This Is the Best Reason to Stick to Low Cost Index Funds

You can enjoy a world of upside without hefty fees.

When it comes to investing your money, you have choices. You could buy individual stocks in your brokerage account and hope they do well. Or, you could take a more hands-off approach and invest in index or mutual funds instead.

When you buy shares of a mutual fund, you're paying a team of experts to select your investments for you. In turn, you pay a fee for that service. If you're not comfortable choosing your own stocks for your portfolio, or you don't want the pressure, then outsourcing that task, so to speak, may be worthwhile -- even if it means having to pay a substantial fee.

But in a recent tweet, investing guru Graham Stephan outlined some of the fees you might get stuck paying when you rely on fund managers to choose your investments for you. And if you don't like the idea of losing a lot of money to fees, then you may want to focus your investing strategy on index funds instead.

How index funds work

Index funds are passively managed funds whose goal is to simply track and match the performance of different market indexes. Take the S&P 500 index, which consists of the 500 largest publicly traded stocks today. If you buy shares of an S&P 500 index fund, you're effectively investing in those 500 stocks -- only without having to buy them individually.

Since index funds don't use actual fund managers, the fees associated with investing in them are very low. Mutual funds, on the other hand, have different expenses to cover, and that cost is passed along to investors. 

But hefty investment fees could eat away at your returns over time. So if you want to avoid expensive fees, index funds are the way to go.

Now, you may be thinking, "But won't I do better with mutual funds than with index funds?" The answer? Not necessarily. 

In fact, a recent Morningstar report confirms that passive index funds commonly outperform actively managed mutual funds. So don't assume you're going to lose out on higher returns by opting for index funds. (To be clear, actively managed mutual funds sometimes do better than index funds. The point, however, is that they don't have a solid history of outperforming their passively managed counterparts.)

Is there a drawback to sticking with index funds?

The primary downside to limiting yourself to index funds is that your portfolio won't outperform the broad market. Remember, index funds simply aim to do as well as market indexes -- not beat them. If you want the opportunity to generate a higher return than what the broad market is delivering, then you'll need to hand-pick other investments, such as individual stocks or choose a mutual fund with a strong performance history and hope it keeps doing well. 

But if you're happy with matching the broad market's performance, then index funds are a good choice. And for context, the average annual return for the S&P 500 index since its inception in 1928 through Dec. 31, 2021 is 11.82%, according to Investopedia. Invest $10,000 at that return for 30 years, and you'll be sitting on over $285,000. That's really not such a bad deal.