”

thanksgiving turkey

 

While I don’t necessarily see this drastic of a possibility to occur in the market, to say that the probability is 0 is to also make a mistake.

Considering all assets, having a safety net, and allowing for the possibility of failure of one asset will allow real financial independence and resilience.

Thinking Critically when Investing is Very important

There’s a few things here I want to touch on before concluding.

First, investing in stocks has been a great way to build wealth in the past, and something I do in my investment portfolio.

With this section of the post, I’m not saying investing in stocks is a bad thing. Rather, I’m trying to inspire unique and original thoughts for you to think about in personal finance life.

There are benefits and risks to everything in life, and it’s important to weigh them before making a decision.

Second, investing passively in low cost index funds has been, and probably will be, a solid investment going forward. With that said, if it becomes too prevalent in the future, there could be very wild swings in the market (and also the possibility for manipulation and a lack of liquidity overall).

There’s no such thing as a free lunch (even though many people hype index fund investing like it’s a gift from a higher power).

Third, speaking a little more in general, it is imperative to think critically about your situation. Everyone is different – everyone has different life experiences, perspectives, upbringings, and goals. Sadly, following the herd blindly will not result in success.

Instead, following what you believe, and have researched, works (and maybe that is following the herd) will lead to success.

Is Index Fund Investing the Best Way to Invest?

Index fund investing isn’t going away, and it’s a great way to invest and diversify your investments.

By investing in index funds, you can own thousands of companies, and get exposed to the broader market. There are many benefits for investing in index funds, as well as risks.

With the risks of index funds described above, am I going to stop using index funds in my investment portfolio? No.

Am I considering other assets and thinking more about my asset allocation, strategy, and the market going forward? Yes.

Am I trying to think critically in everything I do? Yes.

At the end of the day though, thinking critically is important in everything you do.

The markets don’t care if you succeed or not. It’s okay to re-balance your portfolio, it’s okay to assess the risk of your portfolio and see if there is anything you can do to navigate potential storms, and it’s okay to challenge yourself and your thoughts.

Index fund investing could be a great choice for your portfolio – you have to do you own research and decide what is best for you.

Readers: do you own a piece of thousands of companies? Do you enjoy researching individual assets? What are your thoughts on index funds?

The Benefits and Risks of Investing in Index Funds
The Benefits and Risks of Investing in Index FundsThe Benefits and Risks of Investing in Index Funds

Save

Share this awesome post:

Comments 14

  1. Erik, I am an individual stock picker at heart, but do have some index funds for diversification. I especially like them in my IRA for diversification there. VYM is my favorite and fits closely with my dividend growth strategy. Tom

    1. Post
      Author

      You like studying those individual stocks. While I like that as well, I like doing other things!

      Love the diversification comment. Thanks Tom.

  2. Ther are a few reasons that I like to invest in an index fund or ETF. The first is the long term trend. It’s always up. The second is the diversification and it quite easy to diversify your money even if it’s not a lot. The third is the cost. The less you pay in fees, the more money you’ll keep in your pocket in the long run.

    1. Post
      Author
  3. We are big Vanguard and Index Fund fans over here 🙂 It took us awhile to realize the benefits, but after seeing many excellent blog articles around the topic, we realized how beneficial index fund investing can be and have used it for several years now. It is a great tool in our portfolio!

    1. Post
      Author
    1. Post
      Author
  4. I am trying to diversify and invest in Index Funds and ETFs more but most of my portfolio is still in individual stocks. I agree with you it is time consuming and I don’t think I spend enough time on it to justify my selections. It is a slow process to change bad habits!

    1. Post
      Author

      It’s alright – making improvements little by little is great, but if you are successful with individual stocks, then it’s probably fine!

  5. We’re predominantly in Vanguard and Fidelity index funds. Mr. Groovy plays with some individual stocks that have paid off, but it’s a gamble. We’re prepared to lose that money.

    My brother tried to get me with his financial advisor. She’s into products way too complicated for me, i.e. Master Limited Partnerships, etc. My brother has fun spending hours upon hours analyzing. He’s a financial/computer braniac. I’m not.

    1. Post
      Author
  6. Great post. I’d be curious at what percentage of money in the market is in index funds. The article I just read said in 2017 it was 18% (up from 9% in 2016). The article stated that index funds might take a majority of the market somewhere between 2021-2024. I don’t know if that is accurate, but worth keeping an eye on. I kind of hope if this was to happen, more money managers would popup to try to take advantage of the situation and make the playing field more even. But we will see.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.