Are index funds the best investment?
For 35 years, Bay Area finance revolutionaries have been pushing a personal investing strategy that brokers despise and hope you ignore. [This is] the story of a rebellion that’s slowly but surely putting money into the pockets of millions of Americans, winning powerful converts, and making money managers from California Street to Wall Street squirm.
So writes Mark Dowie in a recent issue of San Francisco magazine. Dowie describes how Google prepared for its IPO in 2004. Aware that hundreds of young employees would soon be millionaires, the company brought in a series of financial experts to teach them to make smart investment choices.
- Stanford University’s Bill Sharpe, winner of the 1990 Nobel Prize in economics said, “Don’t try to beat the market.” He advised the Google employees to put their money into indexed mutual funds.
- Burton Malkiel, author of the classic A Random Walk Down Wall Street (in which he posits that a “blindfolded monkey” could pick stocks as well as a professional money manager) and former dean of the Yale School of Management said much the same thing. “Don’t try to beat the market … and don’t believe anyone who tells you they can — not a stock broker, a friend with a hot stock tip, or a financial magazine article touting the latest mutual fund.”
- Jack Bogle is the founder and retired chairman of The Vanguard Group. What did this expert on mutual funds advise? The same as the others. “Brokers and financial advisors … are there for one reason and one reason only — to take your money through exorbitant fees and transaction costs, many of which will be hidden from your view.”
These experts, and many like them, recommend the same thing: take the slow, sure path to wealth. Invest your money in index funds. Index funds are low-maintenance, low-cost mutual funds designed to follow the price fluctuations of a broader index, such as the Dow Jones Industrials or the S&P 500. They are boring investments. But they work.
Related >> How to Invest in Index Funds
Jack Bogle’s common-sense approach has inspired a loyal following among savvy investors, many of whom participate in the Vanguard Diehards discussion forum.
[This] forum is characterized by its contributors’ commitment to low cost — primarily index — mutual fund investing, its unusually civil tone, and the thoughtful replies to almost all who post a question, no matter what their level of investing knowledge.
Some of these diehards call themselves Bogleheads in tribute to their muse. Three of them recently published The Bogleheads’ Guide to Investing, which is an excellent guide to smart investment choices. In the book, the Bogleheads stress their philosophy: Make index funds the core — or all — of your portfolio.
But not everyone believes that index funds the best choice for personal investors. A week ago I shared a brief conversation about money with Sparky, a friend to whom I often go for investment advice — he reads widely on the subject, and is well-informed. He doesn’t like index funds. Also last week, Jim at Blueprint for Financial Prosperity urged his readers, “Don’t just buy index funds.” Another blogger is worried that even index funds may be getting too complicated.
Even some professionals prefer other stock investment strategies. For example, Lowell Miller wrote a well-regarded book entitled The Single Best Investment: Creating Wealth with Dividend Growth in which he touts high-quality, moderate-growth, dividend-producing stocks as the best choice. In The Only Investment Guide You’ll Ever Need, Andrew Tobias admits the virtues of index funds, noting that over time they beat the returns on nearly every other sort of investment. But he notes:
For the prudent, thoughtful investor there is now the possibility of the ultimate fund. The one you put together yourself. The Personal Fund. It is no-load, of course, because you don’t charge yourself a nickel. And not just low-expense, like an index fund, but, rather, no expense.
This “personal fund” approach is exactly what my friend Sparky was trying to describe to me in our conversation last week. I like the idea of using some portion of my portfolio for a personal mutual fund. It’s easier for me to pay attention to my investments when they’re stocks I picked myself. But I will always want the core of my investments to be in index funds.
Despite the dissenters, most experts agree: index funds are an excellent way to get rich slowly. Dowie’s article on the subject is long, but is worth reading if you’re serious about your stock investments. Bookmark it. Print it. Save it for later. But make some time to read it.
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There are 55 comments to "Are index funds the best investment?".
For me the primary attraction of index funds is their “set-it-and-forget-it” convenience. Sure, I could probably earn more (possibly much more if I happen to be lucky) with a personal mutual fund, but I want to keep my life as simple as possible. That includes my financial life. For me, the cost of my time and energy in picking and managing my own fund would outweigh any financial gains I might get from it. If I were interested in stocks as a hobby or just fascinated with the system in general, I’d feel differently; it would be a good use of my time because it would be something I enjoy doing. I would never say that index funds are the best long-term strategy for everyone, but they’re probably the best strategy for those of us who want to spend as little time managing our money as possible.
I discovered this approach by doing basic personal investment research a few years ago. After getting the basics on track- zeroed out high interest debt, adequate short term savings- the investments started to roll.
An interesting approach if you’re going to do both index investing and individual stocks is to use your IRA for all of the heavier trading. While you eat into your limited resources for commissions, you save yourself the painful sting of capital gains taxes. I found that with individual company stocks, I would often be inclined to cash out after times of peak performance. With an index fund? You know it’ll rock back and forth but you’ve got decades between you and selling it.
I’ve found great success in a mix of S&P 500 (SPY) and Vanguard European Index (VGK).
