You don't have to try to pick the winners in the stock market to achieve long-term investing success. A proven strategy is to just invest in the market itself.
Index funds track the performance of a particular market index, like the S&P 500. They're a form of passive investing, because they allow investors to buy a lot of stocks at once and hold them for the long term.
The first index funds were mutual funds introduced in the 1970s by John Bogle, the founder of Vanguard Group. Nowadays they, and many exchange-traded funds (ETFs), which are also considered index funds, have become a popular way to invest: Accounting firm PwC estimates that, in 2018, 36% of money in the market was invested in such passive funds.
Here's why index funds make sense for most investors:
While professional investors make a living by trying to outperform the market, that strategy is difficult to successfully execute over a long time period. Even famed billionaire investor Warren Buffett, whose stock picks are closely followed, has said that index funds make "the most sense practically all the time."
Why? Even though individual stock prices can fluctuate wildly, the broader index tends to go up over time — and with index funds, you don't have to pick the winning stocks to benefit from the market's overall gains. The S&P 500, an index representing the 500 largest U.S. companies, has delivered average annual returns of almost 10% going back 90-plus years.
The past decade in particular has been an excellent time to invest in index funds. Since bottoming out in March 2009, the S&P 500 has surged more than 340%. If you'd invested $500 in an ETF that tracks this benchmark index — and reinvested your dividends, or the quarterly profit you're paid by the fund holder — your investment would be worth more than $2,700 today.
Index funds pool money from a group of investors and then buy the individual stocks or other securities that make up a particular index. That model helps to reduce the associated costs that fund managers charge, compared to those funds where someone is actively strategizing which investments to include.
Fees matter because they can cut into your overall return. Among equity mutual funds — those made up of stocks — the average expense ratio for index funds was 0.08% in 2018, compared with 0.76% for actively managed funds, according to figures from the Investment Company Institute. That works out to $0.70 for every $1,000 invested versus $7.60.
By not paying a lot for someone to pick and choose your investments, you get to keep more money to reinvest in your portfolio.
With an index fund, the mix of stocks — what's known as its diversification — helps to minimize your portfolio's related risk. That means your portfolio's value is less likely to fluctuate wildly, because an index like the S&P 500 typically moves up or down less than 1% on any given day.
You could buy all components of an index individually, but you'd spend a lot of money doing so. With an index fund, you can get all those stocks with the click of a button.
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