Are Index Funds a Good Investment? – Why Warren Buffet Recommends

Are-Index-Funds-a-Good-Investment
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Index funds have become more popular among investors in the 21st century. Passive investing overall has become more popular to the point where passive management now accounts for almost 50% of all assets for U.S. stock-based funds, according to CNBC.

So, are index funds a good investment? Why are they becoming more popular? Why would Warren Buffet recommend index fund investing to the average investor?

All these questions, and more, will be answered in the following paragraphs.

What are Index Funds?

To know what index funds are, we first have to know what an index, alone, is. An index is a mathematical average that tells you how a specific group of stocks, commodities, or other securities is doing. In this case, we will mostly be focusing on stocks.

We actually use indices all the time in our lives for aspects outside of investing.

For example, if a group of people is trying to calculate the average fluctuations of weight within the group, that calculation is an index!

The same applies to our market. The fluctuation of the value of a group of securities is an index. In this case, an index fund is a basket of stocks that mirrors a particular index. When you purchase an index fund, you purchase a small percentage of each stock held within the index.

One of the most popular indices in the world is the S&P 500 Index. It calculates the average price fluctuations within the top 500 companies/corporations in the United States. By purchasing an S&P 500 Index Fund, you are purchasing a small percentage of each of the companies that are held within the S&P 500 for a fraction of the price.

explanation on index funds

A Common Misconception About Big Indices

In this example, we will be using the S&P 500 to explain a common misunderstanding of large indices. But keep in mind that nations all across the world have different indices, just like the U.S. does. They have big indices that track the majority of the nation’s market, as well as smaller ones.

The S&P 500 is one of the largest indices in the U.S., due to this, they tend to go hand in hand with the overall U.S. Economy.

However…

It should be very well noted that the market or index performance does not reflect the performance of a nation’s economy. 2020 is a perfect example of this. Due to the occurrences of the pandemic, the U.S. economy did very poorly throughout this time.

The Gross Domestic Product (GDP) of the U.S. dropped by about 4% by June, unemployment skyrocketed, and people were in danger of losing their homes. Yet, the market and the S&P 500 only dropped for a couple of months, then picked right back up on their bull run, despite the economic distress.

Be very careful not to confuse a big market index with the economy of its nation.

It is a very common mistake, and even large finance influencers commonly have mistaken the two.

Index Fund: Pros

Index funds have many advantages over other funds. Here are some of them!

Great for passive investors.

First off, index funds are generally for passive investors. These are investors who prefer to do minimal work for their investments, while also having a decent return on investment (ROI).

When you’re a passive investor, you don’t want to spend your time researching a company to find its intrinsic value, what risks it faces, what growth potential it has, etc. Instead, your objective is to be able to invest in the market, obtain a safety of principal and an adequate return with the least amount of effort possible.

Index funds are a great option for the passive investor.

Index funds provide low operating expenses.

Due to the low-maintenance necessity of index funds, the average expense ratio for an index fund is about 0.2%. More often than not it could even be lower than 0.2%. Compare this to mutual funds, you get an average expense ratio of about 2%.

Believe it or not, this has a huge impact on your returns. Expense ratios and fees can eat away quite a bit from your average return.

This is why having an index fund with an expense ratio lower than 1% is an excellent option. You won’t have to pay so much in fees because the expense ratio for your fund is very low.

Index funds have outperformed actively managed fundsΒ 

Warren Buffet actually made a bet of $1M againstΒ a collection of professional hedge fund managers. He bet that the hedge fund managers could not beat the general market index over a 10-year period…

Warren won the bet, as the hedge fund managers were not able to beat the market index.

92-95% of professional fund managers cannot beat the general market index over the long run. One recent example is from SPIVA Scorecard data from S&P and Dow Jones Indices. During a five-year period, ending December 2018, 82% of large-cap funds generated a return less than the S&P 500.

Many more examples across history have proven many times that the majority of actively managed funds cannot outperform the market in the long run.

Ultimate Diversification

Index funds offer ultimate diversification. You can choose how much you want to diversify your portfolio from the specific index funds you choose.

Keep in mind that index funds don’t only follow stocks. There are funds for other types of securities as well. Some examples are commodities, bonds, and even real estate. Your options are nearly limitless when it comes to diversifying with index funds.

Index Fund: Cons

Although index funds have many advantages, they aren’t quite perfect. They have their downsides and while these may not be significant enough for some people, for others it could mean the deciding factor of whether they will invest with index funds or not.

Vulnerable to market volatility

Since index funds are meant to mirror a specific index, they are susceptible to the same volatility as that index. Also, since index funds are meant to be long-run funds, the short term volatility of their index makes them less attractive than actively managed funds.

This is because actively managed funds are better equipped to defy short-term volatility. Actively managed funds tend to do better in the short-term, passively managed funds tend to do better in the long-term.

According to the SPIVA Scorecard, in a span of one year, only 64% of large-cap mutual funds underperformed the S&P 500. In other words, over one-third of them beat it in the short term.

With this being said, keep in mind that expense ratios are far higher for actively managed funds, and depending on your gain, you might still be better off investing in index funds.

Lack of flexibility

Due to the fact that index funds follow an overall index, once you purchase an index fund you have invested into all the securities within it, even if you don’t like some of those securities. Those securities are part of the fund and your money will be going into them regardless.

Also, if you want to purchase other equities along with your index fund but they are not part of the index, then you will have to make this purchase separately. This isn’t’ too much of a big deal though, you can purchase fractional shares if you can’t purchase the entire equity. Or if you can afford them, simply buy the separate equities in full. Just keep in mind that they aren’t part of that index!