When I read about index funds and how they out perform “over time.” Exactly how much time? Exactly which time periods are we talking? 20 years? 50? 100? I’m not concerned about the time between 1920 and 1980 I want to know about from now until I need to liquidate the asset. I don’t know when that will be or why I’ll need to do it. I might have a basic plan for retirement and so forth but that doesn’t mean I won’t get sick, get downsized and need to liquidate some assets in order to pay bills.
If you bought an SP500 index in 2000 you have lost money. If you bought a Dow Index in 1999, it took 7 years to break even and show an increase in nominal value. Take out inflation and you’ve lost money. 7 years is a long time to make nothing or loose money. An even worse example is if you invested in a Nikkei 225 index fund. Lets look at a 20 year run on that one. If you invested in 1987, opps that index didn’t work out well either. You would have had to invest the Nikkei all the way back in 1987 you have just now broke even in nominal dollars. Adjust for inflation and you are down, a bunch. Investing on my own since 2000 I’ve had a 12% rate of return. Do the math, my money has doubled and then some in the last 7 years. Invest in companies that you understand, have good management, a competitive edge on the other companies in their field and buy them cheap. If you have time to watch TV, surf the internet and so forth then you have time to do your homework and find good businesses to invest in.
Even better, invest in yourself and run your own business.
And if you’d invested at the time of that comment, you’d have gained around 20% by now.
One thing I don’t understand–if there is a good growth fund that has handily beaten the S&P 500 in the YTD, 3-year, 5-year, and 10-year, and has a great reputation–why isn’t that fund automatically better than the S&P index fund? This is especially the case if you can get it without a front-end load in a 401(k). This is the case with me and ANCFX. Can anyone give me a good reason why I should have a big chunk of my 401(k) in the S&P500 index fund over ANCFX?
There will always be around 10% to 20% of managed mutual funds that beat an index in any period of time. The key to remember is that you and I have no idea which one of those funds will be the winner. Past performance tells us NOTHING about future performance. When someone shows you an individual mutual fund that has beat an index you should respond by showing them how thousands have not! Play the odds and simply select the cheapest and most efficient index mutual funds to invest in and then continue to dollar cost average your money into them over long periods of time. Vanguard does this better than anyone else. The Total Stock Market Index Fund is a wonderful example of this discussion. I hope this helps. You can become an expert on investing by simply reading and applying what you learn from these two great books. The Four Pillars of Investing by William Bernstein and A Random Walk Down Wall-Street by Burton Malkiel.
BTW, obviously volatility is another important consideration. It would do me little good to pick a rollercoaster fund. However, ANCFX’s beta is right around 1.00, as are many other managed funds that have outperformed the index.
I can’t speak on behalf of Jim@Blueprint for Financial Prosperity, but I believe that article was intended to be a “Devil’s Advocate” post. As I recall, it ends with him admitting that the case against index funds is pretty weak.
Tinyhands is correct: Jim is playing devil’s advocate. Still, he tries to present some arguments against index funds. I should mention that the discussion in the comments on that entry is worth a read.
I think I need to put a red bar at the top that says “Devil’s Advocate post” or something… BTW, I love index funds. 🙂
For the great bulk of people, yes, it’s the best investment. As Malkiel wrote in ARWDWS, the management fees at managed funds will quickly eat away your returns. Which of these two would you rather get?
A) 8% return (beats the market by 1%) with 2% fees
or
B) 7% return with .25% fees
The point is that even good managers (those who beat the market) will have to be paid, and that management fee will quickly eat away at any returns above the market indexes. Especially when you look at the historical performance of managed funds, you see that the majority of them (I don’t have my copy of ARWDWS right now, so I’m relying on memory here) don’t beat the market at all (and thus produce funds that under-perform the market by several percent after fees are taken out), and very few (maybe 5-10%) manage to beat the market enough to make up for their fees.
Remember, managed funds are buying and selling stocks all the time, and they still have to pay commissions and other trading costs. That eats away at returns. And the turnover in managed mutual funds is so high (managers swap out, and a fund that’s on top one year may be a poor performer the next) that really it’s a crapshoot as to whether you pick a well-managed fund.
On the other hand, I do believe in the Self Fund for investors who have enough time to spend getting educated on, and keeping up with, companies and markets.
So, short answer: Index funds = best for people who use funds. Self Fund = best for people with time to do their own research (but risk is correspondingly higher).
Patrick did your fund do better when fees and expenses are taken into account?
To me that is the biggest benefit of index funds. I have a couple of funds that are tracking the FTSE. They have a fee of 0.5% per annum. Any of the actively managed funds I’ve seen have a fee of at least 1%. That means that my active fund would have to do a whole lot better than the index fund to make up for the fee difference.
I remember reading an article that said that past performance was generally the worst guide to funds as often the best performing managed fund one year would be one of the worst the next and vice versa.
Patrick Szalapski:
I hate to be a party-pooper, but according to BigCharts, the S&P 500 has out-performed ANCFX over the last ten years. ANCFX is up about 60% over that time frame, while the S&P 500 is up nearly 85%.
Travis:
It’d take a whole blog post to fully refute your examples, but the overview is:
* Money needed within five years shouldn’t be held in stocks.
