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 benchmark, like the S&P 500 or the Dow Jones Industrial Average. They're a form of passive investing, because they allow investors to buy a lot of assets at once and hold them for the long term. While many of the biggest index funds track the stock market, some funds track indexes in other markets like bonds, commodities, or real estate.
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.
By late 2019, the amount of money invested in funds that track the market surpassed the amount managed by people who pick stocks, according to data from research firm Morningstar. And thanks in part to index funds, it has become cheaper and easier to invest in the stock market.
You may already be investing in index funds without realizing it. That's because they're the most common type of investment option to select from in many 401(k) plans or with automated investment services like robo-advisors.
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 billionaire investor Warren Buffett, whose stock picks are closely followed, has repeatedly recommended index funds. Most recently, at Berkshire Hathaway's first-ever virtual annual meeting on May 2, chairman and CEO Buffett said: "In my view, for most people, the best thing to do is to own the S&P 500 index fund."
Why? While 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.
There are some inherent risks that come with investing in the stock market, but investing also offers a higher rate of return than the interest rates you'll earn on a savings account. 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 370%. 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 — the total return would be more than 490% and your investment would be worth more than $2,900 today.
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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 averawge 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.
What's more, you don't have to sacrifice on returns by investing in index funds. Only 11% of actively managed large-cap funds beat their benchmarks during the 2010s, according to a report from Bank of America Global Research.
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With an index fund, the mix of stocks — what's known as its diversification — helps to minimize your portfolio's related risk. Because money is spread out across a variety of assets rather than just a handful of individual stocks, your portfolio is less likely to see sharp, short-term fluctuations. For example, 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.
And diversification offers another important benefit: It increases the potential for your overall return. By freeing yourself from the arduous task of trying to accurately pick the winners, buying an index fund means you'll have a mix of some of the winners — and some of the losers.
While broad market index funds offer the most diversification benefits, there are index funds that have a narrower focus. For example, you can buy funds that track companies of various sizes (large-, mid- or small-caps), within specific industries like technology, health care, or real estate, and those that are listed on international stock exchanges.
Because you don't have to be an expert investor to be successful, index funds can be a low cost and easy way to beef up the diversification of your portfolio. That said, buying more funds doesn't necessarily offer any additional diversification benefits and you'll want to research index funds, just as you would any other asset, before investing.
Here are three things to pay attention to when buying index funds:
- What are you tracking? Be sure you understand what index a particular fund is tracking — and what stocks (or other assets) are included in that index. Many indexes have similar names, even if they look nothing alike.
- What fees are you paying? While index funds are typically low cost, the associated administrative fees can still vary widely fund-to-fund. Pay attention to expense ratios and prioritize funds with lower fees.
- Do you have fund overlap? You don't need a lot of index funds to achieve diversification, and experts recommend that even a handful of funds can do the trick. That's why you'll want to pay attention to what indexes you're tracking (and components of those indexes) to ensure that you haven't loaded up on near-identical funds.
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