Are index funds the best investment?

Three piggy banks in the sky

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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brad
brad
13 years ago

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… Read more »

Adam
Adam
13 years ago

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… Read more »

Travis
Travis
13 years ago

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… Read more »

Danny
Danny
8 years ago
Reply to  Travis

And if you’d invested at the time of that comment, you’d have gained around 20% by now.

Patrick Szalapski
Patrick Szalapski
13 years ago

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?

Michael Finley
Michael Finley
8 years ago

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… Read more »

Patrick Szalapski
Patrick Szalapski
13 years ago

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.

Tinyhands
Tinyhands
13 years ago

I can’t speak on behalf of [email protected] 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.

J.D.
J.D.
13 years ago

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.

jim
jim
13 years ago

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. 🙂

Gaming the Credit System
Gaming the Credit System
13 years ago

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… Read more »

Angela
Angela
13 years ago

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… Read more »

majeest
majeest
13 years ago

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… Read more »

VinTek
VinTek
13 years ago

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?

squished18
squished18
13 years ago

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?

Dustin
Dustin
13 years ago

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.

Houser
Houser
13 years ago

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.

brad
brad
13 years ago

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… Read more »

Gerard
Gerard
13 years ago

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… Read more »

Covert7
Covert7
13 years ago

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?

Travis
Travis
13 years ago

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… Read more »

Travis
Travis
13 years ago

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… Read more »

Mike
Mike
13 years ago

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… Read more »

Mike
Mike
13 years ago

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… Read more »

Mike
Mike
13 years ago

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… Read more »

mapgirl
mapgirl
13 years ago

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… Read more »

beanspants1
beanspants1
13 years ago

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,… Read more »

BxCapricorn
BxCapricorn
13 years ago

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!

beanspants1
beanspants1
13 years ago

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… Read more »

Travis
Travis
13 years ago

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.… Read more »

Patrick Szalapski
Patrick Szalapski
13 years ago

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?

VinTek
VinTek
13 years ago

“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… Read more »

squished18
squished18
13 years ago

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… Read more »

VinTek
VinTek
13 years ago

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… Read more »

not confucius
not confucius
13 years ago

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.

tz
tz
13 years ago

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… Read more »

VinTek
VinTek
13 years ago

“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… Read more »

Paul
Paul
13 years ago

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

Dan
Dan
13 years ago

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.

VinTek
VinTek
13 years ago

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… Read more »

adfecto
adfecto
12 years ago

[…] 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. […]

newInvestor
newInvestor
12 years ago

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?

J.D.
J.D.
12 years ago

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.

americangoy
americangoy
12 years ago

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.

Mike
Mike
12 years ago

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… Read more »

The Skilled Investor
The Skilled Investor
12 years ago

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

KM
KM
12 years ago

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… Read more »

Rick
Rick
12 years ago

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

John Aitek
John Aitek
12 years ago

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… Read more »

Lizard Doc
Lizard Doc
10 years ago

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… Read more »

Hammachi Yakimono
Hammachi Yakimono
10 years ago

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?

darctones
darctones
10 years ago

I agree with TinyHands. The “Devil’s Advocate” posts are a far cry from “urging his readers”.

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