* Touting your own returns, you curiously forget to mention inflation, which you brought up every other time.
* You complain about cherry-picking dates for S&P 500 returns, then do it yourself for all the “you would’ve lost money” examples.
* The “losing” returns you cite assume one purchase at the start of the time-frame, and holding throughout. Unless you got 12% annual returns making no buys or sells since 2000, you’re comparing apples to oranges. (Dollar cost averaging into the relevant indices would fix this.)
In other news…
I wonder what Jack Bogle, et al., think of Warren Buffett’s track record. Methinks they’re taking the efficient market hypothesis a little too seriously.
I think that Warren Buffett is an unusual case with regard to being an investor. When the situation warrants it, Warren actively gets involved in how a company is run when he invests in it. So part of Warren’s record is attributable to his ability to add value to his investments. The rest of us don’t have those options and even if we did, how many of us would have the talent to extract that value?
VinTek,
I think the point re Warren Buffett is not to be Warren Buffett, but rather to invest with Warren Buffett (instead of an index fund). If anyone had invested with Berkshire instead of an index fund, wouldn’t they have done better?
Your headline says “Are Index Funds the Best Investment?”. You did not really answer this question. You showed any different examples for both side of the argument, but no evidence for why or why not it should be used.
2 things tend to kill the performance listings of mutual funds vs index funds:
1) Churn – most funds turn assets 50%+ per year, which incurs a big tax hit.
2) Survivor bias – the reason funds say “x% over the past 10 years” better than the S&P is because the funds that underperformed have been shut down. A fund company will start 10 funds, then close the worst half after 5 years and then tout the success of the other 5.
Dustin, J.D. clearly said that he wants index funds to be the core of his investment strategy, augmented by his personal fund choices. That’s what I’ve been doing for many years and it has worked well for me so far. For me, the evidence in support of index funds, backed by lots of research, is much more compelling than the hundreds of anecdotes from people who have been lucky enough to beat the market. Sure it’s possible to beat the market if you happen to pick well. But the evidence shows that in the long run, index funds tend to bring their holders a better return than they’ll get from professionally managed funds.
I don’t put all my retirement money into index funds, but I’ve got a 401k with about 50 percent in an index fund and the rest in growth funds, plus a very small portion in bonds. Works for me (so far, anyway!) and I haven’t touched it. That portfolio has more than doubled in value since 2002, when I had to stop contributing to it because I moved to a different country.
I don’t think this discussion is valid. To put it simply, your investment depends on your objectives, the time you have to manage them and how active you want to be in the market.
Index funds are a great idea for people who do not have the time, interest or motivation to research managed funds/individual shares. They are definitely a great way to get rich slowly.
On the other hand, it you do have the time, interest and motivation to do some research, then I would definitely recommend this instead. Why settle for 10% returns when with good research you can get 15-20%?
Well here’s a question for you experts (and semi-experts!: With things like the DOW and the other major indexes at or near all time highs, would it be wise to buy into stock index funds or should one wait for something like a recession when they’ll dip back down in value.
Or is that a really stupid question?
Patrick Wrote
“* Money needed within five years shouldn’t be held in stocks.”
Which is why I have gold and silver bullion coins, money market account, CD’s and T-Bills- but I hold these only as hedges and money that I can easily get my hands on- not primarily as investments.
“* Touting your own returns, you curiously forget to mention inflation, which you brought up every other time.”
Ok I’ll mention it now. If you go by the real inflation (something like 8%) and not the official government number I’m still up 4%
“* You complain about cherry-picking dates for S&P 500 returns, then do it yourself for all the “you would’ve lost money” examples.”
That was my point to begin with. By picking the start and end date a person can say index funds are great or they can say index funds suck. In other words, it is a meaningless arguement. The idea that an index fund is better or worse is relative to the timeline and goals of the individual investor. I would agree with this statement, “Index funds “can” outperform mutual funds and other investments over a long term period but each investor should be aware that the point at which they choose or must sell their position may negate some or all of their returns.” That would be a more correct and precise statement. How many retail investors got in during the big run up in tech stocks only to get crushed? Where there not people who’s “long term” was up in 2001 or 2002 and at the very least had a lower return because they needed the money that was in their index funds and couldn’t wait until 2006 for their paper profit to come back again?
“* The “losing” returns you cite assume one purchase at the start of the time-frame, and holding throughout. Unless you got 12% annual returns making no buys or sells since 2000, you’re comparing apples to oranges. ”
Two part reply:
1) What I’m comparing is results. It doesn’t really matter to me how they are gotten as long as they are ethically aquired and in the black. If the bottom line is bigger then that is better. Plain and simple. If it takes more work, time and focus then so be it. If I buy and then sell what’s the difference? If the end result is a higher long term net return (after taxes, fees and expenses are subtracted) then why does it matter?
