Warren Buffet dubbed as The Oracle of Omaha, has notoriously been known as the greatest investor of all time for averaging an annual return of 20% for shareholders since the beginning of 1965. However, if you were to ask him, who is the greatest investor of all time, it would likely be his Columbia Business School professor, Benjamin Graham. Graham published one of the most famous investing books “The Intelligent Investor” in 1949 outlines several timeless principles and has become a great book for beginner investors. One of the principles Graham laid out was to decide whether you were an Active or a Passive Investor. An active investor is one who often tries to beat stock market average returns by taking advantage of short-term price fluctuations which involves buying and selling during short periods of time. On the other hand, passive investing requires a buy and hold strategy which is deemed more cost effective. For many people, researching company financials and valuing a company may not be something that interests them or have time for. In this case, a common passive investing approach is to buy an index fund.
What are Index Funds
An index fund is a type of mutual fund or exchange-traded fund that consists of a portfolio of stocks or bonds that matches or follows major indices like the S&P 500 or Dow Jones Industrial Average (DJIA). Conceptually, by copying the profile of the stock market as a whole, the index fund should have an equal or similar performance. For Example, an index fund that follows the S&P 500 would invest in the same 500 large and publicly owned companies that comprise that index. There is an index fund for almost every financial market where the most commonly invested index funds track the S&P 500 which include Vanguard S&P 500 ETF (VOO), iShares Core S&P 500 ETF (IVV), and SPDR S&P 500 ETF Trust (SPY).
Advantages of Index Fund Investing
Index funds garner several advantages including diversification, low expenses, long term returns, and passive investment.
1. Diversification
Index funds that follow indices such as the S&P 500, hold roughly 500 different stocks meaning that any downside fluctuation in any of the 500 stocks will minimize the likelihood of sharp declines in your overall portfolio. Studies show that maintaining a diversified portfolio of 25 to 30 stocks yield the most cost effective level of risk reduction. Therefore, instead of buying 25 to 30 different individual stocks, buying a single index funds diversifies and rebalances based on the indices that it tracks for you.
2. Low Expense
One major benefit of investing in an index fund is low costs or expense ratio compared to actively managed funds. Given index fund managers try to mimic the performance of specific indices, they often buy and sell holdings less often which mean less transaction fees. Index funds usually have low expense ratios and cost less than one percent which benefit the overall performance of the fund.
3. Long Term Returns
The performance of an index fund are closely correlated with their benchmark index. For example, Fidelity’s ZERO Large Cap Index Fund (FNILX) tracks the S&P 500 and delivered a total return of 20.05% in 2020 which actually beat the S&P 500’s total return of 17.4% for the same time period. The average return of the S&P 500 since its inception in 1926 through 2018 is roughly 10% meaning that an index fund that tracks the S&P should yield similar or close results.
4. Passive Investing
Passively managed funds usually don’t try to attempt to beat the indices that it follows, but instead tries to match the overall risk and return of the market. An index fund offers the easiest way to track an index without having to monitor the performance of individual stocks or managers. Passive investing exposes you to total market risk meaning that when the entire market is up, the index is also up and vice-versa.
Index Funds vs. Actively Managed Funds
Advocates for both Index Funds and Actively Managed funds often claim superiority over the other, but choosing between the two comes down to your risk tolerance for the possibility of higher performance. Index Funds are designed to match the performance of a specific market segment or index whereas actively managed funds try to outperform its benchmark. The strategy between both funds differ in that index funds purchases all of the securities in the index that it is mirroring whereas actively managed funds use research to screen and select securities that may outperform the market. Index funds also tend to be less risky due to its broad diversification and its close tie to the overall market it tracks. On that other hand, actively managed funds both have the possibility of outperforming the market or under performing. Given index funds buy and hold shares more often, there is generally less capital gains taxes compared to actively managed funds that trade more frequently. Overall, the superiority of a fund is determined by your preference, time horizon, and risk tolerance.
Final Thoughts
For the average person, people may not have the time or will to research and try to value individual stocks. Index funds give you the ability to invest in broad market segments and minimize your exposure to market risk. Index funds that follow the S&P average returns of 10% for almost a century and pose as a powerful easy to invest passive investing tool. The most common argument against index funds is that you are limited to different strategies that may yield higher returns. For those looking for a risk averse investment that minimizes the odds of under performance, index funds is a premier option to healthy and long-term returns.
