Why Invest in Index Funds?

credit: freedigitalphotos.net by Stuart Miles

credit: freedigitalphotos.net by Stuart Miles

I have friends and co-workers who do not trust the stock market or are intimidated by it. I have also read comments on various blogs where the commenters mention the same thing. I was a little hesitant about writing a post about investing as it is more of a hobby for me and I have no professional knowledge. Also, I hadn’t put up my disclaimer page until recently! (just in case…you never know)

How I became interested in investing
First, let me explain how my interest in the stock market was sparked, and how my experiences shaped my investment philosophy. When I was about 11 years old, my father bought me a Nintendo game called Wall Street Kid. I was a nerd and loved that game, but I’d hide it if my friends came over for fear that I would be teased. I did beat this game, which is an accomplishment that should qualify me to give you all investing advice.
Wall_Street_Kid
Not only did my father buy me an investing game, he invested in a mutual fund for my college education and showed me the statements. They didn’t have 529 plans back in the day when I was a kid. My father bought an actively managed mutual fund from American Century called the Ultra fund. It was a great fund that was “synonymous with stellar growth.” I looked at the statements seeing 20% to 40% growth and I was hooked.

When I was still in college back in 2001, I remember everyone and their mother and their grandmother investing and making money in stocks. Everyone thought they were expert stock pickers and everyone was glued to CNBC. I decided that I was missing out and took all the money that I saved up to open a trading account. It was a lot of money to me at the time. I bought some internet stocks that were recommended by analysts which I had never heard of. I also bought well known stocks like AT&T (they were soon offering a wireless IPO and IPOs were hot!). Yes this is AT&T wireless. To you youngings that don’t know a time without cellphones, wireless phones were a big deal and this stock would no doubt be a big deal (so I thought). About one month after I opened by stock trading account, the internet bubble burst and my stocks came crashing down. I lost 50% of the value in the account.

When I started working, I had a little more money to invest with and put more money into the stock market. Be greedy when others are fearful according to Warren Buffet. I picked up Nokia stock at $14 (I had Nokia phones and liked them). The stock went up to around $40 and I held on because its a stable company. It was a buy-and-hold type of company. An industry leader. A “rule maker” as the Motley Fool called it. I kept it all the way until now. With the advent of smartphones, Nokia phones were an after thought. It’s now at around $4. I bought shares of Starbucks at one point…I wasn’t a customer, but saw how popular the store was. They could probably open a Starbucks inside another Starbucks and still have crazy lines. Well I sold the stock during the latest recession trying to cut my losses. I figured people would save their money and spend it on other things rather than $5 lattes. I must be wrong because the stock is worth about 4 times more than what I sold it for.

My timing was horrible. It probably has a lot to do with loss aversion and the endowment effect which is explained well in this fantasy football analogy by Done by Forty. When I bought a stock, there was an endowment effect or ownership bias. I placed a higher value on it and didn’t want to sell as I thought it would go up more. When the stock went down, I didn’t want to sell and take a loss, hoping that it would go back up.

Mutual Funds

I invested in some winners and some losers, but the losers probably outweighed the winners. Good thing I was also investing in mutual funds through my deferred compensation plan and IRA. Based on my history, if I only invested in individual stocks, my portfolio would be in shambles. You might be asking with mutual funds, why not invest in a professionally managed fund. Obviously the fund managers are more adept and competent as this is their profession. Remember the “Ultra” mutual fund that my father invested for me which was a high flying fund. It was a great fund…until it wasn’t. During the tech boom in the late ’90s it did well investing in tech stocks, but did horribly when the bubble burst. The managers seemed to panic and changed gears, trying to invest in safer stocks. Those didn’t do that well either. Janus funds also were coveted by investors, but were crushed during that tech bubble. Legg Mason Fund’s manager beat the S&P 500 15 years in a row and this was a well respected fund recommended by many financial magazines, but struggled during the latest financial crisis.

So why index funds?
-With actively managed funds, you have to be able to pick the fund that will actually outperform the market. Will you pick the right one?
-Even if the fund managers can beat the market, can they do this consistently year after year?
-Actively managed funds have much higher fees and expenses
-Actively managed funds have much more turnover because they have to buy and sell stocks in an attempt to beat the market. This causes higher costs and it is not tax efficient as it results in capital gains. On the other hand, index funds invest in an index and therefore do not have much turnover.
Still not convinced, read this article by Rick Ferri in Forbes entitled 5 Lies About Index Funds.