2) Isn’t buying and holding the idea behind an Index fund? Simple investing. You put your money in and it gets bigger over a “long term.” Which is my point. Index fund owners are betting that the index will continue to grow over the long term period they have to invest. They are not getting in and out. They are not finding opportunities to buy new companies or get rid of the dogs. They are adding to their position (regardless of whether its making them any money or not) but not changing it. The basic arguement that index funds do better over the long term make them sound like savings accounts with just a better return. That is simply not the case. it is how they are sold but not how it really works out. Timing is important. The “when you get in” and “when you get out” is more important that the index fund touts make it out to be.
Not every investment is always up or always down but pretending like the lazy man’s method of index investing is a sure fire way to make you a big winner is foolish. It can be a good place to put a portion of your money but the context should be there when discussing the value of the strategy.
Covert7 Asks:
“With things like the DOW and the other major indexes at or near all time highs, would it be wise to buy into stock index funds or should one wait for something like a recession when they’ll dip back down in value.”
The basic answer you’ll get from the financial press and your average money manager is that it doesn’t matter because it will always go up “in the long term.” You are going to make money if you keep it in the index fund for the “long term” no matter when you get in or when you get out is how the mantra goes.
I find that thinking to be dubious. I don’t have an MBA or a fancy office and I spend most of my spare time actually researching individual companies (so I can buy and hold them over a period of years) instead of sitting on my can watching the dough roll in from an index fund.
Look. I’m sure your friend Sparky is a great guy, a comedy genius with great fashion sense. And I’m sure he knows the price of everything.
But this is a financial advice blog. People’s lives rely on this stuff. And Sparky is the guy:
…who said “bonds are for retirees. More risk! please”;
…who said “index funds suck… I don’t want to have my investment rely on the average of the bad and the good. I want the good and the good”;
…who listed a bunch of ways to tell a good mutual fund from a bad one, but didn’t think to mention loads or fees;
…and who, if I read him correctly, built a personal mutual fund consisting of “one company from each of those [8] categories…the best of the best for each category” and referred to this eight-stock fund (?!) as “diversified”.
So someone’s gotta say it: your friend Sparky is a gambler and taking financial advice from him is like investing in lottery tickets. I wish him luck, but his investment strategy has no place on this blog. This is “Get Rich Slowly”, not “Take Risks Gleefully”, “Day-Trade Frenetically”, or “Churn the Portfolio Constantly”.
You need to buy a copy of Bernstein’s Four Pillars of Investing, read it at least once, then give it to Sparky.
Gerard says:
“Index funds are a great idea for people who do not have the time, interest or motivation to research managed funds/individual shares.”
No. The notion that index funds are children’s toys that aren’t fit for Real Investors is pernicious. It must be stopped!
The problem with managed funds is that (a) they can’t beat the market over the long term; (b) you can’t identify the ones that will beat the market over the short term until after the fact; and (c) they all operate at a handicap because their management fees are huge compared to those of index funds.
The problem with individual stocks is that unless you own hundreds of them you aren’t diversified enough to reduce the risk of significantly underperforming the market.
“Why settle for 10% returns when with good research you can get 15-20%?”
Because risk and returns are proportional. By taking a chance at 15% you run the risk of getting 5%. And, while being rich would be nice, being poor would absolutely suck.
Covert7:
You can’t “wait until a recession” to start investing. That’s called “timing the market” and it’s a classic mistake.
The market is unpredictable – you and I may think it’s overvalued, but that doesn’t mean it won’t go farther up. If it does, and your money is all in cash when it happens, you’ll miss a chance at some growth.
Contrariwise, we could have a 20 year bear market starting tomorrow. It has happened before.
So, what do you do? I can’t really tell you without writing a book, and that book would probably be Bernstein’s “Four Pillars of Investing” mixed with Andrew Tobias’ book, because those are what I’ve read most thoroughly. 🙂 They say the Bogleheads book is good, too, though. And reading Malkiel couldn’t hurt.
The basic idea is this:
You’re going to put your money into more than one place. For example, put 35% into a domestic index fund, 30% into an international index fund, 30% into a bond fund, and keep 5% in cash. You will want to adjust these percentages for your own situation – read the books!
You’re going to do this slowly. Don’t dump all the money into the funds next Tuesday, or you’ll be sad when the market crashes on Friday. Invest 30% per year for three years, or 25% per year for four years, until you reach the right fractions in stocks, bonds and cash.
Dollar-cost average: you have to keep saving. Invest the savings several times a year, like clockwork, without fail. This will help to average out the highs and lows of the market.
Finally, rebalance: every two to four years, you readjust your portfolio back to the target percentages. The idea is that, if US stocks tank, but international stocks don’t, you sell some international stock and buy US stock. This also helps smooth out the difference between bull and bear markets.
(And this, by the way, is part of the reason you need to own bonds. They’re not just for geezers: they are your reserves, which you keep around so that you’ve got something to buy stock with when all of the stock markets have crashed and there are bargains everywhere.)
Travis writes: “When I read about index funds and how they out perform “over time.” Exactly how much time? Exactly which time periods are we talking? 20 years? 50? 100?”
The academic source for your answer is Jeremy Siegel’s book Stocks For The Long Run. Professor Siegel has crunched the numbers for you. For any 20 year period of time, stocks have been the best investment, even including Black Friday of the Great Depression, and the precipitous drop in the 80’s. (I forget what people call that day.)
