Why the Index Fund?

There are many financially educated people (including Warren Buffett) who recommend investing in index funds. Why? This month we will delve deep into this issue as we focus on why index funds are important for your future wealth creation and why they cannot solve all of your problems. We will also tackle the ETF. That's the not so little brother to the index fund who can get you in trouble if not careful.

The first publicly traded index fund was created by John Bogle, the founder of the Vanguard Group, in 1975. Many people called it Bogle's Folly and a waste of time. This first index fund provided you and me an opportunity to invest in the S&P 500 companies without active management, reducing the cost dramatically, especially when the load (commission) went away a few months later.

Was it a folly? It probably made sense to many that active management, even with the extra cost, would clearly beat a fund with no management. Intuitively that might make sense, which is probably why it took a long time for the index fund to gather popularity. Most people stuck with their high fee, high load managed mutual funds. After a few years, the research started coming in. The facts surprised some folks.

Index funds beat managed funds without loads (commissions) and trounced them when including the loads that got paid to the salespeople. This is when people starting doing the math. There was a 50/50 shot of beating the market before fees. After the fees, the odds dropped to about 30%. So, yearly about 30 fund managers beat the market and 70 did not after fees. The next year, about the same thing happened.

Here was the interesting twist. It was different managers beating the market in any given year. It was not the same ones. There was no consistency on who was going to beat the market, but there was plenty of consistency on who did not. Many mutual funds went belly up. This is where survivorship bias comes into play, making the numbers even worse for active management. See one study here.

So, now the research was coming after years of performance review showing that active management was a losing option for the average investor. This did not make Wall Street happy as you might imagine and so they fought back with more marketing and they even cut their fees and loads slightly. And then, BOOM. A thing called a computer was created and the information became available to a mass audience.

All of the sudden, the information on boring finance journals was being released and explained to the average investor who was willing to educate themselves. As investors became more educated, the money flowed into index funds BIG TIME. Vanguard became known as the place to buy index funds and that meant BILLIONS of dollars started flowing in. Others noticed what was going on.

Other firms starting creating their own index funds to compete with Vanguard. Some had loads and most had higher fees (Vanguard is a not for profit so they can keep their fees lower than competitors who have to make a profit). Some even started cutting their fees below Vanguard just to try to get back all of the money that left their expensive funds years ago. See an example at Fidelity here.

So, what are the odds of beating an index fund over time? The latest results showed over three years, 74.3% of actively managed funds trailed the index. Over five years, 86.5% underperformed. Over 10 years, 91.4% underperformed. Over 20 years, 94.8% underperformed! The numbers are even worse with the inability to capture all of the dead funds (survivorship bias) that went out of business.

It is basically like going down to the casino and thinking you are going to win. Could you? Sure. Are the probabilities on your side? Hell no! What the research keeps telling us is the casino wins in the end. You become the casino when you own a diversified portfolio of index funds at the lowest possible cost. Ultimately it comes down to whether you want to be the gambler or the casino.

Most level headed financially educated people would choose to become the casino. Which index funds? A total U.S. total market index fund like VTSAX or FZROX would do fine at Vanguard or Fidelity. If that is all you want to own, then okay. You can add VTIAX or FZILX for large international exposure as well. The reason is diversification and a reduction in volatility of the portfolio. See a list of index funds here.

Will index funds stop you from losing money? No. In any given year when the market goes down, your index fund that owns the market will go down, but it will very likely go down less than the average managed mutual fund because of the fees. And when the market goes up, your index funds will very likely go up more than the average managed mutual fund because of the fees. Over time, the casino wins by a lot!

What about the Exchange Traded Fund (ETF)? These work very similar to index funds and the fees can be just as low and maybe lower. If you buy and hold the same index funds except as ETFs, you will get about the same returns over time. The problem is most people don't. They trade ETFs like individual stocks and that works against your interest and benefits Wall Street. Buy and hold is the smart way to go.

How many index funds or ETFs should you own? The advise is the same. Get an asset allocation plan and add a few extra beyond the total U.S. index fund if you choose (I do). Owning a large international, small international, small-cap value, and real estate index fund has helped increase returns slightly with less volatility in the past. It might or might not do that in the future. Learn more about this issue here.

How about bond index funds? Does the research tell us the same thing? Yes. When buying bonds to reduce the volatility of a portfolio and provide income, choosing VBTLX or FXNAX at Vanguard or Fidelity will work. The returns will be lower than stocks over time, but you will get what the market gives you without giving up much of a cut to Wall Street. The same advise goes with the ETF bond versions.

What is the bottom line? Follow the research and do the math. You are wise to stick with very low cost index funds that diversify you broadly over different size companies and the world and then feed those funds month after month for as long as you can. Ignore the noise. Do not try to find the needle in the haystack. Simply own the entire haystack without too many moving parts. Financial Freedom to follow!


Stuff the lawyer wants me to say: Investing outside a bank or a credit union is not FDIC insured. You may lose the value in the investments you select. All information provided here is for informational purposes only. It is not an offer to buy or sell any of the securities, insurance products, or other products named. Translated: I am not selling anything! Educate yourself, research the information that you learned and finally make the right decisions that will benefit you and your family going forward.

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