Why index funds are the key to simple, smart investing

My elevator pitch for simpler, smarter investing: Index funds

When I began writing for Money magazine in the 1980s, the conventional wisdom was that individual investors needed to do their homework to find a top-performing “actively managed” mutual fund (with a person at the helm picking and choosing stocks). And it seemed to make sense: Just find a shrewd active mutual fund manager, and you’d get the best returns.

But a few years into the job, I read a life-changing book, A Random Walk Down Wall Street by Burton Malkiel (still an essential read now entering its 13th edition). He made the case that investors are better off buying and holding a passively managed mutual fund—like an index fund. Decades of academic research have shown that Malkiel was right.

Since then, I’ve been singing the praises of index funds whenever I can, in both boom times and less-than-boom times. After every talk I’ve given over the past 30 years, I’ve gotten the same question: What’s the “big secret” to making a killing in the stock market? And I give the same answer every time: There is no secret. Get into an index fund and stay there. 

For example, if you had invested $1,000 in an S&P 500 index fund when the Great Recession began back in December 2007 and stuck with it through those challenging years, you would have recovered your money by mid-2012. If you then stayed with the index fund through the present, despite the recent bear market and new recession jitters, you’d still be up 244%.

There is a reason, after all, that more money has been invested in passively managed funds than in actively managed funds. 

Here’s the five-minute index-fund elevator pitch that I’ve been giving for years.

For starters, know that a fund is simply a basket of stocks chosen from across the stock market. With actively managed funds, a manager selects which individual stocks go in the basket. On the other hand, an index fund simply invests in the stocks that make up a particular index—a broad sample of stocks like the S&P 500 mentioned above. Then the fund’s value goes up or down with that index—with little intervention from a manager.

But wouldn’t you be better off choosing a top-performing active fund? Sure, if you knew which funds would perform well in the future. Researchers have found, though, that past performance is not indicative of future returns. (In fact, the rules say that funds have to tell you that upfront.)

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Still, fund managers love to point to past successes to sell their services, so let’s compare track records. Index funds have beaten out actively managed funds each year for most of the past four decades. In 2021, for example, only about 20% of actively managed funds did better than your average passive fund. In fact, according to the S&P Dow Jones Indices SPIVA U.S. Scorecard, the average broadly diversified “large-blend” actively managed stock fund has failed to match the returns of the average large-blend index fund for twelve consecutive years

One key reason index funds are so investor-friendly: They charge lower fees. Because you aren’t paying for an active manager to pick and choose stocks, a whole lot less of your earnings will be eaten up by fees. For every $100 you put into an actively managed stock fund, you’ll pay 71 cents in fees per year on average. And that really starts to add up when you’re talking about a lifetime of savings. The same amount invested in passively managed funds will cost you as little as eight cents a year.

Are my five minutes up? Okay, now that I’ve sold you on index funds, it’s important to point out that not all index funds are cheap. I recommend checking out the low-cost offerings at Charles Schwab and Vanguard. And know that I don’t work for these companies, and don’t get a dime or a T-shirt for recommending them. What do I get? Peace of mind knowing that, even during rocky financial times, index funds seem likely to yield steady returns in the long run.

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