Indeed, the most successful investor in history, Warren Buffett, advocates that those unwilling or unable to intelligently evaluate individual stocks should invest in a low-cost index fund such as those offered by Vanguard. Why? Index funds boast three distinct advantages over their actively-managed counterparts:
- They do not require corporate analysis or an understanding of accounting, financial theory, or portfolio policy.
- They have almost non-existent expense ratios, providing a significant competitive edge over actively managed funds and almost completely ensuring superior long-term performance.
- They are made up of dozens or hundreds of companies. This diversification reduces company-specific risk.
What is an index fund?
An index fund is a mutual fund designed to mirror the performance of one of the major indices (e.g., the Dow Jones Industrial Average, S&P 500, Wilshire 5000, Russell 2000, etc.) Unlike traditional, actively managed mutual funds where portfolio managers evaluate, analyze and acquire individual stocks, index funds are passively managed. Basically, this means they consists of a pre-selected group of stocks that rarely, if ever, changes. An investor that bought an index fund designed to mirror the Dow, for example, would experience price movements almost perfectly in sync with the quoted value of the Dow he hears on the nightly news. Likewise, an investor that built a position in an index fund designed to mimic the S&P 500 is, in essence, acquiring stock in all five hundred of the companies that make up that index.
Corporate and financial analysis not required
Index funds are ideal for those who have no idea how to evaluate competitive advantages of various corporations, differentiate an income statement from a balance sheet, or calculate discounted cash flows. Because company-specific risk is diversified away thanks to the dozens or hundreds of companies that make up each of the major indices, such analysis is unnecessary. In addition, an index fund is a cost effective way to acquire hundreds of stocks while avoiding the thousands of dollars in brokerage commissions that would otherwise result.
The benefits of lower expense ratios
Actively managed mutual funds must pay portfolio managers, analysts, research subscription fees and the like. The percentage of a fund’s total expenses including its 12b-1 fees divided by its average net assets is known as the expense ratio. Because index funds are unmanaged (and require none of the aforementioned expenses), the expense ratio is almost non-existent compared to the average mutual fund. This means that less of the investor’s money goes to paying overhead, compensation and sales charges. Over the long-run, the lower costs associated with index funds can result in significantly improved performance.Consider the following: a quick glance at Yahoo Finance reveals the average expense ratio for growth and income style mutual funds is 1.29%. As a result, approximately $1,883 of every $10,000 invested over the course of ten years will go to the fund company in the form of expenses. Compare that to the Vanguard 500 fund, designed to mirror the S&P 500 index, which boasts an annual expense ratio of only 0.12%, resulting in ten-year compounded expense of $154 for every $10,000 invested. In other words, by investing in the Vanguard fund, the investor will have $1,724 more working for him. Compounded over an investing lifetime, the difference is significant.
The importance of dollar cost averaging
At the height of the roaring stock market of the 1920’s, the Dow Jones Industrial Average reached a peak of 381.17; in 1932, the Dow crashed to 42.22. It took over thirty-three years (1929 to 1955) for it to return to the 1929 level. An individual investing all of his money at the height would have waited more than three decades to merely break even! If, however, he had started a dollar cost averaging program, he would have made a tremendous amount of money thanks to his significantly lower average cost basis by the time the market returned to its previous level.