John Bogle essentially posited the same thing and started Vanguard and their index funds.
I’ve seen the statistical tables and it’s all in there if you read Siegel’s book. It came out when I interned at Wharton in the 90’s. (I have a first edition, but unfortunately never got it signed.) I believe they have been updating it with newer editions.
travis, you should stop talking, because you don’t know what you are talking about:
MUTUAL FUNDS:
“Index funds “can” outperform mutual funds”
indexed funds *are* mutual funds. do you mean they can outperform *other* mutual funds? or that they can outperform managed mutual funds? well, thanks for that bit of advice. we’ve already pointed that out.
note: sparky makes this mistake too.
If you are not talking about a mutual fund, then you are talking about an ETF, or an indiviudual stock or bond you picked for yourself.
INFLATION RATE
2ndly, questioning the gov’ts inflation rate makes you sound crazy, and there is no point in changing it for yourself. when doing a comparison, you still compare the original cost (in that year’s dollars) to the current cost, and then make some adjustment for inflation and whatever else you want to adjust for (or currency depreciation for example). and you should use the same adjustments for the 2 investments you are trying to compare, otherwise, you aren’t comparing apples to apples. you could say “inflation” is 50%. it doesn’t matter when making a comparision, it just just makes it confusing for other people to follow what you are talking about.
CDS:
3: you hold CDs in a rising interest rate environment? oops. be sure not to mention that too loudly when tooting your horn.
HEDGING:
and what are you hedging with a T-Bill or money market fund? you have hedges that don’t protect against any loss. hedges are used to limit downside loss, but they also limit upside gain. sounds like you are not as confident in your investing skills as you think.
i guess you are hedging the future gains of your money market account with your CDs. that’s funny.
GOLD & SILVER COINS?
also holding gold and silver coins has a cost -ie insurance from theft by crackheads. you’d be better off with an ETF that mirrored the gold or silver market. otherwise, you are taking an odd risk if you have more than a few hundred bucks in gold and silver (ie, more than $200, which would be 1/3 of an ounce of gold).
TIMING MUTUAL FUNDS:
also, when you “get in and get out” of indexed funds is not particularly important. they will rise over time because companies become more efficient at serving new needs of the 6 billion people in the world.
when the world stops growing and falls into a horrible warlike existence due to a catastrophic event, ie a comet crashing into earth causing a severe food shortage, something of that nature, then stocks will not have room to grow. but then, your portfolio probably won’t be your primary concern.
You’re stepping up into high finance with this entry, JD. No longer are we trying to rinse aluminum foil with rainwater. We’re going for gains! We’re making big money. And, I noticed how some readers wanted MORE than 10%. They wanted 15-20%! And most of these folks knew their stuff. Yee-haw! Good stuff people. Let’s get away from Getting Rich Slowly….let’s get there by Thursday!
also, as a question to JD for Sparky, how is Sparky measuring his risk tolerance in reguard to a mutual fund or stock he wants to invest in?
typically, risk tolerance is a measurement of volatility. volatility is measured as the diff in daily changes over some period (you get to choose your period, perhaps since the beginning, since a major change, past 5 years, or something).
Then this volatility measurment and std deviation from it becomes the risk.
the beta on yahoo finance is a shortcut. 1= market return, 5 = +-5X market return on average. so if the market rises 5% in a day, then a stock with a beta of 1 will rise around 5% and a stock with a beta of 5 will rise 5*5 ~ 25% on average.
however, that involves looking at past returns, which Sparky said he didn’t do, or trusting yahoo’s measurment of beta.
so how’s he know how much risk is in his portfolio? is it by number of stocks?
not being rude, just honestly curious. because i’d consider Sparky to be a scientific base case equalling basically no professional investment experience and i’m curious how he’d define risk among his portfolio he would build.
again, not a snark, because efficient market theory states its impossible to beat the market with professional experience (making it mostly worthless in the long term), but in the short term, luck can kill efficient market theory.
beanspants1 wrties:
“index funds are mutual funds”
Yes I meant managed mutual funds
“2ndly, questioning the gov’ts inflation rate makes you sound crazy”
Then there are a lot of crazy economists that pay attention to the numbers and say, “sumthin’ ain’t raat.” Number one rule of history. Governments lie and exaggerate for the benifit of those in power. Hedonics, Substitution, and weighting all understate inflation. The BLS has been directed by various administrations to change its method of calculating inflation numerous times over the years to intentionally understate inflation. Clinton’s former Sec. Treasury wrote about it explicitly in his memoirs.
T-bills, CD’s and money market I use as a place to hold cash rather than a savings account or under the mattress. Not as a hedge, I didn’t deliniate that well. I hold precious metals in small quantity (normally about 10% of my overall portfolio but closer to 20% right now) as an inflation hedge. The money market on it’s own would be sufficient and easier to get at than the others as a place to hold cash but I’m getting 6.5% on CD’s and the money market was a little less the last time I checked. As one thing comes to maturity I put the money into what ever is the highest rate is at the moment. At a point where I get more cash than I want to hang onto at the moment then it gets moved into a long term investment with the intention of holding for decades.
