Please ensure Javascript is enabled for purposes of website accessibility

3 Reasons You Should Invest in Index Funds -- and 2 Reasons You Shouldn't

By Katie Brockman - Jan 30, 2021 at 9:34AM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

Index funds can be a fantastic investment, but they're not for everyone.

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.

Gold figurines of a bear and a bull

Image source: Getty Images.

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.

Invest Smarter with The Motley Fool

Join Over 1 Million Premium Members Receiving…

  • New Stock Picks Each Month
  • Detailed Analysis of Companies
  • Model Portfolios
  • Live Streaming During Market Hours
  • And Much More
Get Started Now

Related Articles

Motley Fool Returns

Motley Fool Stock Advisor

Market-beating stocks from our award-winning service.

Stock Advisor Returns
356%
 
S&P 500 Returns
124%

Calculated by average return of all stock recommendations since inception of the Stock Advisor service in February of 2002. Returns as of 05/28/2022.

Discounted offers are only available to new members. Stock Advisor list price is $199 per year.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.