In 1975, John Bogle, the founder of Vanguard, introduced the world’s first index fund. These simple funds buy stocks and match the market (more precisely, to match an “index” of the market, such as the S&P 500), versus the traditional mutual fund, which employs an expensive staff of “experts” who try to predict which stocks will perform well, trade frequently, incur taxes in the process, and charge you fees. In short, they charge you to lose.
Index Funds: “If you can’t beat ’em, join ’em”
Index funds set a lower bar: No experts. No attempts to beat the market. Just a computer that automatically attempts to match the index and keep costs low for you. Index funds are the financial equivalent of “If you can’t beat ’em, join ’em.” And they do so while also being low cost and tax efficient and requiring hardly any maintenance at all. In other words, index funds are simply collections of stocks that computers manage in an effort to match the index of the market. There are index funds for the S&P 500, for Asia-Pacific funds, for real estate funds, and for anything else you can imagine. Just like mutual funds, they have ticker symbols (such as VFINX).
Bogle argued that index funds would offer better performance to individual investors. Active mutual fund managers could not typically beat the market, yet they charged investors unnecessary fees.
Illusory Superiority and Wall Street
There’s a funny effect called illusory superiority, which refers to how we all think we’re better than other people (especially Americans). For example, in one study, 93 percent of respondents rated themselves in the top 50 percent of driver skills—an obviously impossible number. We believe we have a better memory, and that we’re kinder and more popular and more unbiased than others. It feels good to believe it! Yet psychology has shown us that we are flawed.
Once you understand this, Wall Street makes a lot more sense: Every mutual fund manager believes he can beat the market. To accomplish this, managers use fancy analysis and data, and they trade frequently. Ironically, this results in lots of taxes and trading fees, which, when combined with the expense ratio, makes it virtually impossible for the average fund investor to beat—or even match—the market over time. Bogle opted to discard the old model of mutual funds and introduce index funds.
Modern Day Index Funds
Today, index funds are an easy, efficient way to make a significant amount of money. Note, however, that index funds simply match the market. If you own all equities in your twenties and thirties and the stock market drops (like it has from time to time), your investments will drop. Expect it! It’s normal for your investments to go up and down. Over the long term, the stock market has always gone up. As a bonus for using index funds, you’ll anger your friends in finance because you’ll be throwing up your middle finger to their entire industry—and you’ll keep their fees for yourself. Wall Street is terrified of index funds and tries to keep them under wraps with increased marketing of mutual funds and nonsense like “5-star funds” and blogs that highlight action, not results.
Index Funds Are Great Investments
You don’t have to take my word for it. Here, a few experts on the benefits of index funds:
“I believe that 98 or 99 percent—maybe more than 99 percent—of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs.”
—WARREN BUFFETT, ONE OF AMERICA’S GREATEST INVESTORS
“When you realize how few advisers have beaten the market over the last several decades, you may acquire the discipline to do something even better: become a long-term index fund investor.”
—MARK HULBERT, FORMER EDITOR OF HULBERT FINANCIAL DIGEST
“The media focuses on the temporarily winning active funds that score the more spectacular bull’s eyes, not index funds that score every year and accumulate less flashy, but ultimately winning, scores.”
—W. SCOTT SIMON, AUTHOR OF INDEX MUTUAL FUNDS: PROFITING FROM AN INVESTMENT REVOLUTION
Pros and Cons of Index Funds
|Amount in your portfolio||Annual expenses of a low-cost index fund (.14%)||Annual expenses of an actively managed mutual fund (1%)|
Advantages: Extremely low cost, easy to maintain, and tax efficient.
Disadvantages: When you’re investing in index funds, you typically have to invest in multiple funds to create a comprehensive asset allocation (although owning just one is better than doing nothing). If you do purchase multiple index funds, you’ll have to rebalance (or adjust your investments to maintain your target asset allocation) regularly, usually every twelve to eighteen months. Each fund typically requires a minimum investment, although this is often waived with automatic monthly investments.
Okay, so index funds are clearly far superior to buying either individual stocks and bonds or mutual funds. With their low fees, they are a great choice if you want to create and control the exact makeup of your portfolio.
But what if you’re one of those people who knows you’ll just never get around to doing the necessary research to figure out an appropriate asset allocation and which index funds to buy? Let’s be honest: Most people don’t want to construct a diversified portfolio, and they certainly don’t want to rebalance and monitor their funds, even if it’s just once a year.
If you fall into this group, there is the option at the very top of the investment pyramid. It’s an investment option that’s drop-dead easy: target date funds.
Frequently Asked Questions on Index Funds
Do you pay taxes on index funds?
Constant buying and selling by active fund managers tends to produce taxable gains—and in many cases, short-term gains that are taxed at a higher rate.
Do index funds pay you monthly?
Dividends from index funds usually follow one of three different dividend payment patterns. Specifically, monthly, quarterly, or annually.
Can we withdraw index funds anytime?
An investment in an open end scheme can be redeemed at any time. Unless it is an investment in an Equity Linked Savings Scheme (ELSS), wherein there is a lock-in of 3 years from date of investment, there are no restrictions on investment redemption.