Why index funds are the key to simple, smart investing

My elevator pitch for simpler, smarter investing

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 great 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. 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, which is often. After every talk I’ve given over the past 25 years, I’ve gotten the same question: What’s the “big secret” to making a killing in the stock market? And every time, I give the same answer: There is no secret.

And people are finally catching on. Over the summer, for the first time ever, more money has been invested in passively managed funds than in actively managed funds.

To celebrate this milestone, 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. An index fund, on the other hand, simply invests in the stocks that make up a particular index—a broad sample of stocks like the S&P 500. Then the value of the fund 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. Over the past 20 years, according to research by investment analysis platform Morningstar Direct, the average broadly diversified “large-blend” index fund, like those based on the S&P 500, made an annual return of 5.21% (after expenses). The average large-blend actively managed stock fund returned just 4.46% (after expenses). So, if two decades ago you’d invested $10,000 in index funds, you’d have nearly $28,000 today. If you’d put it in the average actively managed fund, you’d have only $24,000. In fact, index funds have beaten out actively managed funds each year for most of the past four decades. In 2018, for example, only about a third of actively managed funds did better than your average passive fund.

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 76 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.

Talking about money can leave you tongue-tied. My weekly newsletter is full of financial conversation starters.

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 index funds are finally getting their due.

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