Limited gains

The gains of your index funds are limited to that of the gains of the index. This means that if one security did amazing within the index fund, your gains will still match the overall index rather than that specific security. Some investors are looking for above-average returns from their investments, you won’t usually be finding that with index funds.

Why Warren Buffet Recommends Index Funds

“The best, single thing you could’ve done on March 11th, 1942, when I bought my first stock, is buying an index fund and never look at a headline. Never think about stocks anymore. If you put $10,000 in an index fund with reinvested dividends, it would’ve come to about $51,000,000 today” – Warren Buffet in 2018.

The legendary investor, Warren Buffet, could not have explained it more clearly. Index funds were not a thing until the 1970s, but had they been around in 1942 when Warren started investing, he would’ve bought in. The reason for this is because, over the long run, history has shown us many times that very few can outperform the market.

No one can accurately predict the market for a long period of time. If the most professional hedge fund managers and mutual fund managers in the world cannot beat the market on a 95% basis over the long run, what can make an ordinary investor believe that he or she will do better?

Unfortunately, it’s all luck when it comes to outperforming the market on a consistent, long-term basis.

If you ignore the headlines and simply keep investing consistently, you will be greatly rewarded in the long run. Yes, in the short run you will see tremendous down-dips, but don’t let the emotional part of you take over what should only be a logical approach to investing.

If the most successful billionaire investor is telling you to invest in index funds, maybe it’s something you should consider.


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14 Comments

  1. I have very little experience with the stock market. But what I did has turned out well. If Warren Buffet says something about finance, I perk up my ears. I am sure it is a silly reason, but that man always has a smile on his face. I like being around pleasant people, especially when they are good at what they do!

    1. 110% in agreement with that! Warren Buffet is someone we should spend a lot more time learning from!

  2. You know there is only one stock I’m interested in is Cannabis lol because every state that accepts medical or just legalizing it is making an abundance of revenue I don’t even know how much stocks cost when you go to purchase them so I’m sure Indexed stocks should be more cost worthy for a common man such as my self.

    You were so completely informative on your content I have no questions on it the only one I would have you have answered can I get the profit off of one part of the indexed funds.

    Thank you for you’re great content I can say I actually enjoyed reading it 

    1. Haha, cannabis is pretty good but make sure to analyze what you’re buying before officially making a purchase. Make sure it’s not the hype that’s getting you into something. Cannabis seems to be something worth looking at, but even then, one should be well aware of things like: what cannabis company are you buying stock from, how is that company doing, how is their management, how are they expanding, and much more. Fundamental analysis is very important.

      I appreciate the feedback πŸ™‚

  3. This information will be extremely helpful for my investing journey, thank you so much!!! for me, the most obvious benefit which prompts my investment in index funds is that the portfolio becomes instantly diversified, minimizing the chances you’ll lose your money. Gracias for this πŸ™‚ the fact that Warren Buffet recommends it tells me that you know exactly what you’re talking about

    1. De nada πŸ˜‰ Glad it was helpful. Thank you for the feedback πŸ™‚

  4. Hello there, Thanks for sharing this awesome article, from what I’ve seen across your website, you really take the time to put the real facts out there. I have always wanted to go into index funds investment, I just want to know which investments would be the best to make for specific index funds. Do you have any advice on that?

    1. Legally I cannot give you financial advice but I can surely give you my educated opinion. I personally like to go for diversification when it comes to long-term investing. Eventually, I’ll move into specific companies that I’ll be conducting some fundamental analysis on but most people are not willing to do that. I would say that the best investments to make when it comes to diversified indices would be VOO or VTSAX. Also SPHD for its dividends and low volatility, it’s an ETF though. These are only 3 options for stock indices that you could look into because of diversification and high dividend yield. For bonds, I like VBTLX for its US bonds and low volatility. Like I said earlier, this is not advice but rather an educated opinion based on what I’ve learned from experiences and research.

      Hope this was of some help πŸ™‚

  5. If Warren Buffet recommends it than it is definitely something worth listening to. I recently started investing into stocks and it’s been quite a fun experience. Of course there are ups and downs but you should always invest money that is extra and you would be ok with losing. I have heard index funds but I need to look into it more sounds like a good opportunity

    1. When it comes to long-term investing, losing money shouldn’t be something that you should be expecting in the long-run πŸ˜‰ index funds are an amazing tool for this to be possible. Sure, in the short-term there may be ups and downs but in the long-term, you want to know that your money will be growing. I appreciate the feedback and I’m glad this article was helpful πŸ™‚

  6. This is the first time that I am hearing about index funds and I think that it is probably a good way for me to go with my investments and if Warren buffet can recommend this then it then I guess it is really a good investment. Thank you for this broad enlightening of what it is all about.

    1. Happy to help πŸ™‚ it’s definitely worth taking a look at 

  7. Hello, thank you for sharing this resourceful and informative article. I know little and have close to no experience with stock markets but knowing Warren buffet recommends index funds is more than enough for me to believe that index funds would be a great option. Your elaboration on that was easy to understand. Thank you so much for speaking English haha

    1. Haha, I’m glad this was helpful and I’m glad this was easy to understand. Trying to read about this stuff from website like the IRS website is like a maze, they basically speak a whole other language that only those who understand the terminology can understand. I try to simplify everything they and others say with these articles. Thank you for your feedback πŸ™‚

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