Why Index Funds Are the Best Choice for Most Investors

December 5, 2012

Index fundsThere are two basic ways to invest in equities. One is to take on the life of an active investor by researching, selecting, and tracking your own stock holdings or those of various actively managed funds. The other is to invest your money in index funds and then sit back, relax and enjoy the ride.

While it may seem that investing in index funds is the lazy man’s way to investing in stocks, it is also the more successful path for most investors. Index fund investing spares you a lot of the cost and complication of trying to be active investor.

Time and Effort

Being an active investor takes work! You have to follow market trends, track industries’ individual stocks, research your investment choices and, once they’re made, constantly monitor them for changes in position. That’s a lot of time and effort that most people don’t have.

By investing in index funds you don’t have to do any of that. You’re investing in the market and going along for the ride. Index funds really are a passive way to play the stock market. Rather than betting on any given stock, industry group or fund manager, you’re relying on a given index for that market or industry. You make a single decision to buy into the index fund and then you’re done.

You can invest in general market indices, such as the S&P 500. Or you can invest in index funds for individual sectors, such as emerging markets or technology.

You Probably Have Better Things to Do

This is the flipside of the time and effort factor. If you are retired or independently wealthy or in some other situation where you can devote a full-time effort to investing, then the active approach might work for you. But most of us have other things going on in our lives that don’t permit that kind of effort.

If you have a full-time job, a family, and an active life, those activities are probably soaking up most of your time – as they should. And in all probability, you work in a job that isn’t related to investing. That means that you are an “expert” in some other field. That field needs to get the bulk of your time and attention. Since you only have so much time and energy, active investing may take you away from that.

Fees!

A built-in problem with active investing is fees. Trading individual stocks involves transaction fees, and actively managed funds have higher fees than index funds. As an active investor, these fees will reduce your investment return. That can have a substantial negative effect on your investment portfolio over the long run.

Since index funds are passively managed, fees are reduced. This will improve your long-term investment return.

You Might Beat the Index Averages One Year But Lose the Next

One of the attractions of active investing is the potential to beat the market. If you are not content to earn market averages, and have a sense that you can do better, the idea of active investing will appeal to you.

But when it comes to investing, reality doesn’t usually match up well with our desires. You may beat the market averages in one year or even two, but you’ll probably give it back in other years.

One of the problems of active investing is the potential to fall in love either with your investment holdings or with your investment philosophies. For example, if you’re partial to certain technology stocks, you could get stuck holding too many when the market falls.

With index funds you’ll never be overweight in any stock.

Most Funds Managers Don’t Beat Market Averages Either

You don’t necessarily have to hold individual stocks in order to be an active investor. You can also invest in funds that are actively managed. But like active individual investors, actively managed funds also attempt to beat the market, and that adds greater risk.

The reality is that most actively managed funds do not beat the market, and in fact many under-perform it (some studies even indicate that most actively managed funds under-perform the market).

Just as is the case with individual investors, a fund manager may beat the market in some years but under-perform it in others. The net result isn’t as pretty as the advertising copy often suggests.

When you invest in index funds, you can never under-perform the market. Since the first rule of investing is not to lose any money, index funds put you ahead of the game. With all of the risks involved in active investing, most people will be better off using index funds instead.

What is your investing strategy? Leave a comment and let us know what you think of index funds!

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Kevin

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Kevin
Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

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