Updated on 09.24.07

Why Does Everyone Preach About Index Funds? What They Are And Why They’re Good – From The Very Beginning

Trent Hamm

yepA reader asked me recently why so many people write glowingly about index funds. I even do this – in fact, all of my investment money is currently in index funds. What are they, and what’s the big deal behind them?

I’m going to try to summarize a lot of economic theory in a way that as many people as possible can understand. To do that, I’m going to generalize in some places and not be exactly precise. You can jump in with commentary if you wish, but keep that in mind when you do.

Let’s start at the very beginning. When you go to work, you’re paid a certain amount of money. The reason that an employer does that is because they believe the work you do provides more value to the business than the wage they pay you. Otherwise, they would either pay you less or give the work to another worker. It’s for this reason that bosses hem and haw about giving people raises.

If you work for a large company, there are a lot of people working there, and theoretically all of them are providing more value each day than they’re getting paid. This is how a business builds itself up and turns a profit. In a nutshell, an average business should always be growing in value because of the efforts of the people working there.

Overall, though, all of the workers at all of the businesses in America are producing more valuable work than they’re getting paid. This is called productivity, and the productivity numbers for the United States indicate that it’s a very productive nation, indeed – the workers of the United States as a whole, from the CEOs to the janitor, produce more value than they’re getting paid.

Where does all of that extra value go? That value is the value of the businesses themselves, and for publicly traded companies, that’s reflected in the values of their stocks. Stocks are just a representation of the business, after all.

Let’s summarize: people are paid to work because they add more value to the business than they are paid. So, in the natural state, over time the value of a business should go up. If a stock represents a small piece of a company, then the value of that stock should go up.

As we all know, sometimes bad management or other issues causes the effort of lots of employees to go to waste. Take Enron, for example – that’s an example of how management can fail, but these failures are relatively rare and it’s very hard to predict them. Lots of things can cause a stock to fall temporarily or permanently, but the continued effort of all of the people involved means the natural state for a business is to increase in value, and thus for its stock to go up.

Now, let’s say you have the money to invest in the stock of one company. A lot of people invest this way by choosing individual stocks to invest in. That one company might be a really good one and skyrocket. It might also just be an average company and just do average. It might also be another Enron and just completely fall apart.

Obviously, you want that high-riser, but what you really want is to avoid that Enron. If the stock you happened to buy is another Enron, your money is gone. This is a very big risk with individual stock investing – if you buy a lemon, your money goes poof.

Now, as I mentioned above, the average company’s stock should go up in value because of the contribution of the work of all of the employees. Over the long haul, that has always been true. There are more good companies out there than bad. The average stock over a long period should go up, but not all stocks do.

One way of getting around that risk is to buy a lot of stocks, often called a portfolio. If the average stock goes up, but not all stocks do, if you own a big handful of stocks, a few will likely be bad, but there will be enough good ones that your overall money should increase in value. But there’s still a risk – let’s say you make three or four unfortunate choices out of ten? It happens very easily.

You want to keep minimizing that risk of bad stocks, so you keep buying more and more and more individual stocks. Eventually, you just buy everything that meets a certain set of criteria – say, all of the stocks on the New York Stock Exchange with a value of more than $100 million. This way, you own all of the companies and the idea that all of the workers in America as a whole are producing positive value is working for you. You’ll own a few lemons, but you’ll also own a few home runs, too, and you’ll own all of the average stocks that are going up over time because of the contributions of their workers that we talked about at the start.

That strategy is called indexing, and you can buy them in the form of index funds. An index fund is exactly what I described above: they define some rule or set of rules, then just buy the stocks that follow that rule. Because it’s so easy to do this, the companies that run index funds generally don’t charge very much in fees for doing this for you.

It’s popular because it’s very easy and it works. Instead of worrying about a lot of investment choices, you just pick an index fund or two and simply put money in them until you need it. The companies that offer them don’t charge much at all for the service of doing this, either.

Why don’t people do this all the time if it makes such sense? Many investors want to trust a human with their money, not a rule or a philosophy. They like to put money in a mutual fund that is managed by a person or a team of people – these people spend their time looking at stocks and making active choices about which individual stocks to invest in.

That philosophy sounds very nice – and there are a lot of people who do that because they trust fund managers to make good choices. There are just a couple problems: humans are fallible and imperfect, and these personally-managed funds are laden with fees to pay the people to manage the fund. While you have the positive of human intuition, you have the negatives of human fallibility and the large fees.

In a nutshell, people get very excited about index funds because they’re very easy to invest in and they naturally minimize your risk. They take maximum advantage of the fact that no matter what business you work in, when you go to work you contribute value to that company. While it’s not the be-all end-all of investment strategies (you can’t have huge gains, for example), it is very strong because it minimizes the risk of investing in stocks without giving up some very strong gains.