I prefer Vanguard index funds as I find that they have the lowest fees.

Check out these blogs and resources that I enjoy reading and that go more in-depth about investing
Bogleheads Wiki
Oblivious Investor
Mom and Dad Money

Individual Stocks
There will always be an allure with investing in individual stocks. It is sexier than a diversified portfolio of stocks. There is more risk, but the rewards can also be greater. You’ve probably heard something similar to the following:
If you bought 100 shares of Apple Stocks back in 1997 when Apple wasn’t the high-flying company it is now, your stocks would now be worth about $150,000. In the back of my mind, I always think I’ll hit that home run with a stock.

Because of the risk, I’d say that for the majority of people, it is better to keep individual stocks as only a small part of your portfolio such as 5% which is what I do. Do you really have the time and patience to research stocks? Even if you do, are you confident in your abilities to consistently buy low and sell high?

For interesting reads on stocks and market trends, I enjoying the following:
The Motley Fool
Jim Jubak on MSN
Jon Markman on Marketwatch
Troy on The Financial Economist

46 thoughts on “Why Invest in Index Funds?

  1. C. the Romanian

    A great article! I am really considering to start investing and buying stocks, but I am just at the “want” stage in my life and I know nothing about investing. Of course, I saw the movies and individual stocks sound really charming for now – probably until I get to lose most of my invested money on them. But indeed, going safe is the best way to do it, especially at first when you don’t know the market, the ins and outs and… well… the “stuff” about investing :))
    C. the Romanian recently posted…How Much Does Pregnancy & Birth Cost?My Profile

    Reply
    1. livingrichcheaply@gmail.com Post author

      Thanks C. Definitely check out the Boglehead Wiki and the other blogs. I think that’s the beauty of index investing…you don’t really need to know that much about investing. I read about investing for many years, but I still know very little. That’s why it’s just better to invest in broad indexes. Not sure if index investing is available in Romania.

      Reply
  2. Brad @ RichmondSavers.com

    This really is a great article! I like index funds for a few reasons:
    1) There is nearly no way an average investor or even one of these “star” investors can beat the market over a 40-year period. Taking that a given, why wouldn’t you want a diversified slice of the entire market?
    2) The expenses are tiny on an S&P 500 mutual fund or a similar ETF. The difference in paying 0.05% per year and 1%+ in expenses for a managed fund can easily add up to hundreds of thousands of dollars over a lifetime. So you’d be paying dearly for “expertise” that is almost guaranteed to lose (see point #1).
    3) You can easily setup automatic investing with index funds so you take your own human error out of the investment process. Setup something small like a $100 automatic investment twice a month through the low-cost index funds at a place like Schwab and this will just run on autopilot forever. You don’t have to time the market, remember to invest, etc. It just happens and your brain can’t get in the way!
    Brad @ RichmondSavers.com recently posted…Quick Tips: What is an ETF?My Profile

    Reply
    1. livingrichcheaply@gmail.com Post author

      Thanks for the in-depth comment Brad. I absolutely agree with your reasons for liking index funds. My brain hasn’t gotten in the way of smart investing too often…I try to keep my hands off of it as that has provided better results.

      Reply
  3. Rita P @ Digital Spikes

    Yeah very nice article and agree indexing works more effectively than active investing. Also I had similar experience with Nokia stocks as I had picked it up at $13 and saw it rise till $40 and fall back but I still booked loss at $10 when there were rumors about company shutting down but that didn’t happen. Now they are making windows phone with Lumia series and it may go up from, $4 to touch double digits again
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    1. livingrichcheaply@gmail.com Post author

      Thanks Rita. Yes Nokia…I was so excited about that stock and thought it was a solid company. I’m hoping that the windows phone does well. We’ll see!

