7 Reasons You Need to Consider Index Fund Investing Today

By Kevin Just Start Investing


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Updated on

The below is an awesome guest post on index fund investing from Just Start Investing. You can learn more about him and the website at the end of this post.

What would you rather do, travel to a different grocery store for every item you need to purchase this week? Or head to one (or a couple) grocery store(s) to grab everything you need, like you do now?

This is not a trick question, the answer is the second option.

The same theory should apply to investing as well.

You can keep things simple and get everything you need with a few investments rather than investing in 10, 20 or 100 individual stocks – which takes a lot of time and effort.

Index fund investing is the perfect strategy for beginners. We’ll talk through 7 huge benefits below, but at a high level, it’s easy and effective. It takes the complexity out of stock picking.

With index fund investing, you can buy the overall stock (or bond) market instead of individual stocks (or bonds). This guarantees your performance will match that of the market your decide to mirror (like the S&P 500) with minimal work involved! Anyone can do it.

I like to point out that it’s not just me with this opinion. Many expert investors, like Warren Buffett, agree with and promote index investing as well.

As Buffett told CNBC, “Consistently buy an S&P 500 low-cost index fund… I think it’s the thing that makes the most sense practically all of the time.”

What is Index Fund Investing?

If you want to dive deep on this subject, I wrote a comprehensive guide detailing what index fund investing is, which you can find here.

The Cliffnotes version of index fund investing is as follows:

“An index fund is the combination of an index and a mutual fund. Well, really an index fund is a  mutual fund. But it is a mutual fund that invests to mirror a specific index, rather than whatever the mutual fund manager feels like choosing that day.”

And as you’ll learn below, there are many benefits to choosing this simple index fund over actively manages ones.

Before index fund investing or investing in the stock market, ensure you ask yourself some simple questions. These essential questions will help you prepare and choose the right investments.

7 Reasons to Take Up Index Fund Investing

Below are a few of the benefits of investing in index funds. While the list is not super comprehensive, it does highlight most of the reasons why smart investors should choose index funds.

1. Low Expense Ratios

The first, and arguably most important benefit to index fund investing is the low expense ratios.

An expense ratio is a fee that gets charged annually to keep the index fund (or mutual fund) up and running. It is your cost.

It is important to keep expense ratios as low as possible, which index funds typically do. You can easily find funds with expense ratios between 0.0% and 0.1%.

On the other hand, some actively managed mutual funds charge up to 1% or higher!

Over an investing life cycle of 40 years, this can add up to a huge cost. Let’s look at a quick example of two people investing $10,000 per year into an index fund returning 7% annually.

Except, one person’s fund has an expense ratio of 0.02%, and the other is 1.00%.

7 Reasons You Need to Consider Index Fund Investing Today

The low expense ratio fund grows to almost $2 million! While the 1% expense ratio fund is just over $1.5 million.

That’s about a 25% difference in return (or about $500,000) just because of the expense ratio.

2. Index Funds Do Not (Usually) Have Hidden Fees

I hope it’s now clear after that example above that fees are quite bad for your investment portfolio.

And the fee structure on index funds are a pretty simple concept.

But expense ratios are not the only kind of potential fees out there. There are also:

  • Load fees
  • 12b-1 fees
  • And much more…

Index funds, in general, do a good job of eliminating or minimizing these fees so that you can keep more of your money in the long-term.

3. Free Trades

This is the last point on fees, I promise.…

Index funds (when investing with the right broker) have no transaction costs.

Typically, a broker (like Fidelity or Scottrade) will charge you $5-$10 per trade.

So every time you buy a group stocks, bonds or funds, you need to pay the fee. And every time you reinvest into the market at a later date, you pay this same cost again. And again. And again. Every time you reinvest.

However, with index fund investing, if you invest through the right broker you can trade their index funds for free!

Charles Schwab and Vanguard are both great places to start – they offer a wide variety of index funds that you can trade for free (that also have rock bottom fees)!

4. Simplicity

Index fund investing is simple and easy to do. Anyone can do it! Yes, anyone!

For one, this means you don’t have to pay an overpriced financial advisor to steal your money. Or, as they call it, “help you invest for your future.”

Note: Not all financial advisors are out for your money and sometimes it’s perfectly fine to consult with one. However, make sure they are a fiduciary. Which means the advisor, as a fiduciary, owes the client a duty of loyalty. Simply put, they must act in the best interest of their client. More on that here.

But more importantly, it also means you don’t need to stress or waste a bunch of time investing. Index investing is a “set it and forget it” investing strategy.

Yes, you need to check in once in a while to add funds or rebalance your portfolio, but you don’t have to constantly be checking in on stock performance and deciding on what to buy and what to sell.

5. You Have “Guaranteed” Returns

No, you are not guaranteed to have positive returns (I wish I could promise that to you), but you are guaranteed to match market returns. Which, historically, has had long term positive returns.

The S&P 500 (an oftly cited index) has historically returned +7% annually. $10,000 invested today would be worth $138,426 in 40 years at that rate (assuming a 0.03% expense ratio). Not bad!

With actively managed funds, you are not guaranteed this market return. Your manager is trying to beat the market, which rarely happens over the long term. Oh, and they’re charging you 1% all the while.

Even if an active managed fund beats the market by 1 percentage point consistently, you’re still in the same spot as if you would have taken the stress-free index fund investing route.

6. They are Tax Efficient

Index funds are tax efficient because they have low turnover.

Turnover is how often the stocks within your funds are being traded and replaced. For example, if your fund is made up of 10 stocks each comprising 10%, and 2 of the stocks were traded and replaced with 2 new ones in a year, then turnover would be 20%.

Consequently, any capital gains on those two stocks sold would be passed onto investors who would need to pay taxes on those gains.

With an active fund, turnover usually high as the manager is actively making trades. This means you typically have to pay more capital gains taxes.

An index fund turns over much less often because indexes do not change very often. So you’ll have less capital gains and less capital gains taxes to pay – keeping more of your money in the fund and growing.

7. Diversification

Last but not least, index fund investing provides diversification.

Diversification is a fundamental investing principle that involves owning multiple investments to limit your risk of one investment taking a tumble.

For example, if you owned only Enron in the late 90s and into the early 2000s, you’d be screwed. You’d literally have lost all of your money.

Sure, on the other hand, if you owned Apple or Amazon from the early 2000s to now you would have made a killing. But diversification helps to balance the two extremes and set you up for steady, long term gains.

Diversification ensures you don’t get screwed, and the cost of that is limiting any huge, quick upswings in your portfolio.

Plus, with just three simple funds you can set up a diversified portfolio that is easy to manage and maintain.

Index funds are amazing investment vehicles that every new, average and seasoned investor alike should take advantage of.

Getting started with index investing is easy too, so don’t wait another day!

About the Author: Just Start Investing is a personal finance website that makes investing easy. Learn the simple strategies to start investing today, as well as ways to optimize your credit cards, banking and budget.

What do you think of index fund investing? Is this something you do in your portfolios? Let us know in the comments below.