Warren Buffett is one of the most successful investors in history, so when he talks, it pays to listen. Thankfully, one investment strategy he consistently recommends is so incredibly easy that even a total newbie can adopt it with ease: Putting money into index funds.
These passively managed funds have the straightforward goal of tracking the performance of existing market indexes. For example, an S&P 500 index fund will aim to match the performance of -- you guessed it -- the S&P 500 itself, usually by holding all the components of the index.
What are the benefits of index funds?
Index funds take a lot of the work out of investing. When you buy individual stocks, you should carefully examine each company's financials and make sure you understand its business model before moving forward (not that every trader does, but they ought to). With an index fund, you can simply look at that fund's performance rather than examine each individual stock it covers. That saves you a ton of legwork.
Perhaps more importantly, index funds also offer investors instant diversification. If your portfolio consists of just a few individual stocks and one company you're invested in tanks, you can lose a large fraction of the value of your holdings (at least on paper). On the other hand, when you own an index fund, you're getting a large bucket of stocks, so even if several companies within that bucket fall sharply, others may be rising at the same time, offsetting those declines and keeping your potential losses in check.
Finally, index funds are fairly affordable. All mutual funds charge investors annual investment fees that amount to a set fraction of the size of your take -- the expense ratio. Actively managed mutual funds commonly feature expense ratios of 1% or more. The reason? You're paying for the expertise of a fund manager and their associates, who will be hand-picking its investments, choosing when to buy and sell stocks, and overall, putting together a unique blend of stocks they hope will deliver better returns than the market averages. (Spoiler alert: Most of them don't. Last year, after factoring in their fees, just 29% of actively managed funds outperformed their benchmarks. And over longer terms, the percentages drop even further.)
With an index fund, you're not charged for that "expertise," because it takes very little to simply buy and hold the components of broad market and sector-tracking indexes that already exist. As such, their expense ratios are substantially lower -- often, one-tenth of what actively managed funds charge.
Are there drawbacks to buying index funds?
If your preference is to have complete control over your investment portfolio, then index funds may not be for you. If you buy an S&P 500 index fund, you don't get to choose which stocks make it into the S&P 500, and so if there are a handful you don't like, you're still stuck with them.
Furthermore, index funds seek to match the performance of existing indexes -- not beat them. If you're hoping to outperform the market -- and yes, it is possible for an individual investor to beat the market -- you'll need a different strategy.
A great place for investors to start
Index funds aren't limited to stocks; there are funds that mirror the bond markets, too. But if you're not too close to retirement and have the option to invest more aggressively, stocks are generally considered a stronger wealth-building tool.
Now you can buy stock-focused index funds directly through mutual fund companies or certain brokerage accounts, but you can also buy index funds that trade publicly. These funds are known as exchange-traded funds (ETFs), and the benefit of going this route is that you can track their prices with ease. If you're just getting started with index funds, you might consider the Vanguard Total Stock Market ETF (NYSEMKT:VTI) or the Vanguard S&P 500 ETF (NYSEMKT:VOO).
Take Buffett's advice
All of this brings us back to Buffett, a man famous for building an investment portfolio that has wildly outperformed the market over the long term. In his view, most of us should not try this at home.
"A low-cost index fund is the most sensible equity investment for the great majority of investors," said Buffett. "By periodically investing in an index fund, the know-nothing investor can actually out-perform most investment professionals." It's really hard to argue with that.