Warren Buffett, one of the world's most successful investors, has famously touted index funds as the best way for the average investor to generate wealth.
While index funds do have plenty of advantages, some investors may find that this type of investment doesn't fit their needs. There are a few reasons why you should consider index funds, but also a couple of reasons they may not be the best investment for you.
Why to invest in index funds
1. They create instant diversification
An index fund tracks a stock market index, such as the S&P 500 or the Dow Jones Industrial Average. This means these funds usually hold all the stocks within these indexes.
When you're investing in hundreds or thousands of stocks at once, your portfolio is much more diversified than if you were investing in a handful of individual stocks. If you're investing in 10 different stocks and one of them doesn't perform well, it could have a dramatic effect on your portfolio. But if you're investing in an index fund that contains 500 stocks, one underperforming stock won't have as much of an impact.
2. They're more likely to bounce back from market downturns
There are many different types of index funds out there. Some are niche funds that track smaller sectors of the market, while others are broad market funds that mirror major market indexes, like the S&P 500. One major advantage of broad market funds is that they're more likely to recover from market downturns.
The S&P 500 has been around for almost a century, and during that time it has experienced countless corrections, downturns, and full-blown crashes. However, it's always bounced back stronger than ever after each one. While there's no way to know for sure what the market will do in the future, history shows us that if the market crashes again, the S&P 500 will very likely recover. And when your index funds mirror the S&P 500, that means your investments will bounce back as well.
3. They're less expensive than other types of investments
Index funds are passive investments, which means that they don't have portfolio managers choosing which stocks to include in the fund. They simply track indexes, so they automatically include whichever stocks are in the index.
Compared to actively managed mutual funds, index funds tend to be cheaper. Actively managed funds do have someone choosing which stocks to include in the fund, and that results in higher fees.
In theory, actively managed funds should see higher gains than passive funds, because there's an expert deliberately trying to improve the fund's performance. However, in 2019, only 29% of actively managed U.S. stock funds outperformed their benchmarks, according to research from Morningstar. So not only are index funds less expensive than actively managed funds, but they tend to perform better, too.
Why not to invest in index funds
1. They can't beat the market
Index funds have their perks, but one of their most significant disadvantages is that it's impossible for them to beat the market.
By definition, index funds are simply average. They are designed to follow the market, so they cannot beat the market. For many investors, this isn't necessarily a bad thing. Index funds may only experience average returns, but their low costs and limited risk still make them an appealing option.
However, if you're looking to maximize your investment returns and beat the market, index funds may not be the right choice for you. Instead, you may opt to invest in individual stocks. There's more risk involved with this option, but the potential rewards are more significant, too.
2. You have to invest in all the companies in the index
Another disadvantage of index funds is that they don't provide much flexibility. Because index funds track certain indexes, you don't get a choice about which companies you're investing in. If a company is included in the index that your fund tracks, you have to invest in it.
Again, this isn't necessarily a bad thing. But if there are particular companies you'd prefer to avoid, you don't get that option with index funds. You'll either need to invest in all the companies in the index fund, or avoid that fund altogether.
By investing in individual stocks, you have greater control over your portfolio. Researching each individual stock you invest in does involve a lot more legwork, but you also have far more flexibility than you would with index funds.
Maximizing your investments
Index funds can be incredibly powerful, and there are plenty of advantages to choosing this type of investment. But if you're eager to take a more hands-on investing approach, they may not be the best investment for you. By doing your research before you invest, you can make sure you're choosing the best option for your situation.