Index Funds: The Gold Standard of Stock Market Investing

In 2008, Warren Buffet, the most successful investor in history, made a bet with Protégé Partners LLC, a hedge fund, that pitted the world of active and passive investing against each other. It was a simple bet; both parties would invest and whoever had the most money after 10 years, net of fees, won. (The winner got to choose the charity that the combined $1M+ would go to.) Protégé Partners LLC invested the money in their own hedge fund. Contrary to what most people thought Buffet would do, he didn’t invest in his own Berkshire Hathaway. Instead, he invested in an Index Fund, specifically Vanguard’s S&P 500 Admiral fund (VFIAX).

What is an Index Fund?

In the world of stock investing, there are two philosophies: active and passive. Active is the realm of Goldman Sachs, Meryl Lynch, and Berkshire Hathaway, where people are paid big bucks to research stocks and invest in companies that they think will do well. Passive investing is the home of the Index Fund, pioneered by the company Vanguard. The basic philosophy behind passive investing is that it is impossible to predict the future, so why waste time and lots of money trying to. Instead of working to pick the winners and the losers, invest in them all.

Index funds work by pooling money from investors (like yourself) to buy stock in every company within the index it tracks (the most common index is the S&P 500). Your money simply sits in those shares, going up and down in perfect tandem with the index. There is no high-cost fund manager and research analysts behind the scenes placing bets on one stock versus another.

To form an analogy, let’s talk in terms of beer. I always like trying new beer, but there are always some that I like more than others, as I’m sure is true for you as well. Let’s say you walk into a new grocery store to buy beer, and they only have 6 varieties, all of which you’ve never heard of before. You could buy a 6 pack of one, but if you hate your first sip, you’ve just wasted 6 beers because you’re going to throw the rest of them away. Alternatively, you could buy 1 of each (in essence, you are indexing the grocery store). Some of them you may not like but others you may love. You’ve taken the guess work out of finding the beer for you, because you’re able to drink them all.

 

What are the benefits of an Index Fund?

Index funds have a lot of benefits over other investments (individual stocks, mutual funds, and hedge funds), particularly for the average investor:

  • Fees: One of the main differences between mutual funds and index funds is the cost of running them. Mutual funds must hire expensive personnel to research stocks, listen to earnings calls, and market their products, all of which costs money. Those costs are passed on to investors in the form of investment fees. The typical investment fee for a mutual fund is 1%-2%! Index funds forgo nearly all of those costs, bringing fees down to nearly 0%. Vanguard’s fund, the one that Warren Buffet invested in earlier, costs just 0.04%.
  • Taxes: When mutual funds make trades, someone (meaning You) must pay the taxes on the capital gains. This is true even if you don’t sell your investment in the mutual fund. So, if you’re invested in a mutual fund that buys and sells investments a lot, you could be on the hook for a big tax bill at the end of the year. Index funds, however, very rarely buy and sell in investment. This leaves you in control of when you pay your investment taxes because it’s tied to when you sell out of your index fund.
  • Diversification: We’ve all heard the phrase “don’t put all of your eggs in one basket”. Another word for that is diversification, or spreading your investment across many different companies. Index funds allow you to own every company in an index within one simple investment. To be fair, most mutual funds are sufficiently diversified as well. Instead of owning all 500 companies in the S&P 500, they may own say 200 of them. However, index funds provide the lowest cost way to invest in a wide variety of companies and industries.

 

Why I invest in Index Funds:

When I first started investing about 10 years ago, I tried lots of different stock-picking strategies and researched mutual funds. However, the more I read and studied, the more I realized how full of sh*t most of those books and money managers are. My favorite investing quote that I heard in business school is: “on average, the average investor is average”. There are always going to be people who, over a given period of time, beat the market. People often point to Warren Buffet as proof that you can beat the market consistently. However, I am not Warren Buffet and I don’t spend my days reading endless financial reports. For me, the best use of my time is to focus on wealth-building areas I can control and let my money grow in the most efficient way possible: Index Funds.

 

What happened with the bet?

Oh! I almost forgot. While the jury is still out on the results, we’re 9 years into the 10 year bet, it would take some major events for Buffet to lose the bet. The hedge funds averaged 2.2% over the 9 years through 2016, yielding a value of $1,220,000 from a $1M investment. The index fund which averaged 7.1%, yielding a value of $1,854,000, a difference of over $630,000!

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