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  1. Beth says:

    This is great, thank you! I’ve been preaching the Index Fund Gospel for a while, and this will be a handy link to send to explain the concept far better than I can.

    Hey, next up, can you look at money market acounts as a potential alternative to high-yield savings accounts? In all the PF talk about ING, HSBC, etc., I never see people mention MMAs and I wonder if I’m missing something.

  2. jtimberman says:

    Good summary of index funds.

    I recall that Warren Buffet said something along the line of investing in index funds is the best thing to do because then you get to own every company. I don’t remember the exact quote, but that is the general idea.

    A good one too.

    Also, don’t feel bad about buying managed mutual funds. Just make your purchase wisely – index mutual funds are a wise choice :-). Remember, the mutual fund management companies hire people for their funds that are total experts in the kinds of companies in each fund. These are stock analysts, and they come to work in a car longer than your house.

  3. Steve W says:

    What about managed funds with a 10-year history of returns superior to indexed funds in the same category? Does a superior 10 Year average outweigh the higher cost of an indexed fund?

  4. Johanna says:

    If you could go back in time 10 years and invest your money then, then sure it would. But past performance is not a guarantee of future results, as they say. With thousands of mutual funds out there, you’d expect that a few of them would beat the market every year for 10 years in a row, just out of random chance. Those fund managers look like geniuses, when they’re really just lucky, and have no better chance of beating the market in year 11 than anyone else does.

  5. To optimize on the management costs of an index fund, we can get similar benefits by investing in ETF (Exchange Traded Funds). Additionally they offer tax benefits and can be traded like stocks!

  6. Julianne says:

    Can you discuss the tax implications? I max my IRA and 401k and put most of my other long-term savings into savings accounts and CDs, but I’d like to diversify a bit more, but how do taxes figure into the equation? No one ever talks about this.

  7. Andrew Stevens says:

    I think the reason why the PF blog community doesn’t talk about money market accounts much is because I’ve just about never seen a money market account which beats high-yield online savings accounts. Before the Internet reduced costs on savings accounts so dramatically, money market accounts were definitely the place to put your liquid savings (emergency funds) because passbook savings accounts paid nothing. But now, money market accounts don’t seem to pay any better than high-yield online savings accounts.

    I’m willing to be proven wrong here (and please, please let me know if you do find a money market account which pays appreciably better than the top online savings account), but I don’t think you’re missing out on anything, Beth.

  8. James says:

    In regards to MMA’s vs. high yields savings accounts, I have to admit, I am a rate chaser. I check bankrate.com on about a weekly basis to see where most online banks are keeping their interest rates at. Granted, MMA’s give you the benefit of check writing, but more often than not, MMA’s and high yield savings accounts offer the same interest rates (in my experience). Not to be an advocate of igobanking.com, but I just opened a savings account there with an APY of 5.30%, and yes, I know that will drop in the ensuing weeks. Cheers.

  9. Michael says:

    Good post. I have seen brokers pick some winning funds, but when they pick losing funds, it’s an ugly thing.

    Trent, I was wondering if you’d consider posting about health insurance. It’s such a high fixed cost, and navigating deductibles, co-pays, coverage percentages, and so on is confusing. I recently found my employer’s plan was worse than buying coverage myself — others might benefit from an explanation of their options.

  10. LTruslow says:

    Lazy Investing is the way to go! I use the “no brainer” approach. Divide your portfolio into four equal parts of S&P 500 Index, Extended Market Index, International Equity Index, and Total Bond Market Index.

  11. benp says:

    @Steve W

    Well perhaps such a fund exists, but when comparing performance be sure to include fees and not just “returns”, also make sure that investments have the same risk profile as you would expect better returns for more risk. Then assuming you really have found such a fund, realize that their strategy/method/ability to beat the market can go away when one of their employees starts working at another firm who copies their idea.

    Recommend book:
    “A random walk down wall street”

  12. Ryan says:

    Excellent article. And I second Truslow on the lazy portfolio. You might even go a step farther just total stock market for your domestic stock allocation.

    FWIW, Vanguard’s Prime Money Market is yielding 5.21%. I think it’s a solid place to keep cash for the long haul.

  13. MossySF says:

    Vanguard Prime MMF is current paying 5.21%. (Has been fluctuating from 5.20%-5.30% for the past year.) This is definitely competitive with many online banks.

    I pay 34.3% income tax so Vanguard CA Tax Exempt MMF is paying a tax equivalent of 5.57%. (Has ranged from 5.5%-5.8% the past year.) This beats all but FNBO’s teaser rate. Somebody in the 35+9.3 tax bracket taking standard deduction would get a tax equivalent rate of 6.57% which no online bank has come close to.