I don’t and would not own huge quantities of physcal metal but I do own enough that I can cover a month’s worth of living expenses should it be necessary. That’s not many coins, less than what I could carry in my jeans. Most of my gold and silver holdings are in SLV and GLD.
I consider almost all my investements long term. I buy and hold. Hopefully there will never be a need to sell them when it is disadvantageous. There are exceptions to that of course. Tax Certificates in Indiana can pay as high as 25% and are generally redeemed in less than a year. (which reduces their return but never below 15%).
My basic point is a response to the title of the orignal blog post. The answer is in my opionion, “no.” There are other investments which can produce better returns over a longer term and which the invester has a greater control over. These can take a number of different forms.
If the question was, “Are index funds the best investment for people with low to medium risk tolerance and no time or desire to have a more hands on approach?” Then the answer would be “Yes they are.”
If you look at the majority of millionares out there they don’t have a lot of their money in stocks, be they index funds, mutual funds or indvidual stocks. The majority of their money is in other investements (preferably ones with good tax advantages) They invest in businesses that they operate (ussually boring things like salvage yards and dry cleaners), rental property and development property.
If you work for someone else make an income that is less than six figures and invest your money primarily in index funds then what you are going to get is moderately comfortable. Certainly not rich. Getting rich requires more risk, more thought, more research and more work than that.
Angela and Majeest, thanks for your comments. I suppose an index fund like DSPIX has been a bit over ANCFX on the 10-year and the 1-year (now). Doesn’t ANCFX’s outstanding performance on everything in between mean something, or did this fund just have an 8-year good run whose time is done?
“I think the point re Warren Buffett is not to be Warren Buffett, but rather to invest with Warren Buffett (instead of an index fund). If anyone had invested with Berkshire instead of an index fund, wouldn’t they have done better?”
The short answer is “yes.” But it’s always easier to pick a winner after it’s already won. It’s difficult to pick a winner before the race is run. How many people were smart enough to invest in Berkshire Hathaway when it was initially being offered? Is there an equivalent of that stock (in it’s early days. Of course BRK is still around today) today, and what is it? Who is the next Warren Buffett? If you find him, you’ll do well. But then again, there’s no indication that you’ll find him.
The whole point of index stocks is not picking a winner or loser, but knowledge that the market as a whole always rises in the long term. Warren Buffett is good and smart. But I’m inclined to believe that a large number of the people who actually invested with him in the early days were more lucky than smart.
VinTek,
I agree that the people who invested with Warren Buffett within the first 15 years of Berkshire were likely more lucky than smart. But how about after that? The Berkshire annual report states historical results back to 1965. I would say anybody who started consistently investing in Berkshire from 1980 onwards is more smart than lucky.
That’s the beauty of long-term performance. Even if you don’t get in at the very start (first 15 years), you can still get in and do better than the average market.
Investing in Warren Buffett today is likely a risker proposition, because of his expected life-span as an average human being. I agree that choosing the next Warren Buffett to invest with today is a challenge. Jack Bogle himself mentioned a few names recently in an interview with some folks from the Motley Fool. However, a lot of these individuals (funds) have closed the door to accepting more money, as their funds have become too large.
So I would agree with the following strategy: Invest in index funds today, but keep looking for the next Warren Buffett. When you find them, invest with them instead. In order to find them, look for 15 years of performance that has beat the S&P 500 by a significant margin (3% annually?).
Squished18,
Your strategy sounds good, but is it worthwhile? Remember, the market beats over 90% of the funds over the long term. How much time and energy do you want to spend looking for the next Buffett when you can beat 90% of the funds without breaking into a sweat?
And Warren is unique in that he’s stayed in one place. If you find the next Buffett, how do you know he won’t jump ship to another fund or another company? Do you dump the stock or company and take an enormous tax hit? Or do you hold tight and hope that the next guy in charge is just as good?
To be honest, I don’t hold a strict index porfolio myself, and I’ve been upfront about it. My core is in index funds, but weighted more toward value and small-to-mid caps than a strict market capitalization approach. So I’ll hold not only a Total Stock Market fund, but also a mid-cap and small-cap index funds, and value funds. Oh, and some international index funds too, weighted in much the same way.
Outside of my core, I have holdings in emerging markets (wild rides there) because that’s where the growth potential is; natural resources (another wild ride) because I think that the emerging markets are going to consume more, not less, of them; and a health fund, because I think they’ll make money hand-over-fist as the baby boomers start retiring. I hold this stuff for the long term and ride out the downturns, DCAing my way in. Rather than try to find the next golden boy of investing, I try to figure out where the future trends will be, and then try to get there first. A lot less pain and effort for me in that approach.
First, thanks for the link. =)
Also wanted to point out another non-believer of “just index funds” is The Motley Fool. They’re relatively young but they seem to have a great track record. They love index funds (vs. actively managed funds) but they also think investors need to supplement that with smart individual stock picks here and there. I tend to think that as long as you have a solid foundation with an index fund, then it makes sense to make a couple of “bets” on stocks you feel strongly about — maybe you’ll hit a home run.
