The knowledge that index funds regularly beat the marketplace has been around for years. In 1975, John Bogle created the first index fund in the United States. Today, that fund is run by the Vanguard Group. After decades of research, Bogle was convinced that there were no mutual funds that beat the average performance of the marketplace over the decades. While his early innovation was derided as insane, it eventually caught on and became one of the key investment strategies for retirement and long-term goals.
How an Index Fund Works
In essence, an index fund buys up shares in all of the stocks or bonds in the marketplace. An S&P 500 index fund would invest in stock from every company traded on the S&P 500. Once these shares are purchased, nothing is done with them for years or decades. Index funds can charge incredibly low management fees because the shares are rarely traded, added to or removed.
Each investor in an index fund is buying a single share of the hundreds of stocks that make up the fund. If the market goes up, the value of that index fund share increases. When the market drops, the share declines in value. Unlike actively traded mutual funds, index funds are designed to mimic a benchmark.
Statistically, about half of mutual funds fall short of their goals over the course of a year. A full 70 percent do not beat their targets over 10 years. Over 20 years, a mutual fund has an 80 percent chance of missing its goal. While it is possible that an investor could pick the perfect stock or mutual fund for long-term investing, a more likely result is that the market will ultimately win.
Even among the 20 percent of mutual funds that meet their targets over 20 years, the added fees from active trading start to add up. Historically, there have been very few mutual funds or stocks that have beaten the marketplace for decades once fees are accounted for. While an index fund charges an average of one-tenth of a percent, actively managed funds typically charge about 1 percent. Over the course of a decade or more, the higher fees can easily cost thousands and thousands of dollars.
Playing the Loser’s Game
In 2975, Charles Ellis published an article called “the Loser’s Game”. In it, he argued that the investment management business was based on the faulty belief that professional money managers could beat the market. According to analyses of historical stock market trends and mutual fund reports, the basic premise of money managers was entirely wrong. Professional money managers very rarely beat the marketplace, yet people were still willing to invest in individual stocks, bonds and actively traded mutual funds.
There is not a perfect investment strategy for everyone. After all, a young professional may be more willing to take a gamble with their money than someone approaching retirement. At the same time, it is important to reconsider current investment strategies. The news constantly shows the latest winners in the stock market, so it appears like investing in this stock will be a safe bet over the long term. As the results show, very few mutual funds or stocks are able to beat the stock market over the course of decades.
The Buffett Bet
Eight years ago, Warren Buffett was giving a speech where he stated that most hedge funds are not worth the fees that people have to pay. As a result, he offered a bet to anyone who would accept. Buffett ultimately bet Ted Seides, a hedge fund manager, that Buffett’s index fund investment would beat Seides’ hedge fund over the next 10 years. The $1 million bet began on January 1, 2008. To win, Seides or Buffett would have to earn the most from their investment strategy after fees were accounted for.
While there was a brief period after the recession where Seides was ahead, it turns out Buffett’s long-term strategy was sound. By March of 2016, Seides hedge fund was up just 22 percent. Warren Buffett’s index fund had advanced by 66 percent. While the situation could reverse itself, it looks like Buffett will be collecting on his bet in another two years.
Investing in an index fund is not just for major investors like Warren Buffett. In reality, the low fees, easy process and long-term profits from index funds are ideal for the average investor. Initial investments can be as low as $500, and the yearly fees are drastically lower than any comparable stock or actively traded mutual fund. While the daily stock winners get the headlines, the actual long-term winner is the index fund. It is possible for an investor to beat the market for a short period of time, but unlikely over the long haul.