Q: I've heard many people recommend index funds for everyday investors, including billionaires like Warren Buffett. Should I just put my money in index funds instead of buying individual stocks?
There certainly are good reasons to invest in index funds as opposed to individual stocks or actively managed mutual funds. In fact, Warren Buffett has even gone so far to say that low-cost index funds are the best investment most Americans can make.
One good reason is diversification. Even if you have 15-20 individual stocks in your portfolio, one of them collapsing could cost you a lot of money. On the other hand, if you buy a S&P 500 index fund, your investment will depend on 500 different stocks, only three of which account for more than 2% of the index (by weight).
Mutual funds can accomplish the same thing, but at a much greater cost. Many actively managed funds have expense ratios of 1% or more, which can eat into your returns over time. In contrast, the Vanguard S&P 500 ETF (NYSEMKT:VOO), for example, has an expense ratio of just 0.04% -- so for every $10,000 you have invested, your annual fees and fund expenses will be just $4.
In fairness, mutual fund fees can be worth it if they are justified by the fund's performance. For example, one of my personal favorite mutual funds, Dodge & Cox Stock Fund (NASDAQMUTFUND:DODGX), charges a 0.52% expense ratio, but has consistently outperformed the market for decades, even inclusive of its fees.
To be clear, Buffett wasn't saying that people who have the knowledge, time, and desire to research and choose individual stocks or mutual funds shouldn't do it. In fact, if that's the case, I encourage you to do it. Rather, he's pointing out that most Americans don't have these three characteristics, so index funds are preferable to uneducated stock-picking or, in most cases, choosing actively managed mutual funds.
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