Why I Use Index Funds

Corey —  December 3, 2009 — 1 Comment

       If you’ve used my free portfolio recommendation calculator, you’ll know that I recommend a diversified portfolio of low-cost index mutual funds. Some people recommend actively managed mutual funds or picking your own stock investments, but here are my reasons for using and recommending index mutual funds.

Maximum Diversification

       Index funds offer unsurpassed access to a diverse number of stocks and bonds within any single asset class. A single index fund can give you a piece of over 4,000 companies. Try replicating that with individual stocks and you’ll find yourself sinking under all those commission charges. Most actively managed funds are concentrated on no more than 30 stocks. If they’re investing in more than that, then what are you paying those “smart” fund managers for anyway?

Low Costs

       Index mutual funds handily beat actively managed mutual funds when it comes to costs and fees. This is especially true when you compare low-cost index funds (like those at Vanguard) to actively managed funds. On average, other mutual funds cost six times more than Vanguard’s. Mutual funds at Vanguard have total expenses of about 0.2%, while the expense ratio on actively managed funds is commonly 1.2% or even higher. The less you pay in costs, the more you keep for yourself. Additionally, index funds have lower portfolio turnover (buying and selling stocks) than actively managed funds – resulting in lower trading costs and lower taxes.

Tax Efficiency

       Because index funds trade much less often than actively managed funds or stock-picking brokers, you’ll pay lower taxes. Now this only matters in taxable accounts (not 401(k) plans, 403(b) plans, 457 plans, IRAs, or other similar accounts). But in taxable accounts it can make a BIG difference in your net returns.

Market Performance Less Fees

       An index fund will always perform exactly as well as the index it tracks less the fees (expense ratio). So if you invest in an S&P 500 index fund, you can be guaranteed to get returns equal to the S&P 500 minus the expense ratio you pay for the index fund. This is essentially guaranteed because that’s the purpose of the index fund – to match the index.

       This is not true with stock picking or actively managed funds. You have no idea what your performance will be. Actually, there’s a good chance you’ll underperform an index fund invested in similar assets. A study by the Center for Research in Security Prices (CRSP) found that over a 31 year period (1970-2000) only 19 of 345 mutual funds (only 5.5%) beat their benchmarks by 1% or more. Another 42 funds (or 12.2%) matched their benchmarks within 1% (plus or minus). Meanwhile, 80 of the funds underperformed their benchmarks by at least 1% and another 204 funds were discontinued due to their dismal performance.

       So if you took your chances with funds that try to beat the market, you only had a 17.7% chance of at least matching the market. That’s worse than a 1 in 5 chance. You would have had over an 80% chance of doing worse than the market! If you had used index funds, you would have had a 100% chance of matching the market’s performance within 1%. Take your pick.

Less Time Required to Monitor

       Using index funds requires far less time than stock picking or using actively managed funds. If you’re picking stocks, you’ll have to continually keep up on your “favorite picks” to make sure you don’t miss any “opportunities” or pitfalls. If you’re using actively managed mutual funds, you have to keep up on your fund manager and you might have to search for replacement funds if yours is discontinued because of poor performance.

       Using index funds allows you to focus on more important things in life – things you enjoy more than poring over financial statements, mutual fund prospectuses, and investment research. Even though those sound like worthwhile activities to increase your investment returns, research has shown that there is little to no evidence that such strategies are profitable in the long run.

The Evidence Favors Indexing

       Mountains of evidence exists in the form of academic research supporting the case of index funds. There’s far more than I can cover in this short post, and most of you won’t be interested in reading it. But if you are, I highly recommend checking out the 12 Steps at Index Funds Advisors. There you can find all the evidence you need to see that index fund investing is far better than stock picking or using actively managed funds.

       The investment and financial services industries have a vested interest in convincing you that it’s possible to beat the market – either by doing it yourself, buying their systems, or letting them do it for you. But Nobel laureates and academic researchers have found that no evidence exists to support the idea that such strategies will work in the long run. The successes you see among investment professionals and individual investors are exactly what you’d expect to see based purely on statistical luck. Don’t let a lucky few tempt you into frittering away your investment dollars.

Stay Tuned!

       There you have it – my reasons for using and recommending index funds. I’ll be writing more about investing over time, but that’s a good basic introduction as to why index funds are the best choice. If you’re interested in learning more about personal finance, make sure you sign up for free updates to Provident Planning!

Corey

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Corey is currently pursuing a Master of Arts degree in religion. While he enjoys learning and writing about Christianity, another one of his new passions is writing about personal finances in order to help others make wise decisions with their money.

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    […] with Provident Planning explains why he likes and recommends index funds. I don’t currently have an opportunity to invest outside of my 401k but you can bet that I […]

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