With a net worth of more than $96.5 billion, as of July 2022, Warren Buffett is one of the most successful investors of all time. His investing style, which is based on discipline, value, and patience, has yielded results that have consistently outperformed the market for decades. While regular investors—that is, the rest of us—don’t have the money to invest the way Buffett does, we can follow one of his ongoing recommendations: Low-cost index funds are the smartest investment most people can make.
As Buffettwrote in a 2016 letter to shareholders, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
If you’re thinking about taking his advice, here’s what you need to know about investing in index funds.
- Index funds are mutual funds or ETFs whose portfolio mirrors that of a designated index, aiming to match its performance.
- Over the long term, index funds have generally outperformed other types of mutual funds.
- Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they’re highly diversified).
What Is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that holds all (or a representative sample) of the securities in a specific index, with the goal of matching the performance of that benchmark as closely as possible. The S&P 500 is perhaps the most well-known index, but there are indexes—and index funds—for nearly every market and investment strategy you can think of. You can buy index funds through your brokerage account or directly from an index-fund provider, such as Fidelity.
When you buy an index fund, you get a diversified selection of securities in one easy, low-cost investment. Some index funds provide exposure to thousands of securities in a single fund, which helps lower your overall risk through broad diversification. By investing in several index funds tracking different indexes you can built a portfolio that matches your desired asset allocation. For example, you might put 60% of your money in stock index funds and 40% in bond index funds.
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Index Fund: Pros
Very low fees
Lower tax exposure
Passive management tends to outperform over time
Index Fund: Cons
No downside protection
Doesn't take advantage of opportunities
Cannot trim under-performers
Lack of professional portfolio management
What Are the Benefits of Index Funds?
The most obvious advantage of index funds is that they have consistently beaten other types of funds in terms of total return.
One major reason is that they generally have much lower management fees than other funds because they are passively managed. Instead of having a manager actively trading, and a research team analyzing securities and making recommendations, the index fund’s portfolio just duplicates that of its designated index.
Index funds hold investments until the index itself changes (which doesn’t happen very often), so they also have lower transaction costs. Those lower costs can make a big difference in your returns, especially over the long haul.
“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades,” wrote Buffett in his 2014 shareholder letter. “A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”
What's more, by trading in and out of securities less frequently than actively managed fund do, index funds generate less taxable income that must be passed along to their shareholders.
Index funds have still another tax advantage. Because they buy new lots of securities in the index whenever investors put money into the fund, they may have hundreds or thousands of lots to choose from when selling a particular security. That means they can sell the lots with the lowest capital gains and, therefore, the lowest tax bite.
If you're shopping for index funds, be sure to compare their expense ratios. While index funds are usually cheaper than actively managed funds, some are cheaper than others.
What Are the Drawbacks of Index Funds?
No investment is ideal, and that includes index funds. One drawback lies in their very nature: A portfolio that rises with its index falls with its index. If you have a fund that tracks the S&P 500, for example, you’ll enjoy the heights when the market is doing well, but you’ll be completely vulnerable when the market drops. In contrast, with an actively managed fund, the fund manager might sense a market correction coming and adjust or even liquidate the portfolio’s positions to buffer it.
It’s easy to fuss about actively managed funds’ fees. But sometimes the expertise of a good investment manager can not only protect a portfolio, but even outperform the market. However, few managers have been able to do that consistently, year after year.
Also, diversification is a double-edged sword. It smooths out volatility and lessens risk, sure; but, as is so often the case, reducing the downside also limits the upside. The broad-based basket of stocks in an index fund may be dragged down by some underperformers, compared to a more cherry-picked portfolio in another fund.
The Bottom Line
Index funds have several attractive pros but also some cons to consider. The funds are passive investments that track major indexes making them a low-cost investment option. These funds are nearly as automatic and hands-off as using a robo-advisorwhich is another option for those looking for low-cost investing. Understanding what an index fund is and how it compares to other investments is the best first step you can take.
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Warren Buffett is a highly successful investor with a net worth of over $96.5 billion as of July 2022. His investing style, which is based on discipline, value, and patience, has consistently outperformed the market for decades [].
One of Buffett's ongoing recommendations for regular investors is to invest in low-cost index funds. In a letter to shareholders in 2016, Buffett stated that both large and small investors should stick with low-cost index funds, as they tend to outperform actively managed funds [].
What is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that aims to mirror the performance of a specific index. It holds all or a representative sample of the securities in that index. The S&P 500 is one of the most well-known indexes, but there are indexes and index funds for nearly every market and investment strategy [].
When you invest in an index fund, you get a diversified selection of securities in a single investment. Some index funds provide exposure to thousands of securities, which helps lower overall risk through broad diversification. By investing in different index funds tracking different indexes, you can build a portfolio that matches your desired asset allocation [].
Benefits of Index Funds
Index funds offer several advantages:
- Low fees: Index funds generally have lower management fees compared to actively managed funds because they are passively managed. This can have a significant impact on returns over the long term [].
- Tax advantages: Index funds generate less taxable income compared to actively managed funds because they trade less frequently. They also have the advantage of being able to choose lots with the lowest capital gains when selling securities, reducing the tax burden [].
- Broad diversification: Index funds provide exposure to a wide range of securities, which helps spread risk and reduce volatility [].
Drawbacks of Index Funds
While index funds have many benefits, there are also some drawbacks to consider:
- No downside protection: Since index funds aim to mirror the performance of an index, they are vulnerable to market downturns. When the index drops, the value of the fund will also decline [].
- Missed opportunities: Index funds do not take advantage of opportunities to outperform the market. They cannot trim underperforming securities or make active investment decisions [].
- Lack of professional portfolio management: Index funds do not have a dedicated fund manager making investment decisions. While this reduces costs, it also means that the fund does not benefit from the expertise of an investment manager who may be able to outperform the market [].
In conclusion, index funds are a popular investment option recommended by Warren Buffett. They offer low fees, tax advantages, and broad diversification. However, they also have limitations such as the lack of downside protection and missed opportunities for outperformance. It's important to consider these factors when deciding whether to invest in index funds [].