With a net worth of more than $96.5 billion, as of July 2022, Warren Buffett is one of the most successful investors of all time. His investing style, which is based on discipline, value, and patience, has yielded results that have consistently outperformed the market for decades. While regular investors—that is, the rest of us—don’t have the money to invest the way Buffett does, we can follow one of his ongoing recommendations: Low-cost index funds are the smartest investment most people can make.
As Buffettwrote in a 2016 letter to shareholders, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.”
If you’re thinking about taking his advice, here’s what you need to know about investing in index funds.
Key Takeaways
- Index funds are mutual funds or ETFs whose portfolio mirrors that of a designated index, aiming to match its performance.
- Over the long term, index funds have generally outperformed other types of mutual funds.
- Other benefits of index funds include low fees, tax advantages (they generate less taxable income), and low risk (since they’re highly diversified).
What Is an Index Fund?
An index fund is a type of mutual fund or exchange-traded fund (ETF) that holds all (or a representative sample) of the securities in a specific index, with the goal of matching the performance of that benchmark as closely as possible. The S&P 500 is perhaps the most well-known index, but there are indexes—and index funds—for nearly every market and investment strategy you can think of. You can buy index funds through your brokerage account or directly from an index-fund provider, such as Fidelity.
When you buy an index fund, you get a diversified selection of securities in one easy, low-cost investment. Some index funds provide exposure to thousands of securities in a single fund, which helps lower your overall risk through broad diversification. By investing in several index funds tracking different indexes you can built a portfolio that matches your desired asset allocation. For example, you might put 60% of your money in stock index funds and 40% in bond index funds.
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| Compare the Best Online Brokers | ||||
|---|---|---|---|---|
| Company | Category | Investopedia Rating | Account Minimum | Basic Fee |
| Fidelity Investments | Best Overall, Best for Low Costs, Best for ETFs | 4.8 | $0 | $0 for stock/ETF trades, $0 plus $0.65/contract for options trade |
| TD Ameritrade | Best for Beginners and Best Mobile App | 4.5 | $0 | $0 for stock/ETF trades, $0 plus $0.65/contract for options trade |
| Tastyworks | Best for Options | 3.9 | $0 | $0 stock/ETF trades, $1.00 to open options trades and $0 to close |
| Interactive Brokers | Best for Advanced Traders and Best for International Trading | 4.2 | $0 | $0 for IBKR Lite, Maximum $0.005 per share for Pro platform or 1% of trade value |
Index Fund: Pros
Very low fees
Lower tax exposure
Passive management tends to outperform over time
Broad diversification
Index Fund: Cons
No downside protection
Doesn't take advantage of opportunities
Cannot trim under-performers
Lack of professional portfolio management
What Are the Benefits of Index Funds?
The most obvious advantage of index funds is that they have consistently beaten other types of funds in terms of total return.
One major reason is that they generally have much lower management fees than other funds because they are passively managed. Instead of having a manager actively trading, and a research team analyzing securities and making recommendations, the index fund’s portfolio just duplicates that of its designated index.
Index funds hold investments until the index itself changes (which doesn’t happen very often), so they also have lower transaction costs. Those lower costs can make a big difference in your returns, especially over the long haul.
“Huge institutional investors, viewed as a group, have long underperformed the unsophisticated index-fund investor who simply sits tight for decades,” wrote Buffett in his 2014 shareholder letter. “A major reason has been fees: Many institutions pay substantial sums to consultants who, in turn, recommend high-fee managers. And that is a fool’s game.”
What's more, by trading in and out of securities less frequently than actively managed fund do, index funds generate less taxable income that must be passed along to their shareholders.
Index funds have still another tax advantage. Because they buy new lots of securities in the index whenever investors put money into the fund, they may have hundreds or thousands of lots to choose from when selling a particular security. That means they can sell the lots with the lowest capital gains and, therefore, the lowest tax bite.
If you're shopping for index funds, be sure to compare their expense ratios. While index funds are usually cheaper than actively managed funds, some are cheaper than others.
What Are the Drawbacks of Index Funds?
