Should I Invest in Index Funds?

If you're a "this is too long to read" kind of person, the short answer is yes.

Index funds are designed to passively track, or "mirror", a group of stocks. Common examples include index funds that track the entire US stock market, or the S&P 500.

Passive investing sounds boring and slow. Turns out, the data doesn't support that conclusion. Index funds have been shown to outperform actively managed mutual funds over long periods of time - which is mostly driven by low fees. The additional benefit of diversification also means that your risk is generally lower than when investing in individual stocks.

Active vs Passively Managed Funds

Actively-managed mutual funds sound more aggressive & fancier, which makes us generally inclined to think they would be better. After all - isn't it true that you get what you pay for?

Investing is the one world in which this doesn't always hold true. Because actively-managed funds have a fund manager doing active trading in an attempt to beat its index, the fees associated are higher. That means that in order to truly WIN, the fund has to first overcome the additional drag fees impose on the investor... and THEN get better returns.

This has been studied time and time again. One of the best resources on this topic is the SPIVA (S&P Indices vs Active) report. The data below is from the SPIVA 2022 Report 1a, illustrating the percentage of actively managed US equity funds UNDERPERFORMING their benchmark index over periods of time. You may notice that as the time horizon increases, the percentage of actively managed mutual funds coming out on top falls incredibly low. 

Index Funds or Individual Stocks

When you invest in Apple, for example, you own a share of that one company. If Apple happens to do poorly, so does your investment.

When you invest in an S&P 500 index, you invest in a large number of companies with a single purchase. Here are the top holdings in VFIAX, Vanguard's 500 Index Admiral Shares, as described by Morningstar:

These are not ALL the holdings, but the highest weighted ones. Do you see that by buying VFIAX you not only own Apple, but hundreds of other companies too?

Don't put all your eggs in one basket, or all your investments in individual stocks.

Do Fees Matter?

Most index funds have expense ratios, or internal operating expenses, less than 0.2%. Some companies, like Fidelity, are even offering funds with expense ratios of 0%! Vanguard offers a wide variety of index funds with expense ratios less than 0.04%. 

This percentage essentially represents the portion of your returns that go to pay the fund's bills, instead of being given to you.

In contrast, actively managed mutual funds often have an expense ratio of 1% or more.

Assuming a $10,000 initial investment, subsequent annual $10,000 investment, and background 8% returns for both categories - here is a visual representation of your investment over time. The underlying assumption is an expense ratio of 0.04% for the index fund and 1% for the actively managed mutual fund.

When you couple the tremendous amount saved in fees with the fact that over a 20-year time horizon 92.14% of all actively managed domestic funds FAILED to outperform their benchmark index...

Index fund investing is a no-brainer.