Some people want to retire early and pursue other passions in life. Others simply want to have enough money, and never have to worry about money again. Whatever the reasons for pursuing financial independence, index funds are one of the best ways to achieve this goal.
In this article, we are going to look at the top reasons why you should invest in index funds.
What is an index fund?
Imagine you want to invest in an apartment. You approach a real estate agent and express your needs. They tell you they have 1000 apartments, and you can choose from one of them.
It then becomes a gamble which one to pick. In the event you make a poor decision, there goes your investment.
However, they also have another option. They tell you, you can buy a small percentage of each of the 1000 apartments and aggregate them to one.
And since the apartments are in different locations and markets, you get to spread your risk.
Therefore, in the long run, your investment of small percentages of each which aggregate to a whole ensures you have a good return on your investment.
The index fund is no different.
An index fund is an aggregate of stocks or bonds that track and match the performance of an index (the whole market), for example, the S&P 500.
So, there is no human element of tracking and trying to beat the market like a mutual fund.
In the long run, index funds have shown to outperform a human-managed fund.
1) They have a better return on investment
In the long term, index funds have a higher return on investment. They outperform individual stocks hands down.
For example, in 2007, Warren Buffet entered The Million-Dollar Bet with the Protégé Partners, a New York investment firm. It was a 10-year wager that the S&P 500 index fund would outdo their carefully picked five hedge funds, which they were to trade in for the challenge.
It is important to note that Buffet used his own money and not Berkshire’s.
In December 2017, Buffet won the challenge and donated the money to charity.
However, his victory didn’t seem assured. On January 1, 2008, the stock market crashed, and the hedge funds swooped in and made a killing hedging.
During this period, Buffets’ index fund fell by 37% while the hedge fund lost 23.9%.
Nonetheless, from their Buffet beat Protégé in every year from 2009 up to 2014. However, it took four years to come on top of the hedge funds in terms of cumulative return.
This bet demonstrates that an index fund will weather the ups and downs of the market, and it will eventually balance out and perform better compared to an actively managed fund.
Hence, an index fund is a better return on your investment.
When you buy individual stocks or bonds, you have uncompensated risk. This is a risk you are not paid enough to take.
So, if a company goes bankrupt, it is downgraded or defaults in borrowing you go under with them. Unfortunately, it happens a lot in the stock market.
To protect yourself, you can invest in an index fund. Just like we have seen, an index fund is an aggregate of all the stocks in the market.
Therefore, in case one company goes down, your investment does not go under with them. In the same vein, when a company is doing well in the market you also gain and do not miss out.
Eventually, everything balances out in an index fund.
3) It is easy
Most people do not know or are not motivated to learn how to invest. They feel it is a drag and a bore.
Luckily, if you are one of them, you have an option, and can invest in index funds without being actively involved.
With index funds, you open an account with an investment management company and commit to making a monthly contribution to your account.
From there, you then leave it and let it grow.
4) They have very low fees
Index funds are simple to put together and manage. They do not have overheads like mutual funds. On top of that, the portfolio of stocks is automatically balanced and adjusted, and no human is needed.
With as little as 0.04% annual management fees, all these savings get passed down to you.
However, a mutual fund is different. It has a portfolio manager who handpicks selected stocks and tries to beat the market.
When trading, they will contract trading fees and management fees. All of these fees add up and will be passed down to you the investor.
Since portfolio managers rarely beat the market in the long term, the investor ends up losing their money.
Therefore, index funds are a much more favorable option, and you get to enjoy low fees.
5) Tax Efficient
Did you know an index fund is more tax-efficient compared to an actively managed mutual fund?
On account, those portfolio managers are actively buying, and selling, they have an estimated turnover of 85%, they pay capital gains taxes on every sale they make.
This makes actively managed mutual funds one of the most tax-inefficient. On the contrary, index funds are tax efficient.
In theory, an index fund portfolio, for example, an index fund of the total stock market will only have two turnovers.
That is in an Initial Public Offering (IPO), or when a company is delisted from the exchange.
In these two situations, there are no capital gains made. Consequently, there will be no capital gains tax.
However, in reality, the turnover is about 4% in index funds. Nonetheless, negligible compared to the 85% of actively managed funds.
Therefore, overall, index funds are more tax-efficient compared to other actively managed mutual funds.
6) Easy to build your portfolio
One of the cardinal rules in investing is never to put all your eggs in one basket. As an investor, you have to diversify your portfolio.
And with index funds, you can do that easily, and quickly.
For example, your investment plan calls for three funds in your portfolio. That is stocks, bonds, and real estate.
To get started, you can buy Total Stock Market Index Fund, and then add bonds with the Total Bond Market Index Fund, and lastly, your real estate through the REIT Index Fund.
Therefore, there is no need to worry about overlapping your assets. You know what a fund holds just by its name.
With index funds, you do not need to pay thousands of dollars a year to have an investment manager build your portfolio.
7) Less time consuming
In traditional investing, you would need to do your research, and identify well-performing stocks.
You will also need to follow the trends of the market, and try to beat the market.
However, this strategy needs a lot of time, energy, and commitment, which most people do not have.
By investing in an index fund, you free up your time and do not have to track the market. You put your money in, forget about it, and let it grow.
8) Take advantage of market returns
When you try to beat the market, you may miss some opportunities.
For example, if you have invested in the total stock market index when the market goes up, you do not miss out. This is because you have invested in the whole market.
However, with a mutual fund, you can only take advantage of gains made in the market if you had invested prior. Therefore, the chances of missing out are very high.
To that end, an index fund makes sure you take advantage of all market returns, and never miss out.
9) No Factor Risks
There are two schools of thought when it comes to investing. There is the Total Market versus the Factor Investing.
In factor investing, you have to analyze what are the drivers of return in a particular asset class. These are macroeconomics and style.
However, in total market investing, you do not have to worry about factors. The structure of the index fund already captures all factors risks, and there is no need to analyze them.
10) Controls investor behavior
Stock trading has been likened to gambling. For example, when an investor makes gains on stocks they have placed their bet on; it produces the same effect as winning in gambling.
Unfortunately, this investment strategy will make you lose money.
But investing in an index fund, investor behavior is controlled. You do not have to keep trading in individual stocks trying to beat the market.
In the end, this protects your wealth and builds you more.
11) Widely available on most investment accounts
Index funds are as universal as they get. Many investment accounts can be used to invest in them.
For example, a 401(k) can be used to invest in an index fund, and grow your money for retirement nest.
Or a 529 can be used to invest in index funds to grow your kids’ college fund.
By and large, the type of investment account used will depend on your desired financial goal. However, other factors like tax benefits, the maturity of investment account, among other things should be considered as well.
Other investment accounts you can use to invest in index funds are; Solo 401(k) s, Thrift Savings Plan (TSP), Health Savings Account (HSA), Roth IRAs, custodial brokerage accounts, taxable accounts, and many more.
The road to financial freedom is hard. It requires a lot of sacrifices, patience, planning, and dedication to achieve it.
And one of the surest ways to get there is through index funds. Time and time again, everyday folks have been able to achieve financial independence using them.
With the above advantages going on for an index fund, it is only wise to start investing and achieve that financial independence.