5 Reasons You Should Include Index Funds In Your 401K Or IRA


Thirty percent of Millennials surveyed say that cash is their preferred long term investment, according to Bankrate. Why is this? Some may say that it is intimidating and overwhelming to decide what to invest in. Not wanting to make a potentially costly mistake, it may seem easier to stand on the sidelines. Unfortunately, parking cash in a checking or savings account will simply not make your money work for you in a way that will greatly increase your wealth over the long run.

With an abundance of new and existing asset classes (hello bitcoin), the choice of what to invest in is as complex as it ever has been. Should today’s younger generations be focused on investing in cryptocurrency? Could picking individual stocks lead to the greatest returns? It’s easy to see how the abundance of choice could make an asset we deal with often, like cash, seem like the most friendly choice. It’s no surprise that three in five Millennials have no financial exposure to the stock market.

Index Funds Should Reign Supreme

However, I firmly believe that passively investing in the stock market with index funds should be the preferred long term investment of choice for today’s young professionals. For starters, index funds take all of the guesswork out of investing. Using a simple two fund or three fund portfolio is a perfect way to begin investing your money.

For those not convinced, here are 5 more reasons why you should include index funds in your investment portfolio.

1. A Portfolio Of Index Funds Is Easy To Manage

Once you invest, you can essentially forget about it. If you choose individual stocks, you should be rebalancing regularly to avoid too much exposure to specific sectors or companies. With a broad total stock market index fund, you are well diversified and the impact of one stock rapidly increasing or decreasing in price won’t be as pronounced.

Checking your portfolio every six months to a year is good enough when you have a simple portfolio of a couple of index funds. For many investors, all they really need to do is rebalance their ratio of stocks to bonds to their desired risk level, and then they can again forget about it.

In a world where no one seems to have enough time to get through all of life’s demands, this is one less thing to worry about.

2. Choosing Index Funds Is Simple

Simply find a low cost total market index fund, and invest in it regularly. Continue to buy and hold until you retire to minimize fees and taxes, and you’ll be well ahead of the majority of people.

I personally love Vanguard’s VTSAX because it’s a diversified total stock market index fund, and it only has a 0.04% expense ratio, which means that less of my money is going to pay fees and overhead expenses. A new fund, with similar characteristics is Fidelity’s FZROX, which is also a total market index fund, but its defining feature is that it has absolutely no fees or expenses.

Here’s an excellent primer on asset allocation to get you started.

3. You Are Guaranteed Market Returns

John Bogle, Founder of Vanguard, says in his book, The Little Book of Common Sense Investing, that most investors do not earn market returns. And he says that the professional investment advisers that do, charge a fee that will cause your earnings to drop below the average market return.

If the average professional money manager and hedge fund isn’t able to consistently beat the market average, it seems silly and foolish to think you’d fare better on your own. By buying and holding an index fund, you guarantee that you’ll consistently earn market returns. Not bad for a portfolio that takes less than an hour to manage every year.

If you’re still not convinced, here’s how Nobel Prize winner, William Sharpe, feels about the subject. He says, “The return on the average actively managed dollar will be less than the return on the average passively managed dollar.”

4. Index Funds Will Remain Viable For Years To Come

There’s a sentiment in the investment world that if everyone invests in indexes, the stock market will stop functioning the way it was intended. For example, if everyone buys index funds, the values of the stock prices of the underlying companies won’t reflect the valuation of the companies, but rather just the inflow of funds to indexes.

Index funds don’t participate in the price discovery process, so if only index fund investors were in the market, then the market would no longer be efficient. If there were no longer individual investors creating the demand and supply which determines fair market prices of stocks, then the entire market would no longer be just that, a market. While, in theory, this is a valid concern, the truth is that the vast majority of the public stock market would have to be held by index investors for the market to become inefficient.

In reality, Bloomberg estimates that less than 18% of global equities are owned by indexers. This is well below some of the threshold numbers that leading economists warn against. Larry Swedroe believes that market can remain efficient as long as index funds comprise less than 90% of all stock ownership. What this means is that investing in index funds will continue to be a viable investment for many years to come, since there’s no indication that those levels will ever be reached. After all, there’s always someone willing to bet that they can beat the market average.

5. Index Funds Are Warren Buffett’s #1 Recommended Investment For Individuals

Warren Buffett’s love of index funds is well documented. In fact, Buffett bet $1 million that an S&P 500 index fund would outperform a portfolio of hedge funds over a 10-year period. Buffett’s index fund trounced the portfolio of hedge funds, and he won the bet easily.

The bottom line is that investing passively in index funds might not only be the easiest way to invest your hard-earned money, but also the best.

reasons you need index funds

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