Index Funds Pros and Cons

Pros

– Low cost
– Diversified
– Transparent
– Consistent returns
– Ideal for passive investors

Cons

– Conservative returns
– Not recommended for impatient investors
– Vulnerable to the global stock market crash

You may have read about index funds, watched it get recommended on Youtube videos or heard about it from a friend. But what exactly are index funds and why do market experts like Warret Buffet, John Bogle, Tony Robbins, Prof. Eugene Fama, Alan Greenspan, Motley Fools, and Charles Schwab recommend these?

But first, we have to differentiate an index vs an index fund.

Indexes are a group of related securities/companies intended to replicate a particular area of the market or the market as a whole. A good example of indexes is the Dow Jones Industrial Index (DJIA) or Standard & Poor’s 500 Index (S&P 500). DJIA is broad market index of 30 stocks while S&P 500 is made up of, you guessed it, 500 stocks.

For example, the “Utilities Index” tracks the general performance of US utilities. The S&P 500 on the other hand measures the performance of its 500 largest US listed companies. This companies are in a broad category of businesses ranging from manufacturing, services, utilities, tech, etc. It is supposed to be an indicator how the US economy is performing.

What is an Index Fund?

An index fund is a financial product that seek to mimic the performance of a particular market index.

Why Should I Invest in an Index Fund Then?

Simply put, an index fund is a mutual fund (or an exchange traded fund) whose holdings mimic that of a market index. And since it’s just tracking the movement of a particular market index, it doesn’t need fund managers to actively pick stocks for you.

No fund managers = Less Fees!!!

In a research from 2001 to 2016, it showed that only 10% of fund managers outperformed their benchmark index. That means 90% of the so called “experts” couldn’t even beat the market. So why bother looking for the top 10% when you can have consistent returns like the market does?

In contrast to indexes, individual stock picking is susceptable to sudden rise and fall due to normal supply and demand dynamics. Sometimes, a company may rise to phenomenal heights only to fall again due within the day, sometimes within minutes. Index funds are already diversified and generally aren’t affected drastically by sudden events like storms, riots or other random phenomena. Indexes generally rise in value over a long period of time. As of this writing, the S&P 500 performed at an average of 10% returns within the decade. That’s pretty hard to beat!

What index fund should I buy then?

Well, that’s the topic for the next post.