There are many wise people who tell you to invest in index funds. Why? What is the reason and evidence that makes index funds your best option when investing your hard earned money? Those are fair questions and it is important to answer them so we can understand why we should create a portfolio of index funds, helping us reach Financial Freedom sooner rather than later or never at all.
Let's start with the low hanging fruit. Index funds are great because the fees are very, very low. Sometimes there are no fees! FZROX and FZILX are two examples of no fee index funds at Fidelity. Fees have a dramatic effect on returns over time. The research has been in for many decades. If you reduce your fees on any asset class in the stock and bond markets, you increase your returns over time.
Index funds work because of diversification. Owning a mutual fund owning thousands of companies rather than a few, reduces risk dramatically. At any point in time a company can go bankrupt, even big companies that have been around for a long time, think K-mart, Sears, Kodak, etc. The mutual fund replaces bankrupt companies with up and coming companies. Diversification is your friend as an investor.
Index funds improve your returns whether markets go up and down. When markets go up, your return is slightly higher because you paid less in fees. When markets go down, you lose slightly less because you paid less in fees. This happens year after year. When you take those returns out over multiple decades, it becomes a great deal of money. Index funds win in the short run and the long run.
You are owning markets rather than having some manager pick individual companies within those markets. Why is that good? The manager is notoriously bad at picking the right companies that will outperform the market. They usually lose, just like the gambler that walks into the casino. Owning the market with an index fund guarantees you the return of the market, which goes up about 75% of the time.
There will be no funeral. Dozens of funds die a quiet death every year. Over the last 50 years, half of all mutual funds have gone away, usually due to poor performance. Your index fund will not die. It will serve you well through the storms and there will be storms. Those returns get better and better compared to actively managed funds over time as one fund after another bites the dust. No funeral for you!
Index funds work to reduce your tax bill. When holding an index fund in a brokerage, you will build up long term capital gains because there is no buying and selling, incurring short term capital gains, internal to the fund. This reduces or eliminates taxes on the index investor as they buy and hold outside of retirement accounts. VTSAX, VTIAX, FZROX, and FZILX are ideal funds to hold in a brokerage.
Index funds reduce regret. Picking individual stocks and managed funds is a loser's game that reduces your returns over time. We have known this for quite some time. If you play that game, you are very likely to regret those decisions as you see what the markets did over time vs. what you did. Index funds stop you from having those regrets. They increase your portfolio growth and decrease any regret.
Index funds provide you a beneficial way to manage your emotions. Your ego is set aside when you buy index funds instead of trying to pick winners. Overconfidence is tamped down when you buy index funds, accepting the futility of beating the market. Your fear is reduced, knowing this method has worked best over many, many decades. Better emotional management = higher returns.
No asset bloat. Actively managed funds that perform well recently are inundated with new money. This forces the manager to buy a lot of stock they probably don't want to buy. They buy more large companies than they want to because they are not allowed to own too much in percentage terms of one particular company. This causes returns to go down over time. This does not apply to index funds.
You don't have to trade with really smart people and machines when you own an index fund. If you buy or sell individual stocks you are stuck trading with people or machines who know a whole lot more information about that business than you do. If you're buying, they are selling. If you are selling, they are buying. Index funds avoids this losing approach. You become the casino, winning in the end.
You don't have a lot of your money sitting in cash when stock markets go up. Most managed mutual funds keep a certain allocation in cash at all times. This can benefit them if markets go down. It hurts them when they go up. Markets go up about 75% of the time. When investing in index funds, 100% of that fund is invested in the stock market (or bond market if applicable).
Low maintenance and peace of mind are benefits of index funds. There is nothing to do, but feed those funds over time. This gives a person peace of mind on the simplicity of owning index funds without having to time the market or the sector or the country or ..... Index fund investors can go live their life as their index funds produce what the markets provide, which is plenty. Buy index funds and never stop!
