Investing in index funds has long been thought to be one of the wisest financial decisions you can make. Index funds are inexpensive, provide diversification, and produce attractive long-term returns. Index funds have historically outperformed other forms of funds actively managed by top investment firms.
An index fund is a type of mutual fund or exchange-traded fund (ETF) that consists of a collection of securities that monitor the performance of a market index like the S&P 500. An index fund invests in the same stocks in about the same proportions as the index it monitors. The index is normally based on a single industry, region, or stock exchange.
Warren Buffett bet $1 million in 2007 that an S&P 500 index fund would outperform an actively managed hedge fund over a ten-year period, and he won by a landslide.
Some investors could be enticed to start adding index funds to their portfolios as a result of Buffett’s victory. If you’re still not convinced, keep reading to learn more about index funds and why they’re so famous.
BROAD DIVERSIFICATION
The most obvious advantage of index funds is that they immediately diversify your portfolio, reducing the risk of losing any or all of your assets.
Take a look at an index fund that monitors the S&P 500. Around 500 separate stocks will be held in this index fund. Although the performance of each of these 500 stocks varies over time, investing in a fund that holds them all aligns the portfolio with the index’s performance. By diversifying your investments through so many companies rather than investing in only one index fund, you will ensure that the value of your portfolio is not heavily associated with the fortunes of any one of the index’s companies.
LOW COSTS
Another big advantage of index fund is that their expenses, such as taxes and management fees, can be smaller than those of other types of mutual funds. The annual management fee collected by each fund manager is the first expense to consider. The cost ratio of the fund determines the sum of the premium. For example, if you invest $1,000 in a mutual fund with a 1% cost ratio, you would pay $10 in management fees.
Expense ratios for actively managed mutual funds are typically between 1 and 2 percent. The majority of the fee goes toward portfolio managers making buy-and-sell decisions in order to outperform the market.
BETTER RETURNS
Even the brightest and most attentive portfolio managers will rarely direct actively managed funds to beat index funds, as Buffett realized when he made his $1 million bet. According to Standard & Poor’s report, only about 23% of actively managed mutual funds outperform the S&P 500 over five years. Individual businesses outperform and underperform the market, but the stock market as a whole appreciates in value over time. As a result, index funds typically provide high returns at a low cost, making them an ideal investment for any investor.
