What Makes Index Funds Really Great?

#1 You can get the market return with no effort.   It is VERY hard to consistently beat the market.    Read A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing to get an appreciation for how hard it is, and how many professional money managers fail to beat the market.   What about picking individual stocks?     Even if you are the next Warren Buffett you need ½ million to invest to make it worth your time.

#2 Index Funds make investing simple- they remove the guess work of which stock to buy or which managed fund will beat the market this year.   You decide on an asset allocation and then buy the lowest cost funds to give you that allocation. 

#3 Index funds have very low costs.   Managing an index is pretty easy- just buy all the stocks in the index.  No reach department or stock analysts required.   Vanguard has funds with expense ratios as low as 0.07%.  Actively managed funds have higher expenses, usually 1% or more.   That might not seem like much, but the higher costs drain away a lot of your investment returns because 1% is a huge difference when compounding over many years.

#4 Easy Diversification, you can buy virtually the entire stock market when you buy a share of VTI.   This ensures you will never lose 95% of your investment due to a bad pick- it would take the end of the world for that to happen to the entire market.

#5 You don’t have to watch index funds like a hawk, index funds will always match their index. Actively managed funds could change drastically- especially if they change fund managers. 

#6 Tax efficiency- Because the index won’t change much year after year index funds typically don’t need to sell much of their holdings.   That means less realized taxable income – which is important if you are holding an index funds outside of a tax sheltered account.

2 Responses to “What Makes Index Funds Really Great?”

  1. ETF says:

    Hi, please give your thoughts on why someone would choose an Index fund over a similar ETF. For example, Vanguard Total Bond Market Index Fund (VBMFX) versus Vanguard Total Bond Market ETF (BND). I’ve been trying to decide between ETF or Index at Vanguard and am leaning towards the ETF with it’s lower expense ratios, no minimum, no commission on trades, and only a $20/year fee. Thanks!

  2. Rick Francis says:

    Thanks for commenting!
    >why someone would choose an Index fund over a similar ETF.
    The two are very similar- I would look at it as two slightly different packages of essentially the same thing. As you indicated you may be able to save a bit in costs, it is always better to lower your costs but I wouldn’t expect a large cost difference. The more practical reason is that many funds have minimums where ETFs don’t- if you don’t have the minimum amount to invest in a particular fund you would have to invest in the ETF.

    ETFs are traded like stocks- i.e. you can buy or sell them at any broker, trade them at any point in the day and or buy with a limit order. There is also a bid-ask spread while not exactly a fee it is a transaction cost. ETFs typically have a commission when buying or selling, however some brokers such as TD Ameritrade and Schwab offer $0 commission trades on select ETFs.

    Funds trade at the end of the day, and may have transaction fees called loads. A front end load is a fee at purchase and a back end load is a fee at the time of sale. There may also be additional fees so you should read the prospectus very carefully to be sure.

    -Rick

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