Warren Buffett’s usual investment advice for individual investors is to invest in index funds. He doesn’t do it himself, but here is why he recommends this for the average Joe like you and me.
Anyone that is learning how to invest in stocks should know very early on the importance of diversifying. This is the idea of spreading your risk. You have probably heard a million times the metaphor of not putting all your eggs in one basket.
There is a way that you can get instant diversification with just one investment vehicle. By using index funds, you can potentially invest in thousands of stocks in just one shot. And it’s much better than you trying to find a bunch of stocks to buy on your own. It saves you a ton of work.
Let me first give you a primer on investing in index funds. If you don’t need an introduction, just skip down to the bottom for a list of the major index funds that you will want to check out.
What are Index Funds?
Index funds are mutual funds that seek to track the performance of a particular index. For example, there are index funds that track the performance of the S&P 500. That means if you hear that the S&P went up 5% on any given day that means your investment in that fund went up as well.
They are often called passively managed funds because they automatically track an existing list of stocks. Often, a computer program does it automatically. This is as opposed to an actively managed fund which has a team of money managers that manually pick the stocks to buy and sell.
Benefit #1 – Instant Diversification
There are many benefits to index funds. The first is something we already mentioned: diversification. By investing in a S&P 500 index fund, you are automatically investing in 500 stocks in just one go. It is like going out to individually buy equal number of shares in each of the companies that are in that index. You get all of the advantages of diversifying in one asset.
Benefit #2 – Transaction Costs and Money Management Fees
You get the advantage of diversifying at just a fraction of the cost of doing it manually. Even if you pay $9.99 on stock brokerage fees to buy each of the 500 stocks in the S&P, that alone would cost you $5,000. But if you buy an S&P 500 index fund, you only have to pay commissions for one trade.
In addition, since these funds are passively managed, your money management fees will be considerably lower. Since there isn’t a team of highly paid money managers that are pulling the strings behind the curtain, they are considerably cheaper to operate. That means lower fees for you.
Benefit #3 – Easy way to get great returns
Index funds are an easy way to get started investing. In fact, if you choose to only invest in index funds for the rest of your investing life, you may actually make out better than a significant portion of people who try to beat the market by stock picking. Actually, you will get better returns than most mutual fund money managers out there.
The key is to keep your money in there over time. History shows us that the stock market rises over time. In any given 10 year period, the stock market always goes up. That means as long as your investment portfolio is tracking the performance and returns of the overall stock market, you will make money.
Downsides of Trying to Beat the Market
Many investors get burned because they try to beat the market. There are several ways they get burned.
First, they spend a bunch of time trying to learn how to invest in the stock market. That is time, energy and money that could be toward increasing their earning potential in their careers. There is opportunity cost to trying to beat the market.
Second, they spend a bunch of money on transaction costs buying and selling individual stocks.
Third, they take a hit on taxes because they often don’t take advantage of the long term capital gains tax. When you are trying to time the market, you can’t always wait for the 1 year market to sell your stocks.
Fourth, research shows that even the majority of highly paid, money managers can’t beat the market. If that is the case for these guys who are so-called experts, the average main street investor should not think that he could do better.
S&P 500 Index Funds
Here is a list of index funds that track the S&P 500 composite index.
- Vanguard 500 Index Fund
- ETrade S&P 500 Index Fund
- DWS Equity 500 Index Fund
- Rydex S&P 500 Fund
Dow Jones Index Funds
These index funds track the performance of the 30 stocks in the Dow Jones Industrial Average
- iShares Dow Jones U.S. Index Fund
- SPDR Dow Jones Industrial Average ETF
Total Stock Market Index Funds
These are index funds that seek to track the performance of the overall stock market.
- Vanguard Total Stock Market Index Fund
- Russell 3000 Index Fund
- Spartan Total Market Index Fund
Small Cap Stock Index Funds
If you are willing to go a little more risky and aggressive, you can invest in a small cap fund. These index funds track the performance of an index of small cap stocks. These will generally give you a higher return over time, but you better make sure you stay in it long enough to see the returns.
- Vanguard Small-Cap Index Fund
- iShares Russell 2000 Index Fund