There are a number of different ways to be a successful investor in the stock market. Some people choose to pick individual stocks, hoping to find the big winners that can catapult their portfolios to superior returns. Then there are those who might outsource their capital to investment advisors that market themselves as experts.
Another often overlooked strategy is to go the passive route, adding savings regularly to an investment vehicle that can match the overall market's return. In fact, it might be a good idea to make your next buy an index fund, like the Vanguard S&P 500 ETF (NYSEMKT: VOO), which tracks the performance of the broader S&P 500.
Here are three reasons why.
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1. It's what Warren Buffett recommends
Legendary investor Warren Buffett is regarded by many as the greatest capital allocator of all time. The conglomerate he has long been running, Berkshire Hathaway, has produced a return of more than 55,000% since 1983, easily crushing the S&P 500. It's a huge understatement to say that he knows a thing or two about increasing shareholder value.
Buffett has long been a critic of active investment managers, claiming that individual investors would be better off simply buying an index fund. And the data backs up this claim, as 79% of fund managers actually lost to the market in 2021, continuing a trend of disappointing relative results. Why would anyone pay for below-market performance?
What's more, Buffett argues that individuals should be honest with themselves about whether or not they possess the necessary analytical skills to be able to assess potential investment opportunities. Some people lack the ability and the time to be able to do this. Therefore, buying an index fund is the best route to go.
2. The benefits of diversification
Owning an index fund that gives an investor broad exposure to the 500 largest U.S. companies provides the benefit of adequate diversification. And this means investors won't have all of their eggs in one basket, whether that's a specific company or a particular industry.
The advantages of going down this path have never been more obvious than they were in the past few years. The COVID-19 pandemic, while undoubtedly a major health crisis, bolstered some industries more than others. We saw businesses like Peloton and Zoom reach incredible heights because people were spending more time than ever at home. The investors who owned these stocks saw their portfolios skyrocket in value.
However, when the post-pandemic hangover set in, and consumer behavior began to normalize as the economy opened back up again, these companies, and their share prices, quickly came back to Earth. Other stocks, especially those in the energy sector, soared in 2022. Owning an index fund would've allowed you to benefit from this.
And now that high inflation and rising interest rates have led to weakness across the economy, with many financial experts expecting a recession in 2023, investors can gain some peace of mind knowing that when the economic picture eventually improves, they are well positioned.
3. Achieving attractive returns
The third reason to invest in an index fund is because of the solid returns it can produce. The S&P 500 has historically generated average annual returns of roughly 10%. This means a $10,000 investment 10 years ago would be worth about $26,000 today. That's not too bad for a passive strategy.
In fact, the stock market has generally produced a better return than other popular asset classes. Equities have outperformed bonds, commodities, and real estate over the past decade, according to data from institutional investment manager BlackRock.
What's more, owning an index fund is tax-efficient, as there likely isn't a lot of buying and selling activity going on behind the scenes. Fees are extremely low compared to active strategies that are likely to underperform, as discussed earlier. This allows an investor's capital to compound uninterrupted for longer, which can lead to life-changing wealth given enough time.