      Reply
  4. Kim@Eyesonthedollar

    I really always think I want to invest in individual stocks, but I usually go ahead and pick the index fund instead. It just seems to make more sense over the long haul. I do have a very small amount in individual stocks, but, like you said, it’s hard to go wrong with the Vanguard funds. I’ve used Vanguard for years and have no complaints at all.
    Kim@Eyesonthedollar recently posted…Do I Have What It Takes To Be a Big Time Credit Card Churner?My Profile

    Reply
    1. livingrichcheaply@gmail.com Post author

      Yes I’m a big fan of them. I think it’s fine to have a small amount in individual stocks. I always have the temptation to tinker with the stock market and buy certain stocks that I read about. As long as it’s only a small portion of my portfolio and I know the risk involved, I’m fine with that.

      Reply
  5. Done by Forty

    Thanks for including a link in this great post of yours!

    And thanks for sharing your personal investing history: it’s beneficial to see how active stock picking plays out in the ups and downs of the market. Right now I think a lot of active investors are building confidence in their ability to pick winners, as the markets have done so well for a few years. Since 2009 you could pick blind and do pretty well.
    Done by Forty recently posted…Birthday & 7 Years from the Goal: Progress UpdateMy Profile

    Reply
    1. livingrichcheaply@gmail.com Post author

      So true…I think it was even more true back during the tech bubble. Everybody…literally everybody thought they could make money because everything was going up.

      Reply
    1. livingrichcheaply@gmail.com Post author

      Good to hear that you’re a fellow indexer. Good point about trusting people…ultimately the “manager” is there to make money for themselves too. They need to make moves to improve your returns, but also to APPEAR that they are doing well. The do some window dressing during the end of the year/quarter: http://www.investopedia.com/terms/w/windowdressing.asp

      Reply
  6. Matt Becker

    Thanks for the shout out Andrew! And thanks for sharing your story. It’s not easy talking about our losses, but your story is definitely helpful for people out there who are undoubtedly going through some of the same things. And you’ve been able to learn from mistakes and settle on a strategy that’s working well for you. It sounds like you’ve set yourself up well for the future.
    Matt Becker recently posted…The Mythical $12,000 BabyMy Profile

    Reply
    1. livingrichcheaply@gmail.com Post author

      You’re welcome! I do enjoy reading your articles on investing as I have a similar philosophy and it reinforces that philosophy. I’ve known about index investing and saw the value in it, but didn’t truly embrace it until the last few years. Hopefully, others will learn faster than me. As you mentioned in a comment on Make Money Your Way…the evidence is overwhelming in favor of index investing.

      Reply
    1. livingrichcheaply@gmail.com Post author

      Yes, it is easy and cheap. I think it is the best bet for amateur investors…but can be a good bet for more experienced ones too.

      Reply
    1. livingrichcheaply@gmail.com Post author

      Yea my dad would only buy me “educational” type games…not violent, shoot’em up type games.

      Reply
  7. Dividend investing Martin

    I understand that for some people investing in individual stocks can be scary and mutual funds are best for them. However, I believe, with individual stocks on long run I can do a lot better. Mutual funds, even index funds are expensive (expense ratio), and their results are poor. They do not beat the market, they do not even keep up with it. Even the index funds lack behind their index although they are trying to keep up with it.

    Today you can make a mix of the individual stocks on your own and invest in them. Today, you can literally create your own mutual fund with Motif Investing and buy it as a whole and beat the market as well as the index funds. Just give it a try, invest in blue chips, dividend paying stocks and you will see for yourself. You can read about Motif Investing on my blog: http://hellosuckers.net/create-your-own-mutual-fund/
    Dividend investing Martin recently posted…Great dividend stocks offering a good entry pointMy Profile

    Reply
    1. livingrichcheaply@gmail.com Post author

      Thanks for your comment. I have heard of Motif but don’t really know much about it. I will check out the article you wrote. Individual stocks on the long run can do better, but you’d have to pick the right one. For an amateur or someone who doesn’t have the means, knowledge or time to do research and analyze companies and market trends, I still think index funds are the best.