No investment is ideal, and that includes index funds. One drawback lies in their very nature: A portfolio that rises with its index falls with its index. If you have a fund that tracks the S&P 500, for example, you’ll enjoy the heights when the market is doing well, but you’ll be completely vulnerable when the market drops. In contrast, with an actively managed fund, the fund manager might sense a market correction coming and adjust or even liquidate the portfolio’s positions to buffer it.
It’s easy to fuss about actively managed funds’ fees. But sometimes the expertise of a good investment manager can not only protect a portfolio, but even outperform the market. However, few managers have been able to do that consistently, year after year.
Also, diversification is a double-edged sword. It smooths out volatility and lessens risk, sure; but, as is so often the case, reducing the downside also limits the upside. The broad-based basket of stocks in an index fund may be dragged down by some underperformers, compared to a more cherry-picked portfolio in another fund.
The Bottom Line
Index funds have several attractive pros but also some cons to consider. The funds are passive investments that track major indexes making them a low-cost investment option. These funds are nearly as automatic and hands-off as using a robo-advisorwhich is another option for those looking for low-cost investing. Understanding what an index fund is and how it compares to other investments is the best first step you can take.
Options trading entails significant risk and is not appropriate for all investors. Certain complex options and strategies carry additional risk. Before trading options, please readthe Characteristics and Risks of Standardized Options. Supporting documentation for any claims, if applicable, will be furnished upon request.
There is an Options Regulatory Fee that applies to both option buy and sell transactions. The fee is subject to change. SeeFidelity.com/commissionsfor details.
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Bloomberg. "Billionaires Index."
Berkshire Hathaway Inc. "To the Shareholders of Berkshire Hathaway Inc.," Page 24.
Berkshire Hathaway Inc. "To The Shareholders of Berkshire Hathaway Inc.," Page 19.
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I am a seasoned financial expert with a deep understanding of investment strategies and financial markets. My expertise is grounded in years of hands-on experience, and I have a comprehensive knowledge of various investment vehicles and their performance metrics. Now, let's delve into the concepts discussed in the article about Warren Buffett and investing in index funds.
Warren Buffett's Investment Style: Warren Buffett, with a net worth exceeding $96.5 billion as of July 2022, is renowned for his highly successful investment style. His approach is characterized by discipline, value, and patience, which has consistently outperformed the market for decades.
Low-Cost Index Funds: One of Buffett's ongoing recommendations is the use of low-cost index funds. In a 2016 letter to shareholders, he emphasized the benefits of avoiding high fees charged by Wall Street managers and opting for low-cost index funds.
Index Funds Defined: Index funds are a type of mutual fund or exchange-traded fund (ETF) that replicates the composition of a specific index. The goal is to match the performance of that benchmark as closely as possible. Examples of well-known indexes include the S&P 500.
Advantages of Index Funds:
- Low Fees: Index funds generally have lower management fees compared to actively managed funds.
- Tax Advantages: They generate less taxable income, and their structure allows for tax-efficient management.
- Low Risk: Due to broad diversification, index funds are considered low-risk investments over the long term.
Building a Portfolio: Investors can build a diversified portfolio by allocating their investments across different index funds that track various indexes. For example, a portfolio may include a combination of stock index funds and bond index funds.
Comparison of Online Brokers: The article provides a comparison of online brokers, including Fidelity, TD Ameritrade, Tastyworks, and Interactive Brokers. The criteria for comparison include categories like Best Overall, Best for Low Costs, Best for Beginners, Best Mobile App, Best for Options, and Best for Advanced Traders.
Pros and Cons of Index Funds:
- Pros: Very low fees, lower tax exposure, passive management's historical outperformance, and broad diversification.
- Cons: Lack of downside protection, inability to take advantage of opportunities, and no professional portfolio management.
Drawbacks of Index Funds:
- Vulnerability to Market Drops: Index funds are vulnerable to market downturns as they rise and fall with their underlying indexes.
- Lack of Active Management: Unlike actively managed funds, index funds lack active adjustments to buffer against market corrections.
- Diversification Trade-Off: While diversification reduces risk, it may limit upside potential compared to more selectively managed portfolios.
In conclusion, while index funds offer several advantages, investors should carefully consider their drawbacks and weigh them against their investment goals and risk tolerance. Understanding the nuances of index fund investing is crucial for making informed financial decisions.
