Jun 7, 2018
Written by:
Al Hill
Are you currently thinking about investing in index funds but are unsure of where to start?
Well in this article, we will provide you a story from the great Oracle of Omaha about index funds to get some perspective from the greatest investor of our generation. Then we will dive into 5 helpful tips to consider before taking the plunge into index funds.
Buffet Bet
Back in December of 2007, Warren Buffet made a one-million dollar bet with Ted Seides (former founder and president of Protégé Partners) that professionally managed money would underperform index funds over the next 10 years.
What the Oracle of Omaha basically said was any normal Joe could contribute to the VFINX (Vanguard S&P 500 Index Fund) and beat the super wealthy and powerful masters of money that are hedge funds.
That sounds a little ridiculous.
Surely the common man is not able to outperform against the leverage and capital that a hedge fund possesses. Nor does the everyday retail investor have the aggregate talent and specialized financial wizardry that a hedge fund has at its disposal.
Honestly, if you heard your neighbor (who only puts his money into a S&P 500 Index Fund) talking about how his portfolio’s performance is going to beat the average hedge fund over the next 10 years, you’d probably smile and think he’s an idiot.
But both your neighbor and Warren Buffet were correct.
Mr. Buffet’s prediction was more than correct – it was mind blowing.
If you had put $10,000 into a hedge fund from December 2007 to December of 2017, you would now have $14,000. If you would have just humbly set aside your money into an index fund like the VFINX, you would have a staggering $21,000.
Well your neighbor is kind of a genius, isn’t he?
Let’s now dive more into index funds and the items you need to consider before investing.
Index Funds
Every rectangle is a square, but not every square is a rectangle.
The same applies with index funds.
Every index fund is a mutual fund, but not every mutual fund is an index fund. The differences boil down to how they are managed and the goals of the fund.
In a mutual fund, there are some super smart and highly paid stock experts who try to beat the broader market by finding outperformers. This is done with a lot of research, money, time and analysis.
They want to eliminate laggards and find great value and growth. Mutual funds want to beat the aggregate market and take on more risk.
Mutual funds, like hedge funds, often fail to beat index funds.
Index funds are different. Index funds want to match the performance of an index (minus any costs or fees, of course).
They don’t try to find single stocks and pack a fund with a bunch of hopeful outperformers. They don’t cycle stocks in and out based on short-term performance.
Index funds just want to match the performance of an index like the DOW, NASDAQ or S&P 500.
Let’s use the S&P 500 index as an example. If I wanted to create an index fund to match the return and performance of the S&P 500, all I would do is purchase every stock in the S&P 500 and distribute the stocks according to their ranking and/or influence in that index. The S&P 500 Index Fund isn’t trying to beat anything, it is what everyone else is trying to beat.
Index funds are the metric by which the performance of many investment portfolios is measured. Like we discussed above, hedge funds didn’t come close to beating the S&P.
In fact, almost no one person or organization beats the performance of the S&P 500. A staggering amount of hedge fund managers try to find the next Apple or Amazon, so they can ‘hit it big’.
They forget how crazy difficult it is for that to happen when compared to the safety, security and positive expectancy of an index fund. These same managers try to create fancy schmancy funds that attempt to outperform the aggregate market with advanced arbitrage techniques and exposure to single markets or limited markets.
The word diversify gets thrown around quite a bit at the arm-chair investors table. If there are any millennials reading this article, you must imagine there was a time when an individual had two choices when it came to diversification: do it yourself or use a financial planner. The former of the two would be a nightmare – it was a nightmare!
Filtering through the myriad of different companies, paying for services to do research, finding underperformers and outperformers… that’s a full-time job. And it was abhorrently expensive for many of those services, bordering prohibitively expensive.
Simply put, you can get all the diversification by making one simple purchase of the index fund itself.
Costs
With index funds, you have a cheap and affordable option for gaining broad exposure to many asset classes. Cheap doesn’t mean it is of less value, in this respect it means it is of high value. One of the primary reasons that many actively managed funds and hedge funds fail to beat index funds is their management costs.
Hedge funds and actively managed funds have exorbitant fees.
This is really the kind of operation you see with brokers: doesn’t matter if you make money or lose money, the broker always gets paid. And the funds always get their cut no matter what.
You pay a quite a bit for the privilege of being in a hedge fund that has a high probability of lagging the index fund it’s pitted against.
This also brings up the issue of accessibility and how easy it is to purchase an index fund.
There are almost no barriers to entry for the common man to participate in an index fund.
With today’s retail brokerage services rivaling the professional services that were offered 15-20 years ago, anyone can easily gain access to an expansive and seemingly limitless amount of index funds.
Retail investors also have access to the prospectus and past performance from these retail brokers. There are very few ‘great’ deals in life, but index funds are one of them. The deal is especially good when we consider how much exposure we gain with the low maintenance costs and ease of access.
Fire and Forget
If you are reading this article, one must assume that you are an individual who likes to gain some knowledge about his/her financial future. You want to learn more about the markets, how they operate, what makes them move, etc.
You’ve probably even dabbled in a little speculation and trading. You probably have even created your own Roth IRA or another type of investment vehicle under your control.
Well one of the biggest benefits of index funds is your ability to invest in them over time without the headache of having to do anything.
You could be thinking, well what if the market starts to tank.
That’s a valid concern, but if you are investing in a managed fund, since they can’t beat the index either, you are still better off.
When most people think of index funds, they think of funds of the S&P 500, NASDAQ or DOW.
There are many types of index funds to participate in. You can find index funds comprised of technology stocks or funds solely focused on metals or agricultural commodities.
There are funds of foreign indexes, funds for small-cap, large-cap and micro-cap stocks.
Not only are there many funds available, there is also a diversification of firms that manage these funds. To name a few Vanguard, Schwab and Fidelity.
When selecting an index fund to invest in, it is always best to go with a name and brand you know. Do your own due diligence and, most importantly, consult with your financial planner in helping to decide which index fund will best fit your investment goals.
Winner
While it does sound odd and unrealistic to say that you, the retail investor, can beat a great majority of financial professionals, it’s true.
Think about this for a moment: The S&P 500 is what trading accounts; investment accounts and private funds measure their performance against. 99% fail to match or exceed the S&P 500. So why wouldn’t you participate in that index fund?
You can skip all the long hours at a firm looking at charts and financial statements and still come out on top.
Index Funds provide a significant advantage and investment opportunity for the retail trader and investor.
By putting money towards these kinds of funds, we eliminate the stress of trying to diversify our portfolio by getting natural diversification through the index the funds seek to emulate.
We also eliminate the exorbitant fees that are applied to many actively managed funds. With index funds we can easily access an investment that not only is secure, safe and shows consistent growth over the years, but also outperforms professionally managed money.
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