“Stop Picking Stocks! Here’s 4 Reasons Why Index Investing Works”
Full disclosure: I love picking stocks! Currently, I have over 25 individual stock holdings. The thrill of investing in a winner like Amazon or Netflix is unbeatable! That being said, index funds has always and will always be my largest holding.
Picking winning stocks is incredibly difficult. Yes, I bought Amazon in 2007. But I also invested in Research in Motion (Blackberry) because of their dominance in the smartphone industry and I invested in SunPower because of the incredible growth potential of solar energy.
Buy and hold investing with individual stocks doesn’t work for most people, as explained by Warren Buffet. Most people are going to be better off buying index funds. Specifically, index funds that track the S&P 500, a diversified portfolio of 500 U.S. companies.
A recent study of professional investors found that only 15% beat the market average in any given year, and only 6% beat the market over 20 years. And yet, we all believe we can do it! Reminds me of the famous driving statistic where 80% of people think they are better than average.
Buy and hold with individual stocks can be a wasted investment, just ask the shareholders of GE and Ford over the past 20 years…
Buy and hold with individual stocks can be a dangerous investment, just ask the shareholders of Enron and Lehmann Brothers…
Compare these outcomes to the alternative of buy and hold investing in the S&P500 index fund.
So why does index fund investing work?
1. It’s managed regularly.
Despite being considered “passive” it is actually managed. Every year, a few companies will be removed from the index and replaced by new ones. In 2001, Enron was removed as they were preparing for bankruptcy and replaced with Nvidia — since then, Nvidia is up 7,000%!
2. It’s popular.
The S&P 500 index is very popular with other countries and retirement accounts. Nearly 50% of the U.S. stock market is owned by foreigners, it is by far the most popular place to invest and it’s not even close. On top of this, retirement accounts are increasingly doing automatic investment into index funds for 401ks — this is consistent demand that advantages the S&P 500.
3. You automatically own the winning stocks.
In 2021, just 5 stocks accounted for 50% of the stock market gains! By owning the index, you essentially guarantee that you are going to own these winning companies. And if you don’t own these stocks, you miss the growth. This dynamic puts stock pickers at a disadvantage.
4. Very low fees.
The Schwab S&P 500 Index Fund (SWPPX) only charges a .02% fee compared to the average mutual fund that charges .70%. That means you are paying 35x more for the mutual fund, and mutual funds don’t beat the market.
These small fees charged by funds add up big over time. The graphic below (provided by Vanguard) displays the impact of a 2% fee over 25 years, which ends up wiping out 40% of your final account value! Be careful with fees!
Clearly, there are several reasons why index investing has the advantage over picking stocks. If you are looking to build long-term wealth and invest wisely, consider a low-cost index fund.
If you are looking for specific names, here are the three recommended by Forbes:
- Fidelity 500 Index Fund (FXAIX)
- Schwab S&P 500 Index Fund (SWPPX)
- Vanguard 500 Index Fund Admiral Shares (VFIAX)
For increased diversification, you can look at a “total stock market” fund that includes smaller companies than the S&P 500 and international index funds for exposure outside the United States.
- Vanguard Total Stock Market Index Fund (VTSAX)
- Fidelity International Index Fund (FSPSX)
“Wealth gained hastily will dwindle, but whoever gathers little by little will increase it.” Proverbs 13:11