Hey, Boomer. There’s money to be made in index funds. And one of the richest men in the world thinks so too. Warren Buffett has instructed that 90% of the cash he bequests to his wife be invested in index funds.
Why not leave her some shares in Berkshire Hathaway, the magnificent company he founded? He’s got a great business partner. He’s got great lieutenants. One of his sons is on the board. What gives?
If you’ve read The Snowball, you know practically everything he does makes money. He must figure his wife will make money in index funds.
Boomer, enough about her. Let’s talk about us.
We’re the ones who don’t want to outlive our money. We’re the ones that want to make some money.
And if we’re going to make money in index funds, we’d better be clear on what they do and what they don’t do.
What’s an index fund?
An index fund is a type of mutual fund. It is distinguished from other types of mutual funds by how it’s managed.
Index funds are passively managed, while the rest of the mutual fund world is actively managed.
Actively managed funds have portfolio managers who continuously:
- buy stock in promising companies; and
- sell stock in under-performing companies.
All of this buying and selling is designed to beat the market.
Passively managed funds have portfolio managers who don’t try to beat the market. Yes, you read right, Boomer. Managers don’t try to beat the market. Instead, they buy virtually all the companies that are contained in the market they’re tracking.
Example of how index funds are created.
The folks over at ABCsofInvesting.net have a nice example on how index funds work. Suppose Apple, Google, Microsoft, and IBM were the only four companies in the entire US stock market–and they accounted for 50%, 35%, 10%, and 5% of the U.S. market.
Then an index fund portfolio manager would buy all of these stocks in these exact percentages.
Because index funds maintain the same percentage of stocks (or bonds) that exist in the index they are tracking.
If index funds don’t ever beat the market, why buy them?
Boomer, you buy them because, the majority of the time, the index fund delivers superior or comparable investment returns to those of a managed fund—at a cheaper price.
Earlier this year, USA Today reported research showing that managed funds failed to beat the market:
- 66% of the time over a one-year period;
- 84% of the time over a five-year period; and
- 82% of the time over a 10-year period.
John Bogle reported similar results in his book The Little Book of Common Sense Investing. There he showed that only 7% of managed funds beat the market by more than one percentage point each year over a 36-year period. Only 7%!
To be fair, John Bogle is a fierce advocate of index funds, as are a host of other renowned investors, like Peter Lynch. Numerous economists have also reported that you just can’t beat the market with any kind of sustained regularity. Read all about it here, here, here, and here.
And still a thriving financial services industry, replete with fund salesmen, financial planners, and HR reps wants to convince you otherwise…
Pay the right price for your index fund.
If you resist the siren song of the financial services industry, and want to buy index funds, then know they have a price just like everything else. We’ll talk about how to make sure you pay the right price in my next post in this series.
In the meantime, don’t lose any sleep over Mrs. Buffett. Something tells me she and her index funds will do just fine.
I receive no compensation for the above mention of Snowball, Warren Buffet’s biography.