Warren Buffett is one of the most well-known investors of our time, so it pays to heed his advice. And if there's one investment he's a big fan of, it's index funds.
To be fair, Buffett has made much of his personal fortune by handpicking successful stocks that have allowed him to beat the market. But he's specifically instructed the trustee in charge of his estate to invest the bulk of his money in S&P 500 index funds upon his passing. And the fact that Buffett has such faith in index funds means they're probably a good choice for you, too.
How index funds work
Index funds are passively managed funds that seek to track the performance of the market indexes they're associated with. An S&P 500 index fund, for example, will aim to match the performance of the S&P 500.
By contrast, actively managed mutual funds don't simply follow an existing index. Rather, they have fund managers who handpick stocks in an effort to outperform the market (which doesn't always happen).
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Why index funds are a great choice for most investors
If you're an investing wiz with a strong history of researching stocks and picking winners, index funds may not be for you. But here's why they're great for the typical investor.
1. They offer instant diversification
Having a well-diversified portfolio could protect you from losses if an individual segment of the market tanks, or even during a general recession. The great thing about index funds is that each share effectively gives you a bucket of stocks instead of just one. For example, if you own shares of an S&P 500 index fund and a few companies within that index have a bad year, the impact on your portfolio will likely be minimal.
2. They take the guesswork out of investing
Do you know what a P/E ratio is? Are you familiar with the concept of earnings per share? These are just a couple of terms you'll need to become familiar with if you want to assemble a portfolio of individual stocks. But if you don't want to do that legwork or feel overwhelmed by the idea of it, then index funds are a smart choice because they do that work for you.
3. They charge very low fees
All mutual funds charge investment fees known as expense ratios that eat into your returns. Actively managed funds commonly have expense ratios of 1% or more because you're paying for the expertise of a team that will be choosing specific investments. With index funds, you're not paying for that expertise, so your fees might amount to just one-tenth of what you'd pay for an actively managed fund.
Of course, the one drawback of index funds is that they don't seek to beat the market (then again, actively managed mutual funds often fail in this regard despite the experts who run them and the fees you pay to participate in their respective strategies). But if you're satisfied with matching the performance of the broader market, then index funds are a pretty good bet.
But don't take my word for it. Rather, rely on Warren Buffett's endorsement of index funds to guide your decision. His track record is far more impressive than mine, and when he talks, it pays to listen. I know I do.