    At the relatively the same rate, I’d much rather have my money at Vanguard versus an online bank because (1) no 6 transfer out limit per month, (2) same day purchase of Vanguard mutual funds with orders submitted before 1PM EST, (3) no way for a scammer to steal your account/routing # since there is no ACH out interface.

  14. Maura says:

    I really like this post. I have never heard such a clear explanation of investing in index funds that goes all the way back to worker productivity.

    The market is almost schizophrenic when prices react to every bit of news, when the underlying companies, as you said, tend to grow in value over time.

    You can do a search on “Lazy Portfolio” to find one of Paul Farrell’s article following several lazy portfolios designed by various financial advisors. Lazy portfolios help investors balance risk with reward by having a plan they can follow consistently. They also help keep people from acting from fear or greed. (buying based on a hot tip…or- oh no! the market is down 100 points! sell everything!) I follow the FundAdvice lazy portfolio.

    I believe that your portfolio should include large cap, mid cap, and small cap index funds, and US and international funds in each category, as well as a certain % in bond funds. The equity-bond split should be determined by the number of years you have to retirement, as well as your risk tolerance. As a CPA, I have seen some inexperienced investors get into the market when it was hot, then sell at the first big dip- thus locking in their losses permanently!

    If you do some reading on investing- I like the articles at fundadvice.com- you can learn to expect the dips and not panic when a normal dip happens.

    The financial press makes a big deal about every drop- but they don’t mention that the market over a long time averages about 10% a year.

    I also believe strongly that most people should start investing for retirement as young as possible, even before they pay off their debts (by which I mean, do both at the same time-save and pay off debts too).

    Why? 1) If their employer contributes to their 401(k) it would be crazy not to contribute at least enough to get the matching contribution, 2)The time value of money is enormous- you lose a lot by not investing over a long period of time 3) it creates a savings habit and 4) It feels really good to have money/investments. It gives you a lot of security.

  15. beth says:

    @MossySF: I’m in the Vanguard Prime, too, so I’m glad to see I’m not the only fan. But what is this CA Tax Exempt fund? I’m in your neck of the woods but am not familiar with that fund. Off to the Vanguard site…

  16. Mrs. Micah says:

    I’m very excited about starting off the next year with index funds.

    Since I have to bank with Fidelity for my 401(k), I’m going to do Fidelity Freedom 2050. Well, I’m going to do a one-hour (or more) researching them before I’m sure.

    But for my Roth or other IRA I plan to do 65% Vanguard 500 Index and 35% Vanguard Bond (the index for that, I don’t remember what it’s called now). And gradually shift the balance as I get older.

  17. Masindi says:

    In Singapore where I live, we don’t have the privilege of buying no-load index fund (like most people do in the US via Vanguard). However, we are lucky to have zero capital gain tax.

    So which country has better personal investment environment? I guess it depends on the expected investment duration.

  18. MossySF says:

    Beth, tax-exempt MMFs hold ultra-short-term bonds issued by various states and municipalities. Due to that separation of powers thing in the Constitution, the federal government cannot tax activity by state & local governments. In addition, state governments will waive state taxes on residents who hold bonds from their own state.

    Not all states produce enough publically traded bond activity to satisfy investor demand so Vanguard has just 5 state-specific (CA, NJ, NJ, OH, PA) money markets and one nationwide tax exempt. If you live in one of the 5 states and buy the MMF from that state, you are exempt from federal, state and local income tax on the interest earned. Money placed in a nationwide fund or a state not yours will be exempt from just federal taxes.

    What this means is the effective interest you get depend on your tax rate. Suppose you rarn 5% in an online bank account. If you pay 35% on that 5%, you earn an after-tax 3.25%. Which means a MMF that is exempt from taxes ends up being a better deal for a 35% tax bracketer at any rate higher than 3.25% compared to the 5% online bank.

    There are more complications to do with standard deduction and AMT but above is the basic concept. The below article has a more complete explanation and a calculator where you can enter 5 different types of money markets and bond funds to compare them.


  19. Chris says:

    I’m only able to invest for retirement right now, and I’m a huge fan of index funds, and of Vanguard’s Target Retirement funds in particular… each is a “fund of funds”, meaning that they each have holdings in certain other Vanguard index funds (e.g. Total Stock Market, Emerging Market, Int’l Market, Bond Market, etc.); you simply choose the fund nearest to when you plan on retiring, and it automatically reallocates from aggressive to conservative as that date approaches. How much easier can you get?

    They also have similar funds for general investing, i.e. non-retirement, in which you can choose among options ranging from very aggressive to very conservative; again, as funds of funds they are as easy as it gets in terms of diversifying your portfolio and managing your risk & hoped-for returns.

  20. Old post but the value exchanging in work is a very interesting model.

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