The best way to invest? Do nothing.
Have you ever dreamed of making money in the stock market? What if I told you there was an easy way to outperform most actively managed investments? Well, here’s the secret:
More specifically, put your money in an index fund, and then do nothing.
It might be hard to believe, but passive, low-maintenance investments like index funds have outperformed actively managed funds–investments that are managed by a team of expert investors. That means that if you simply put your money in a quality index fund and did nothing, you’d have more money than if you invested your money with the average hedge fund.
Doing nothing sounds easy, but it can be hard. Most people want to take shortcuts to grow their wealth. Even “the best” dealmakers have fallen prey to this trap. It is estimated that Donald Trump would at least have about the same amount of money—and maybe up to $10 billion more—if he simply invested his money in an index fund and did nothing.
Intrigued? You should be. Let’s dive in to learn more about index fund investing and how doing nothing can transform your investments.
What is an index fund?
In layman’s terms, an index fund is simply a collection of investments, or assets (usually stocks), that you can invest in. It is called an “index” fund because its performance matches a particular index of assets.
The NASDAQ, S&P, and Dow Jones Industrial Index are all famous stock indices you may have heard of. Each index is different, although they may contain some of the same companies. For example, the NASDAQ is tech-heavy and excludes financial firms while the Russell 1000 is made up of the 1000 largest public companies in the United States.
The S&P 500 is a handpicked collection of 500 of the most economically powerful companies in the U.S. and is often seen as a bellwether of the health of the US economy. Indexes are useful because they let us gauge the broad health of certain sectors of the economy. For example, the movement of the NASDAQ is an easy way for investors to know whether the technology industry is doing well.
Index funds allow you to mirror the movements of these and other indices. So, if you want to place a general bet on the American economy, you might invest in an S&P index fund. If you want to bet on tech, you might invest in a NASDAQ index fund.
You might be thinking, “If I want to bet on tech, why wouldn’t I just buy stock in Apple, Facebook, or Microsoft and call it a day?” Good question. Since diversification reduces risk, investing in an index fund that covers a broad sector is generally seen as a safer investment than investing in a single company. In other words, you don’t want to put your eggs in one basket. With a fund, you’re invested in multiple baskets.
But do they really beat hedge funds?
In simple terms, a hedge fund is a group of investments managed and curated by professional investors with the goal to beat the stock market and earn big returns. Here’s how Wikipedia defines it:
“A hedge fund is an investment fund that pools capital from accredited individuals or institutional investors and invests in a variety of assets, often with complex portfolio-construction and risk-management techniques. It is administered by a professional management firm, and often structured as a limited partnership, limited liability company, or similar vehicle.”
In the past 10 years, all but the most elite hedge funds have underperformed the market. In fact, the Motley Fool reported that Vanguard’s 60/40 index fund–a 60/40 ratio of stocks and bonds—outperformed most hedge funds. Moreover, one sample of European hedge funds found that, over a 10-year period, a mere 14% of them outperformed their benchmarks.
Hedge funds can (and do) beat the market in individual years, but it’s rare for them to consistently make more money than the market. Of course, nobody can predict the future. Hedge funds might be on the cusp of a resurgence—but they also might not be.
Regardless, hedge funds and actively managed mutual funds also have higher expense ratios than index funds, meaning that if a hedge fund earns the same return as an index fund, at the end of the day, you’ll end up with less money.
What is an expense ratio and why does it matter?
Expense ratios are important when it comes to index fund investing. An expense ratio is basically the fee you pay for the fund’s management. Hedge funds, mutual funds, and even index funds all charge fees to their investors. These fees are the price you pay for a company or firm to manage the fund. Since index funds generally buy and hold stocks, meaning they’re not changing frequently, they have much lower expenses—they’re cheap to manage.
Hedge funds and mutual funds, on the other hand, can employ teams of analysts and highly paid consultants who are dedicated to finding great investment opportunities. Thus, they have higher costs. However, sometimes high expense ratios are simply a reflection that famous hedge funds can charge more. In theory, these funds are supposed to make so much money that the expense ratio doesn’t matter. Your return, the money you make from the investment, will offset your cost. In reality, much of the time they are underperforming index funds while being much more expensive.
If index funds are so great, why isn’t everyone investing in them?
Index fund investing is actually pretty popular. Index funds have outperformed hedge funds and thus have seen huge growth, but hedge funds are still popular amongst the financial elite. Some believe the industry will bounce back and index funds may have their own weaknesses, but others believe many hedge funds are still alive simply due to marketing. (Read this article if you want to learn more about what some call the “The most fascinating investing paradox.”)
Can you lose money with index fund investing?
You can lose money with just about any investment. There’s always risk involved and during the 2008 financial crisis, index funds lost a lot of money because their indexes lost a lot of money. If you’ve invested in, say, an S&P 500 index fund and the S&P 500 is down, your index fund will be, too. Waiting is the name of the game with index fund investing, though.
When prices go down, you wait until they recover again, and historically, the stock market has always recovered. Over time, it’s averaged an annual return of about 6-7%, according to Warren Buffet, one of the world’s most successful investors (and a big fan of index funds).
Also, it is important to remember that I’m not an investment advisor and this article is not investment advice—it’s simply a brief look at one small slice of the investment landscape. It should go without saying, but make sure you do your own research and talk to a professional before you put your hard-earned cash to work.
How can you invest in index funds?
There are many ways to get started with index funds. To buy the investments, you’ll open some kind of retirement or brokerage account, like an Individual Retirement Account or a 401(k). You can open an account at an investment firm like Vanguard, a company widely regarded as one of the best providers of index funds, but keep in mind: they can require minimum investments between $3,000 and $10,000 to get started. You can also open an account and trade index fund ETFs (exchange-traded funds) with Schwab—another highly regarded brokerage firm.
Index funds are a simple, low-maintenance way to get started with investing—but any investment decision is a serious matter so, again, do your research. What do you think about index funds? Are they a part of your financial plan? Let us know in the comments!