Why Own An Index Fund?

Posted on October 27, 2014 at 12:08 PM PDT by

A fundamental obstacle for many retirement investors is understanding the difference between an investment and an asset class, and how owning an index fund relates.

Why own an index fund? Because it gives you exposure to an asset class. It might be a stock index fund, a bond index fund or even a real estate or commodities fund, but all of them work the same way: Rather than pick single investments you own them all.

“All” in this sense means every investment in a given index. So, if you own an S&P 500 Index fund, that fund in fact owns all 500 underlying stocks in the index. A bond fund might own 5,000 different bonds. You have an investment that is an asset class, or close to it.

There are very narrow specialty funds, too, but for the purposes of a retirement portfolio most are too volatile to consider. What you want is exposure to the broadest, most liquid, most stable investments that exist in any given asset class, and that’s all.

why own an index fund

Besides diversification, you get to own that exposure at a very, very low price. For instance, a typical active mutual fund that purports to follow large-cap stocks is by design picking some of them and ignoring others.

The proposition is that the manager of that active fund knows which large-cap stocks to own now and which to avoid. They might be focused on value (buy stocks that are out of favor) or growth (buying stocks likely to rise in the medium term) but they all operate on the basic idea that the managers have an inside track that the market does not.

And they might. But most often they do not. They trade in and out of positions all through the year, trying to catch updrafts and avoid declines, but in the end most active managers struggle to replicate the market return for their investment type.

Once you subtract their management fees, they fall even farther behind. If you own the fund in a taxable account, it’s even worse. And your fellow investors might lose faith in those managers and sell off, or simply choose to move money elsewhere.

Risk and reward

The risks are bigger than they seem, while the reward — consistently beating the stock market — turns out to be maddeningly elusive. Every year you don’t pick up the low-cost gains available from a straight index fund is a year lost, forever.

And that’s the salient point: Time is money. You really can’t fool around with a mediocre manager for five or seven years hoping that he or she beats the market once or twice. Subpar returns all of the rest of those years will hurt you, a lot.

It will hurt because you have blown a chance to compound your money, and compounding is how retirements happen. Not flash-in-the-pan stock picks or exciting macroeconomic calls. Just steady, reliable growth, building up over decades.