Warren Buffet, one of the most successful investors in the world, wrote in his 2016 letter to his company’s shareholders a recommendation to both large and small investors to invest in low-cost index funds. It’s funny that Buffet, who can be considered an active fund manager, recommends using passively managed index funds. By why?
What are Index Funds?
According to the Wikipedia for investors, Investopedia, an index fund is a type of mutual fund that holds all of the securities in a specific index. The goal for an index fund would be to match the performance of that benchmark as closely as possible. One of the world’s most popular index funds is the S&P 500. In Europe, index ETFs such as VWRL and IWDA are becoming very popular.
If you are wondering whether or not to invest in index funds, here are five reasons why investing in index funds could be lucrative for you.
1. Index Funds Might Perform Better
The main reason for using index funds is that they could perform better as compared to individual stocks or bonds. One thing about purchasing stocks or bonds is that they introduce a risk of losing all your capital at once.
People who purchase individual securities are very susceptible to the volatility of their asset. If the market moves, large amounts of value might be gained or lost. Buying individual shares is putting all your eggs in one basket. You better not drop that one.
With index funds, you get a broad diversification and in addition to that, you get to pool your costs and add lots of liquidity which all comes at a very low cost, sometimes as low as 0.00%.
The combination of less volatility and usually less costs, when compared to actively managed funds, makes that for most investors, index funds could be considered better performing.
2. Index Funds Could Be Less Risky
One reason why you should consider index funds is the fact that index funds are less risky as compared to individual shares. The biggest advantage when it comes to risk management with index funds is that you will avoid losing all you capital when one investment goes down. Of course, in theory an index fund could lose all its value, but in my unprofessional opinion, that’s highly unlikely.
Also actively managed mutual funds will introduce risks, to be precise, in the form of management risks.
When investing in mutual funds the mistakes of an individual manager will in most cases directly affect you. Yes, some mutual fund managers like Warren Buffet are brilliant but even they could make mistakes.
3. Index Funds Can Be Very Cheap
The goal of investing is for you to make your money work for you, not for the person handling your money. One thing about costs and fees in investing and investments is that they matter a lot.
This is the main reason why you need to pay particular attention to the costs that you pay for your funds. Index funds as compared to mutual funds, usually, have lower costs that will help you save an incredible amount of money in the long run.
4. Diversification is Important
As Warren Buffet puts it across, “Never place all your eggs in one basket.” If that one basket is kicked over then you are screwed.
You need to diversify your investment portfolio at all times. One of the most important reasons to consider index funds is that index funds are an easy way for you to diversify your portfolio. You can invest in many thousands of companies through the use of index funds.
If we look at an index fund tracking and covering the S&P 500, we will learn that the index funds track 500 different companies. As compared to an individual stock, if a single stock within an index fund loses its value, chances are, you won’t even notice. And that’s just the S&P. Other funds such as VTI, VXUS, VWRL contain thousands of companies!
5. The Past Returns are Solid
One thing that’s nearly impossible for any mutual fund manager, is to make a portfolio beat an index fund in terms of long-term performance. Only one in four active managers is able to beat index funds for a longer period of time.
Nobody can guarantee they will keep outperforming the index next year. And nobody knows which manager will outperform and which will underperform.
I hope that it will be clear why I love index funds and passive ETFs so much. If you would like to get started, check out my article on how I invest using DeGiro. Or sign up for DeGiro using my link below. It’s free!