Why Index Funds are Right For You

Who is the Average Investor?

Before going any further, let’s profile the “average” investor:

  1.  Lacks basic understanding of investment fundamentals
  2. Unfamiliar with basic investment metrics such as PE ratios, EPS, etc.
  3. Bases stock purchases on random tidbits of news, the advice of friends, and “hunches”
  4. The totality of their investment portfolio resides in company 401Ks or an IRA
  5. Sells in bear markets, and buys in bull markets
  6. Is bored to tears when their friends talk about the markets

If any more than two of these criteria apply to you, you’re most likely a casual investor.  Or to be more accurate, a crappy investor.  In other words, you have no idea what you’re doing.

And you know what?  That’s okay.  Lots of people would rather be doing something other than looking for the next best stock pick.  I personally love hunting for attractive stocks, but I certainly understand why somebody wouldn’t.  There are lots of other worthwhile things to do in this world!

Well have no fear.  A bunch of smart cookies created the perfect investment vehicle for apathetic investors such as yourself.

Now let’s quickly summarize what this strategy will do, and what it won’t do.

What It Will Do

  • Provide a comparatively safe, diversified investment
  • Guarantee steady growth in your portfolio in the long term
  • Give you the freedom for all intents and purposes to never think about stocks again

What It Won’t Do

  • Make you rich quickly – The largest single year gain for the S&P500 was 34.11%.  An enormous return to be sure, but certainly not going to make a poor person an overnight millionaire.

Endorsed by an Investing Legend

Unless you’ve been living under a rock your entire life, you know who Warren Buffet is.  Warren Buffet is probably one of the, if not the most, successful investors of all time.  As of the publishing date of this article, he’s worth approximately 65 billion dollars.  And below is a direct quote from this legendary investor’s annual letter to Berkshire stakeholders in 2013:

My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.

Well, his track record would suggest that he’s a much more competent investor than I am.  So if this strategy is good enough for him, it stands to reason that it should be good enough for you and me.

But, Everyone Knows That Stocks are Risky!

But wait!  Nothing in stocks is guaranteed.  What if I take your advice, put all of my investment savings into index funds, and lose it all!

Let me tell you something.  If you invest in an S&P 500 index fund and “lose it all,” the fact that you lost your money is the least of your concerns.  Index funds mitigate risk by trying to match the associated index as closely as possible.  If you “lost it all,” that means that 500 of some of the largest businesses in America have gone completely out of business.  Apple no longer exists.  There’s no McDonald’s to go to for a quick cheeseburger.  Every American car manufacturer has shut its doors.

In this scenario, every financial institution in the world has likely completely collapsed.  You’re almost certainly living in an apocalyptic world of total anarchy.  In this Mad Max-esque world, your 401k balance is the least of your concerns.

Don’t forget that index funds are by definition diversified.  If every stock in the S&P 500 had an equal valuation (it doesn’t), then the complete and utter failure of a component of the S&P 500 would affect your portfolio by .2%.  In any case, people saying that stocks are “risky” generally don’t know what they’re talking about.  Short term, yes stocks have enormous volatility and you stand to lose a lot of money.  Statistically speaking, people who hold a diversified set of stocks for a long period of time have a very low chance of losing money.  From a risk perspective, it’s a winning bet.

Why Trying to Pick Stocks is Probably a Waste of Your Time

I’m not saying that you can’t beat an index fund by investing individually in stocks.  You can.  And every year, many people do.  Myself included.

But let’s put this into perspective.  80% of mutual fund managers fail to beat the index.  For those of you who don’t know what a mutual fund manager is, a mutual fund manager is the person in charge of making stock picks for actively managed funds.  In other words, their entire job is to pick stocks that will provide their shareholders with the maximum return possible.  That’s all that they do.  And you can be damn sure that they’re extremely motivated to do so, because successful mutual fund managers get huge bonuses.

See what I’m getting at?  Mutual fund managers are people who spend the entirety of their professional lives trying to figure out how to pick the best stocks.  Mutual fund managers are typically intelligent, successful people who have gone to top universities.  Mutual fund managers have access to analytics tools that are way beyond the reach of average investors like you and me.

And finally, most mutual fund managers consistently fail to beat the markets.

So you think you, an average investor who’s spent maybe two hours reading a single book on investing and read a few blogs on investing, can find better investments than most mutual fund managers?

PennyJunkies is about common sense, and that seems pretty far removed from common sense to me.

Now many people will jump on me and say, “The XYZ Index returned x% annually over the last ten years.  My investments returned y% annually over the last ten years, beating the index by w%!”

Yes, obviously there are many people that beat the markets.  But to be honest, this doesn’t actually mean a whole lot.

The reality is that most people who beat the markets are just lucky.  More importantly, the vast majority of the people who can say this typically have invested a significant proportion of their investments into a single stock that had astronomical returns.  The most common example in modern times is probably Netflix.  If you invested $10000 into Netflix in 2003, today it’s worth $1000000!   This single stock is probably more than compensating for the losses or more typical returns you’re seeing in the rest of your portfolio.  So good job finding yourself a “ten-bagger,” but this doesn’t make you an investment guru.

Conclusion

Ultimately, the point of this article is not to insinuate that it is impossible to consistently beat the returns of an S&P 500 fund.  The point of this article is to humble you into realizing that you’re almost certainly not one of those people.  Deluding yourself into thinking you are, can potentially cost you lots of money.

This is especially pertinent if you don’t even have any interest in stocks!  Your only concern is to make intelligent investment vehicle choices so that your retirement savings are relatively secure.  Well keep it simple stupid.  Throw your investments into an S&P 500 fund, ignore the inevitable ups and downs, and focus on the other things in life that bring you joy.

For the other losers who like looking at graphs and PE ratios on weekends behind a computer desk (myself included), ignore everything I said and keep chugging away!

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