Why Index Fund Investing Is Good for Your Retirement
On December 19, 2007, Warren Buffet, chairman of Berkshire Hathaway and one of the richest men in the world, made a bet with hedge fund investor Ted Seides that an S&P500 index fund invested for ten years would outperform an actively managed fund over ten years. Without going into the details of how the contest was structured (he explains it in his 2017 annual letter), he won that bet.
Buffett’s lesson for everyday savers is simple: “American investors pay staggering sums annually to
advisors, often incurring several layers of consequential costs. In the aggregate, do these investors get their money’s worth? Indeed, again in the aggregate, do investors get anything for their outlays?” The answer is, “no.”
It’s not that the stock market didn’t perform over that decade. In fact, the S&P 500 returned 8.5%. The problem is advisors and fund managers get paid whether or not your portfolio goes up or down. Fortunately for us (and unfortunately for fund managers), the creation of index funds (like ETFs) and the move in the last few years to zero-fee trading at many large brokerages means investing in the world economy as a whole at nearly no cost is available to everyone.
What Is an Index Fund?
An index fund can be a type of mutual fund or an exchange-traded fund that pools money from a lot of investors to buy a diversified array of different stocks, bonds, or other securities. The first index fund was created in 1975 by Vanguard founder Jack Bogle, and it was called “Bogle’s folly.” At the time, investing was expensive, it required a human broker, and the idea was to create greater returns than you could get from risk-free investments like bonds.
Index funds were game changers because they focused on matching the return of an entire class of investments – like the stock returns of the companies in the S&P 500 – instead of trying to beat the market the way actively managed mutual funds do. But to get there they had to overcome the misperception that investment professionals got better returns picking winners than if you just invested in all stocks equally.
Bogle saw a difference between investing and speculating. Investing seeks to preserve capital at a lower rate over a longer time horizon while speculating seeks to find advantages for traders in the short-term at a higher rate of return with a greater risk to capital. Everyone who is saving for retirement should be investing and not speculating. But active fund managers are paid to speculate on market moves and the performance of individual stocks.
Today, index funds can be as broad as a “total market” index or can cover a relatively small set of assets, like emerging markets in Latin America. But the point is you invest in an index, not the wisdom of a manger.
What Are Examples of Index Funds?
There are two key components to consider when buying an index fund: what does the index cover and what is the fund’s “expense ratio.”
Different Kinds of Indexes
You have a lot of choices when it comes to choosing an index fund. Most index funds are comprised of stocks, but you can also buy index funds for bonds and other investment types.
Here are a few well-known stock indexes that you can invest in:
The S&P 500: Available from most companies selling mutual funds, the S&P500 is an index comprised of 500 large companies that are traded on the New York Stock Exchange (NYSE) or NASDAQ.
World Stocks: The specifics of this index will vary on the focus of the fund or ETF. However, the idea is to give investors access to nearly every publicly traded company in the world. One example of a world-wide index fund is the Vanguard Total International Stock Index Fund ETF (VXUS).
Dow Jones Industrial Average: This index was invented in 1896 by Charles Dow. It tracks 30 significant stocks traded on the NYSE and NASDAQ. Though the Dow is the most famous index in the U.S., the way it indexes stocks makes it less representative of the stock market in general than an S&P500 fund.
Russell 3000: This index is comprised of the 3,000 largest U.S. traded companies.
Small-Cap: This type of index tracks small-sized publicly traded companies.
You can also invest in indexes not tied to stock markets. There are index bond funds, indexes that track the prices of precious metals, and indexes that track the price of virtual currencies like Bitcoin.
What to Know About Index Fund Expense Ratios
Index funds are still funds, which means they require a bit of money to manage. (If you have a brokerage account and you pick your own stocks, you may still pay fees, but you will have to decide if a stock is worth keeping or not.)
The expense ratio is the cost of maintaining the fund. That includes the cost of buying and selling assets in the fund, the salaries of its managers, the physical overhead of the fund manager (think offices and computers) and anything else that requires money to keep the fund going. The formula for an expense ratio is Total Costs of the Fund divided by the Total Assets of the Fund: TC/TA.
Actively managed mutual funds have gotten cheaper since the turn of the millennium, as have all other investments. In 2000, the average mutual fund total cost (not including sales commissions) could exceed 1%. And when your fund’s top-line return is only 5%, that means you’re getting 20% less than if you invested the money on your own.
Now the average cost for mutual funds and ETFs is 0.45%, according to Ben Johnson at Morningstar. Still, that’s quite a bit higher than the 0.08% you pay for holding the Vanguard Total International Stock Index Fund mentioned above.
Funds and ETFs list their expense ratios in their prospectuses. If you’re in the market for an index fund, be sure to see how much it costs to own as well as its past performance.
The Advantages of Index Fund Investing
There are quite a few advantages to index fund investing.
Diversification: As John Bogle liked to say, “Don’t look for the needle in the haystack. Just buy the haystack.”
Low Cost: There is not a lot of research and analysis that needs to be done to manage an index fund – which makes them lower cost than other types of mutual funds. Index funds are relatively simple – they just need to adhere to the rules defining the index.
Proven Performance: Index funds have consistently outperformed other types of mutual funds and even professionally managed hedge funds for the very wealthy.
Easy to Understand: You don’t have to worry too much about understanding your investments when you buy an index fund. You know that the money is invested according to a certain formula and your money will rise and fall with the overall market.
What is the Downside of an Index Fund for Your Retirement?
Index fund investing still puts you at some degree of risk. There are times when the overall market falls and, during these times, investors can experience huge (hopefully short term) losses. And, if you need access to your money at a time when the overall market is down, you will have to sell your index fund at a loss.
So, if you are retired and you need access to your money for monthly expenses or at a specific time in the relatively near future, you may want to consider diversification beyond just index funds or at least beyond index funds based on stocks alone.
What Rate of Return Can You Expect From an Index Fund?
The rate of return depends on the index, but if you put all your money in an S&P 500 index, you, like Warren Buffet, can generally assume an 8% rate of return – but that comes with a few caveats.
First, return on investment (ROI) doesn’t take into account the possibility that inflation will eat into your “real rate of return.” If your index fund has grown 8% per year, but the price of everything has gone up 5% per year, you really only have 3% more money.
Second, index investing doesn’t work if you trade in and out of funds. The strategy is to buy a stable index with lots of liquidity and never sell it to buy something better. Some indexes will lag in the short term. In the first five years of Buffett’s bet against the hedge fund managers, he was behind due to the impact of the Great Recession on the S&P500. But over the long-term, his belief that index funds would outperform was proven to be correct.
Third, and building on the second, if you chose an index with too narrow a focus, you could lose money in the long-term. For example, if there was an index fund for all companies that make buggy whips, and you invested in it in 1900, you might think 100 years later you’d have a big return. But of course, you’d be wrong. The same might be true for investing in a fossil fuel industry index in 2020.
For most investors, index funds are the most inexpensive way to get low-risk returns. That’s why they are a great vehicle for your retirement portfolio.