By reducing fees skimmed off by the financial service sector, an index fund can save investors over $1,000,000 over a 40-year investment lifetime.
Many commission-based advisors hate index funds. I don’t blame them… index funds don’t generate commissions like high-fee, actively managed funds.
As an engineer, I enjoy dissecting reality through data and predictive theories. Over the past eight years of investing, I’ve shifted from individual stocks to a portfolio of boring index funds.
In this post, I will equip you with the data and theory to show that index funds are the ideal investing approach (provided you are ready to invest).
Table of Contents
1. Index Funds Outperform 94% of Actively Managed Funds
You may wonder, “Why not invest in actively managed mutual funds, where professional stock pickers can outperform the market”?
For the 15 years ending in 2022, 93.95% of US mutual funds underperformed their benchmark index after fees.
So, why not just pick the 6% of funds that have outperformed the market over the past 15 years?
Past fund performance does not persist. Fund outperformance was due to luck. Past performance does not equate to future performance. I outline the outcomes of SPIVAs research below.
Mutual funds underperform the market because of high fees and market efficiency (defined below). Some mutual funds have fees of up to 2%, while index fund fees are often less than 0.1%.
As an investor, you want direct access to the earnings power of businesses worldwide with minimal fees. Index funds do precisely this.
2. Only 1.3% of Stocks Produce The Total Stock Market Wealth Creation
This study finds that “the top-performing 1.3% of global firms account for the $US 44.7 trillion in global stock market wealth creation from 1990 to 2018″.
If you miss the 1.3% of stocks, you will fail to beat the market. Your expected return will be that of 3-month treasury bills (cash).
You may ask, “Why not just invest in the 1.3% of stocks that produce all the wealth? That seems easy.”
The 1.3% of stocks are easily identified in hindsight (hindsight bias). The problem is that you need to find this 1.3% of companies before they explode in value.
A new set of stocks (1.3%) will pull the market forward in the future. Due to market efficiency (defined below), the it is hard to forecast what stocks will explode in value.
You can see that TSLA was one of the 1.3% of stocks that contributed to the total market return between 2020 and 2022.
But I don’t know what will happen with TSLA moving forward. Neither do you. Nor does anyone else.
Expectations about future earnings are already “priced in” TSLA’s stock. An investor can only expect the market return from TSLA moving forward.
A total market index fund holds all stocks in a stock market. It is the only way to guarantee that you will capture the returns of the 1.3% of stocks that generate the net market return.
3. Markets are Efficient: It's Hard to Beat the Market
The Efficient Market Hypothesis (EMH) states that all available information about a business is already baked into a stock’s price.
In 1960, Eugene Fama won a Nobel Prize showing that EMH holds up well – markets are fairly efficient.
Millions of brilliant people buy and sell stocks daily based on available information.
In a perfectly efficient market, all information is included in the stock price. No amount of analysis can provide an advantage over “the market.”
No market is perfectly efficient. But I believe markets are efficient enough that trying to beat the market is not worth my time.
In an efficient market, it would make sense that actively managed mutual funds underperform the market. The data supports this.
Because of EMH, it is hard to find the 1.3% of stocks that will take off to generate the net wealth of the global stock market.
Therefore, owning the market with a low-cost index fund will maximize your expected returns.
4. Diversification: Less Risk, Same Returns
In an efficient market, you are not compensated for risks that can be quickly diversified away. This is a core component of the Capital Asset Pricing Model.
So what risks can be quickly diversified away?
With a click of a button, a low-cost index fund allows you to own nearly every stock around the world. Therefore, an index fund can diversify away:
- Company-specific risk
- Industry-specific risk
- Country-specific risk
When you own all stocks in a stock market, it doesn’t matter if a single stock crashes. Hundreds or thousands of other stocks will balance out the drop.
For example, assume TSLA goes to zero tomorrow. The S&P 500 index would lose around 1.7% with everything else constant.
A total market stock index fund reduces risk without reducing your expected returns.
To better understand why diversification is a free lunch, read The Power of Diversification: Maximize Risk Adjusted Returns.
5. Index Funds are Tax-Efficient
Consider that a total market index fund that just owns all stocks in a stock market. What happens when a stock like Apple explodes in value?
Naturally, Apple makes up a larger portion of the index. There was no need to buy more Apple stock inside the fund.
What about when a company like General Electric tanks by 50%? While it contracts, GE stock makes up a smaller fraction of the index. There was no need for the index fund to sell GE stock.
Stocks in a total market index fund grow and contract organically. There is minimal buying and selling of stocks within the fund.
Taxable events are triggered only when you sell a stock. Since index funds minimize buying and selling, they are tax-efficient relative to actively managed funds.
6. An Index Fund Saves Your Time
There are endless demands on your time and energy. Life is hard.
Low-cost total market index funds are simple. And simplicity enables consistency, helping your grow wealth sustainably, as I cover in this post.
Less time spent on investing frees up time and energy that can be allocated to other things that enhance your well-being.
Index funds let your money compound in the background while you focus on the essential things in life.
Valuing your time and energy naturally incentivizes index investing, as it does for ffrugal living.
Buying a minimal number of high-quality goods minimizes time wasted shopping, organizing, cleaning, and disposing of stuff (the stuff lifecycle).
7. Index Funds Reduce Behavioral Investing Errors
Vanguard’s advisor alpha study estimates that behavioral errors cost erode returns by up to 1.5% annually.
The hands-off nature of index investing allows you to detach from your portfolio emotionally.
There is no need to track news associated with the individual companies you own.
Nor do you need to buy and sell individual stocks (also reducing trading costs). Therefore, you check your portfolio less often, resulting in a smoothing effect.
Plus, index investors like you tend to be more educated about investing. This can help you view crashes as opportunities, limiting loss-averse tendencies like panic selling.
Conclusion: Index Fund Superiority
Index investing is one of the few black-and-white topics in my head. A total market index fund maximizes risk adjusted returns.
First, the data that backs index investing:
- 94% of US mutual funds have underperformed the index after fees over the past 15 years. It is hard to beat the market due to market efficiency.
- Only 1.3% of stocks are responsible for the net wealth creation of the entire global stock market. You’ll fail to beat the market if you fail to capture this 1.3% of stocks.
From here, we can see that an index fund gives you the market return for a negligible fee (around 0.1%), beating over 90% of actively managed funds.
In addition, there is strong theoretical backing for index investing:
- The Efficient Market Hypothesis shows that markets are quite efficient, making it extremely hard to beat the market.
- The Capital Asset Pricing Model shows that diversification reduces risk without reducing returns. Index funds maximize diversification.
For 99% of people, index funds are superior to individual stock selection and superior to high-fee mutual funds.
Finally, not all index funds are the same. See why not all index funds are diverse (or 100% passive).
Jake out.