The problem is that index funds are usually cyclical, and your job probably is too. You need to hedge your whole life.
If you ask someone who was in something like the Auto or Steel industries in the ’70s, something like the following might happen to you:
1. You put the money into an index fund where it stays flat for the first year.
2. We go into a recession so you lose your job, and your income either is gone or is cut in half. You aren’t putting in any more money into the fund because you don’t have it.
3. You use up your emergency fund, and the SPX drops 30-50% since “earnings” are now negative for the components and big funds are moving to bonds, commodities or something else.
4. You now need to start cashing in your nest egg (or lose your house, or go without health insurance), so you take your losses.
5. Things start turning around, but your “nest egg” is now 20% of its original size between market losses and forced withdraws. So how long will it take to do a 5x so you break even?
If you want a low-maintainence way to invest in stocks, index funds are great. The problem is stocks aren’t always the best investment, and you might want something negatively correlated, e.g. if you have something like BEARX, at step 4, you would be cashing in part of a large gain instead of a loss.
Also, taking some money out and learning new and significant skills (medical, technical, business, insurance, even plumbing, electrical, automotive) is probably a better investment than an index fund.
Human capital depreciates slowly if at all and can’t be taken away by inflation or bankruptcy.
“If you want a low-maintainence way to invest in stocks, index funds are great. The problem is stocks aren’t always the best investment, and you might want something negatively correlated, e.g. if you have something like BEARX, at step 4, you would be cashing in part of a large gain instead of a loss.”
This is where asset allocation comes in, whereby not all of your assets are in stocks. Given that your emergency fund will tide you over during something like a period of unemployment, the theory is that you should have the right “mix” of assets (not just stock, but also bond, REIT and stable funds) for your risk tolerance and age.
If…and it’s a big if…you can manage to continue contributing during downturns, such action will automatically force you to buy more shares when prices are low and fewer shares when prices are high. The whole “buy low, sell high” philosophy comes into play here. What most people do is sell there stuff in a panic when the market tanks, and then buy up stuff when they’re hearing about everyone else making money hand-over-fist in the market. That kind of behavior creates a “sell low, buy high” kind of pattern, which is what you *don’t* want.
“Also, taking some money out and learning new and significant skills (medical, technical, business, insurance, even plumbing, electrical, automotive) is probably a better investment than an index fund.”
I agree investing in new skills is a great thing, but unless you want to work until the day you die, you need to put aside some money in terms of financial assets too. Money is money, no matter what the source. You’ll have to decide if you want to work for it all your life, or if you want to have enough where working is a choice, not a necessity. I’m trying to get to a point in life where it’s a choice. Right now, for me, it’s still a necessity.
From a standpoint of risk and statistics, it’s foolish to try to outsmart the market. I had written something similar to explain this. Spending money on investment letters or trying to time the market makes others rich, not you.
See my post
http://extremeperspective.blogspot.com/2007/01/stocks-are-risky-dont-obsess.html
Here’s a question I have – have had solid performance with some pretty conservative mutual funds in my non-taxable accounts – Dodge and Cox, TRowe Price Capital Appreciation, Dodge and Cox Intl – but what about in taxable accounts? Isn’t this the great efficeincy of index funds – tax advantage? Not making a case for index funds, just wanting to know if anyone has the answer on this.
Certainly one of the advantages in index funds is tax advantages. An index fund, particularly a total market fund doesn’t trade because it already holds all the funds! Of course, the reality is that there will be occasional trades as in the index is adjusted to reflect new companies that have been listed or companies that have been delisted but for the most part, it’s fairly constant. And because it doesn’t trade, the fund doesn’t generate the tax consequences of capital gains. You’re still stuck with taxes on dividends though.
I’m not sure that I would characterize tax efficiency as *the* great advantage of index funds. Certainly it’s a major advantage, but low cost certainly ranks up there as well.
You get more trading with more selective indexes, such as mid-cap or small cap index funds. Companies will grow/shrink into or out of an index and the fund has to adjust accordingly, if it’s to stay true to it’s category.
[…] I am a convert to the passive investment style based on a number of great books, academic papers, and blog articles that I’ve read. I suggest starting with Are Index Funds the Best Investment? over at Get Rich Slowly. […]
How do I buy into an index fund like the Wilkshire 5000? Is there a on-line discount broker that allows me to buy into that fund — without a yearly maintenance cost?
Can you recommend one?
The Wilshire 5000 is not an index fund, but a stock market index. There are indexed mutual funds designed to mimic the Wilshire 5000, however. Try WFIVX. Or, if you have a Vanguard account, try VTSMX. Zecco may allow you to buy WFIVX.
The comments here are fun to read.
Especially amusing are the people who make 15, 20 heck 30% return by investing in individual stocks. It’s the internet, so who cares!
Which reminds me of a friend of my grandma’s – when she comes back from a casino, she always says how much she “won”, however tries to evade to question on “how much she put in the slot machine in the first place”…
I also blogged about this index fund thing – had great fun doing it, in fact.
I’m wary of all the advice to “rush out and buy index funds” when this site preaches “to NOT rush out and buy anything”.
