Over the last 9 years, Wall Street has experienced a historic bull market run. On March 9, 2009 the market bottomed out and the very worst of the Great Recession revealed itself. However, since those dark days, stock prices have gained momentum, with major indices like the Dow Jones Industrial Average and S&P 500 growing over 300% since 2008.
As the US economy continues to show strong indicators, many people have decided that they’re ready to get into the stock market. However, if you’re new to investing, the investment options, industry lingo, and risk can be both daunting and discouraging.
Should I Invest in the Stock Market? (YES)
The first question you may be asking yourself is, should I invest in the stock market? Even if you think the market will turn bearish (and it inevitable will at some point) the answer is a resounding yes. Since the first stock markets were created over 400 hundred years ago, no person or system has been able to reliably predict when the market will rise or fall. The current bull market could go on for another 5 years, or it could end tomorrow. However, as someone who wants to grow their money, new investors must take advantage of their two most important allies: compound interest and time. Moreover, investors must also protect their capital from the corrosive effects of inflation.
What Should I Invest in?
Once you understand why you should invest, the next question is what do I invest in? Fortunately for all of us, there is a simple answer that provides returns that match the market, are less risky (relatively speaking) and are affordable to invest in. It’s called an index fund.
Index funds are investment funds that attempt to match the performance of a stock index. There is a wide variety of indices that track different sectors of the market. You already know the most popular indexes like the S&P 500, Dow Jones Industrial Average, NASDAQ Composite and Russell 2000. An index fund purchases the stocks of the companies in a given index.
Index Funds: No-Effort Diversification
Index funds have become a very popular investment tool, especially for novice investors and investors who don’t want to spend hours moonlighting as a stock analyst. Prominent investors like Warren Buffet and Benjamin Graham are big proponents of index funds.
So why are index funds such a sound investment strategy? There strength lies in their simplicity. Index fund managers simply buy the stocks of the companies in a particular index. Over the last 20 years, the S&P 500 has grown at an annualized rate of roughly 7% (or roughly 10% before accounting for inflation). Index funds like the Vanguard S&P 500 ETF, Schwab S&P 500 and the Fidelity Spartan 500 hold shares of the 505 companies that make up the S&P 500. As a result, index funds typically provide investors with diversified holdings, without the capital or effort required to build a diversified portfolio on your own.
However, the best feature of index funds is their low costs. Index funds relatively low expense ratios is the primary reason they consistently outperform actively managed funds over the long-term.
Low Costs: The Key to Steady & Consistent Growth
The cost of investing in a mutual fund or ETF (exchange-traded fund) is referred to as an expense ratio. An expense ratio is an annual fee expressed as a percentage of your investment. It represents the ratio of your investment that goes toward the fund’s expenses. For example, if you invest in a mutual fund with a 1% expense ratio, you’ll pay the fund $10 per year for every $1,000 invested.
Generally, funds that are actively managed (fund managers actively research companies and track market trends, making a high number of trades in the process trying to find the next big winner and cut losses on losers) have higher expense ratios when compared to an index fund. Nothing eats away at your returns faster than a high expense ratio. Moreover, even if an actively managed fund out-performs the market, to be a favorable option as compared to an index, it has to outperform the market enough to cover the higher operating costs and additional risk (indexes are historically less risky then actively managed funds).
Using Passive Investing to Your Advantage
Index funds are passively managed, meaning the fund managers simply buy and hold the shares of the index companies. This results in very low expense ratios. Index fund managers are not required to perform intensive stock research and only execute a relatively low number of trades to maintain the portfolio (for both indexes and actively managed funds, each trade incurs a cost to the fund). It simply doesn’t take much effort or time to create an index fund. The benefits of low costs are best shown in an example.
Expense Ratio Comparison: A 10 Year Example
The average expense ratio for an actively managed mutual fund is around 1.5%, while the average expense ratio for an index is roughly 0.2%. Let’s say you invest $1,000 in an actively managed mutual fund with a 1.5% expense ratio that gives you returns that match the market at 7%, and you invest another $1,000 in an index fund with an expense ratio of 0.2% that also gives you returns at 7%.
After 10 years, your actively managed mutual fund account will have $1,708, while your index fund will have $1,931, or put another way, the index fund will have outperformed the actively managed fund by 13%. That 13% “loss” went directly into the pockets of your fund manager as part of the 1.5% expense ratio fees.
In this scenario, for the actively managed fund to break even with the market (and the index), it has to outperform the market by an additional 1.3%. But you’re not swallowing the additional risk and costs of an actively managed fund to match the market, you’re doing it to beat the market.
At this point, I need to highlight the additional risk actively managed funds present. While index funds simply track a given index, it must be said that indexes like the S&P 500 are comprised of the largest, and often most stable companies in the US. In contrast, actively managed funds will have some of these large, stable companies (depending on the focus of the fund), but it will also hold high-growth (and high-risk) companies. This is why the average annualized rate of return for all mutual funds over the last 20 years is a meager 4.67%. That’s right, actively managed mutual funds historically perform nearly 3% worse than an index tracking the S&P 500.
To justify the additional risk, an actively managed fund should perform significantly better than the stock market to account for the higher expenses and the additional risk.
Drawbacks to the Index Fund: Meeting the Market and Boredom
Index funds have only two drawbacks: they won’t beat the market, and they are boring. Many actively managed funds will beat the market in the short-term. However, if you plan on having money in the stock market for an extended period of time, an index fund is the way to go.
Only about 1 in 20 actively managed funds beat the market over the long run. In contrast, index funds always track the market. Over the last 50 years, the S&P 500 has grown at an annualized rate of 11.69% (not accounting for inflation).
Owning an index fund does not mean you’re going to own the next Facebook before it explodes, but it also means you won’t own the next Bitcoin before it crashes. Seeing a stock price rise 30% or 40% is exciting, just as much as it is jarring to watch a stock price plummet to $1.00. Index funds may not be the best investment for people who plan on buying and selling stocks on a daily basis, but they are perfect for just about everyone else.
Index Funds are the Right Investment For You
For a vast majority of investors looking for a relatively safe investment with moderate returns, index funds are the way to go.
For those who want to get serious about smart investing, these books are must-reads:
By Benjamin Graham
By Burton G. Malkiel
By John C. Bogle