      Reply
      1. Dividend investing Martin

        Andrew, I believe if you do a little reading and pick those dividend paying behemoths you won’t make mistakes. You can load your portfolio with Coca Cola, McDonald, Procter & Gamble, Johnson & Johnson, Lockheed Martin, Realty Income, and many others (I do not know now on top of my head) and you really won’t make a mistake. Even an amateur can do that. And of course, you need to do some reading and show some interest in investing your money. Thinking that you just buy stocks and don’t do your homework, is a sure way to a disaster.
        Dividend investing Martin recently posted…Effective Money Management TechniquesMy Profile

        Reply
        1. livingrichcheaply@gmail.com Post author

          Do you invest in dividend paying stocks in an IRA or in a taxable account? I think it’s possible to do well with big companies that offer dividends but if you only invest in them, you lose out on the potential of companies with great growth potential. I also contemplated buying General Electric years back…it would be considered a dividend paying behemoth I think…it hasn’t done that well and went down to $5 at one point.

          Reply
    1. livingrichcheaply@gmail.com Post author

      Haha, Thanks! While everybody has to go through their own experiences to learn and find which investment philosophy they agree with, hopefully those who read it may give index investing a try earlier in their journey.

      Reply
    1. livingrichcheaply@gmail.com Post author

      Yes, not sexy but it does work. I understand the feeling that actively investing in individual stocks need time to do properly but I’m not sure any amount of research and time will make stock picks right. Maybe sometimes. But probably not all the time. And how much time would you need? I think even if you had more time, index funds are a good bet. Of course you can have a portfolio of individual stocks also that complements your index funds.

      Reply
    1. livingrichcheaply@gmail.com Post author

      Yes, I’m a big fan of Warren Buffet…Berkshire Hathaway is no doubt a good stock. But, yes, most people should consider index funds.

      Reply
  8. Scott @ Youthfulinvestor.com

    Great article! You really highlight some classic examples of when stocks go bad on us. Believe me, you were not alone on those picks and decisions. Many of have made them. Just remember that with stocks, there’s always someone at the other end. There has to be someone buying what you’re selling and selling what you’re buying. It doesn’t just come out of thin air. I like to think like that when I’m going to make a decision on whether to buy, hold or trade.

    You are right to recognize index funds as powerful tools for beginning investors and those who would lose sleep worrying about whether or not their stocks went up or down.
    Scott @ Youthfulinvestor.com recently posted…The Best Investing Blogs for College Students and Twenty-SomethingsMy Profile

    Reply
    1. livingrichcheaply@gmail.com Post author

      Thanks Scott. Index funds are definitely a powerful tool, not just for beginning investors but for all investors. I no longer lose sleep worrying about how my portfolio is doing. As long as I’m happy with my asset allocation, I sleep fine!

      Reply
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  11. Thomas | Your Daily Finance

    I have not moved over to the dark side yet. I kid I kid. Seriously though I have heard a lot of talk about index funds but just like investing on my own. I like looking up companies and picking what I think is a good move. There are no guarantees with the market but I know the I called a few stock picks that I missed and I am kicking myself to this day. The wifey is in mutual funds so I may move some of her positions into index funds after I am more familiar with them as of right now. I have the time(sort of) to watch the stocks I own.
    Thomas | Your Daily Finance recently posted…August Half-Time Update Preseason is Almost OverMy Profile

    Reply
    1. livingrichcheaply@gmail.com Post author

      I would think active investing is the dark side! Haha, just kidding. I like looking up companies and reading what analysts say about them and researching market trends, but even with all that work, I think that I’d do better with index funds. Of course like you said…you like doing that stuff and have some time to watch the stocks, so that’s why I do invest in individual stocks…it’s just a smaller part of my portfolio whereas index funds make up the bulk of it.

      Reply
    1. livingrichcheaply@gmail.com Post author

      That’s a great way to put it Charles. It is somewhat counter-intuitive because because don’t think that being “average” and staying with the crowd is a good thing but in this case it is.

      Reply
    1. livingrichcheaply@gmail.com Post author

      That’s great. I’ve discussed investing with people who do have an agenda and they are always pushing actively managed funds with loads and expensive fees…I wonder why! As John Bogle says: Costs matter. That’s why index funds generally outperform their actively managed counterparts.

      Reply
    1. livingrichcheaply@gmail.com Post author

      Thanks for your comment Jean. I am a big fan of Vanguard index funds and they come highly recommended by many others as well.

      Reply
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