Index Funds 101

August 1, 2023

You may have started your investing career because you were interested in stock picking or you wanted to hop on the latest meme stock trend.

I mean.. I hope you didn’t, but I can’t judge.

When I first started, I tried out stock picking.

I thought it would be fun to do with a portion of my money and I thought I may have an edge with understanding financial statements, ratios, market trends (thanks Finance degree).

Let me tell you:

It’s not fun losing to the market.

So I abandoned that strategy promptly.

And ever since my money has been hard at work through index funds.

6 benefits of index funds:

First, what is an index fund?

It’s an investment that tracks an index.

You may be familiar with the S&P 500 or the Nasdaq 100.

An S&P 500 index funds only job is to try to match what the S&P 500 does.

Not beat it. Not compliment it. But just be it.

So why do I love them?

For these 6 reasons:

1. They are low-cost.

When you don’t have to pay a professional manager & their team to try to beat the market, your costs go way down.

All you need is a small team to manage these funds & a simple strategy: mirror the index.

And because there’s not a lot of “action” (trading) going on with these funds, they don't generate a lot of taxes for you.

2. They are tax-efficient.

Now, this only applies to your “taxable” accounts.

Your IRA, Roth IRA, 401(k), HSA, etc. are tax-deferred accounts.

You could trade all day long in those accounts (although I wouldn’t) and it wouldn’t be taxable to you.

But a taxable brokerage account is taxed as you go.

So when a fund manager is consistently buying and selling stocks, they're creating a tax impact for you.

An index fund buys and holds an index, so trading is a rare event.

Which means generating a gain, and therefore tax is a rare event.

3. They are diversified.

One of the risks in buying individual stocks is the risk that if one company/stock does poorly, it could have a dramatic impact on your portfolio.

If you hold 10 stocks and 1 company goes out of business, that’s a big drag on your return.

But if you own an S&P 500 index fund, you instantly own a fraction of the top 500 companies within the US without the cost of actually having to buy 500 individual stocks (which is really costly).

4. They are self-cleansing.

What happens if a company starts performing poorly?

They will drop in the rankings of the “top 500 companies within the US”, and if they’re really struggling, they’ll fall out of the S&P500 completely and another company will take its place.

If you own individual stocks, you will have to keep an eye on how the companies you own are performing and making judgment calls on when to sell and what company to replace them with.

That is a difficult call to make.

Index funds will buy the new company doing well and sell the company that's fallen out of the index, which makes them self-cleansing.

5. They beat professional investors.

In 2021, 80% of all actively managed funds failed to beat their benchmark.

And this percentage chance of beating the index only gets worse the longer the time horizon.

Warren Buffett, arguably the best investor of all time, is a huge supporter of index funds:

“By periodically investing in an index fund...the know-nothing investor can actually outperform most investment professionals.”

6. They are easy.

You don’t have to pour over financial statements, watch the stock market, or understand financial ratios to own index funds.

They can be “set it and forget it” for a long time.

Which means you can spend your time doing the things you really enjoy doing.

And you’ll know that your money is invested well in a proven strategy supported by the greats.