Still, I’m hearing that:
-The broader the index fund (not tied to just oil/gas, tech, etc but includes some of everything) the better.
I’m one who literally does “forget about it” after my monthly RRSP payment comes out. Can I just go to my bank (Royal Bank of Canada) and tell them: “I want to buy Index funds, one with zero fees or with the absolute smallest fees possible. And then show me your rates.”? or do I have to buy into these index funds elsewhere?
Unfortunately, the data shows that when individual investors self-assemble and manage their own portfolios, they do terribly. They under-perform a passive strategy, and they fail to diversify adequately. In the process, they pay a huge price and waste a lot of their time.
I have summarized this research by Professors Kumar and Goetzmann in this article:
“What is the cost to individual investors of sub-optimal portfolio diversification?”
which can be found at:
http://www.theskilledinvestor.com/ss.item.30/what-is-the-cost-to-individual-investors-of-sub-optimal-portfolio-diversification.html
This comment is too late to matter to the conversation, but I’m going to say it anyway.
Criticizing index funds because some people are capable of beating the market is silly. You’re right, some people can and do beat the market. Most do not. In fact, most people barely keep up with the market.
Those of you claiming that with just “a little research,” you can get 15-20% on your investment are completely off. Mutual fund managers are experts at what they do, and most of them can’t pull that off. To imply that a person investing in their spare time can easily beat professionals is insane.
It’s certainly possible to beat an index fund. But index funds are overwhelmingly more reliable than almost every flavor of investment. They out perform all but the best mutual funds, and they outperform all but the best individual investors.
So, sure, if you know you’re one of the best individual investors, go for it. But for the rest of us, index funds are just fine.
Mike,
You probably won’t be able to buy the kind of fund you want at your bank. However, here are three possible sources for index funds.: Vanguard, Fidelity, and T. Rowe Price. In addition, look at http://www.ishares.com. They list a bunch of ETFs (exchange traded funds) that are diversified like index funds and trade on the open market like stocks. They also generally have lower expense ratios.
Vanguard also has ETFs. Finally, check out http://www.etfconnect.com. It will give you all the ETFs that are available. Good luck
There are two things that don’t make sense when I think about index funds.
Firstly, most index fund proponents claim that it is impossible to time the market because you don’t know whether it will go up or down in the short-term. This is backed up by the Efficient Market Hypothesis that claims that any opportunity to profit will be eroded by speculators until you cannot make any more profits. However, index fund proponents then claim that in the “long run” the markets always go up. If this were true, that is, if the market always goes up in the long run, then the market will price this in and the opportunities for profit will go and the market will no longer go up in the long run. There is no fundamental difference between long and short term. A lecturer may consider a 1-hour lecture short but a bored student may consider it long. Twenty years may be long for a mortal but for God it is short. Since short and long term are subjective emotion-based concepts, then what applies in the short-term in investing must apply to the long term.
Indexers then point to graphs and say that historic evidence supports the idea that in the long term the market goes up. But isn’t this just performance chasing, which indexers claim is bad?
Another problem I have is with index fund proponents saying that index funds are good because they offer good diversification since it is impossible to pick good companies. They then recommend you invest in a fund that tracks the S&P500. However the S&P500 does not track every company in the world but only American companies, and so by picking American companies you are not really diversifying.
Without costs, index funds are going to run about average as depicted in the nice bell shape curve listed in a previous post. But, when costs are taken into account, that is going to push the index fund in the top 40% or so at least I would imagine, if not far more.
Sure, you can beat the average after the fact., ie., go back and say, hey, if I had just invested in these 10 stocks or these 10 mutual funds I would have beat the market by 20%! Why not just pick the one best stock and assume you put your money into that!…you would have killed the S&P 500?!? Of course, this after the fact. It’s very easy to look back and see the winners. But can you pick them? Can you pick them year after year. Some people can. Probably most cannot.
Also, if you look at a mutual fund screener, make sure you are only comparing companies that hold only the S&P 500 companies in your comparison to the S&P 500 index. In otherwords, I have a Latin America fund that killed the S&P 500. But how would it have performed against an Index over 10 years of Latin America?
I have electric utility stock that I bought in 1979. I use dividends to buy more stock for a few years. Now they give my money back every 15 months. Is this typical return on investment or better?
I agree with TinyHands. The “Devil’s Advocate” posts are a far cry from “urging his readers”.
Index funds are okay if you want to safeguard your money in terms of protecting capital, when it comes to making money they are a bit dubious as with dividends invested you are looking at between 50-100 years to make meaningful gains a £1000 invested might come up to £100,000 or £2,000 as it depends on the valuation of the shares, my advice is if you really want to do it then invest in one or two and see if you can handle the psychological dips over 3-5 years otherwise just invest in well managed companies.
Index funds will never be winners.
But the good thing about index funds is that they will always be runner-ups, beating all the rest except the champion
I am happy being runner-up
I’ve recently sold a home and received a little over $100K. I have NO investing knowledge. I’m 50 and retiring in 15 yrs. I have the money in an Ally savings account at 1%, yeah just 1%! Any advice for investing would be great!
Thank you