Why index funds cost less, reduce risk and make you a better investor

If the movies are any indication, the road to investment riches is paved with adrenaline, frantic day trading, and — of course — frozen orange juice and pork belly futures. As is often the case when Hollywood creates its own version of reality, however, the truth is far less sexy.

The late Nobel Economist Paul Samuelson may have painted investment reality best with this famous quote, “Investing should be more like watching paint dry or grass grow. If you want excitement, take $800 and go to Las Vegas.”

There is very little excitement to be found along the non-feature-length version of a successful investor’s journey. In truth, it’s more often paved with a passive investment strategy, lots of time, and very little trading. That’s what investment research papers like this one tend to find time and time again.

There are always exceptions to the rule (if your name is Warren Buffet you can surely ignore this advice) but for most of us, buying and holding a portfolio of passively-managed index funds will reduce market risk, cost less, and yield greater returns over time.

(For the uninitiated, when we say index fund we’re talking about a mutual fund or exchange-traded fund (ETF) that tracks entire segments of the stock market in a single investment. Some of the most popular index funds invest in the entire S&P 500 stock market index, for example. Index funds are different than actively-managed funds in which money managers hand-pick specific investments to attempt to meet certain investing goals.)

Here’s why index funds — combined with a long-term investing strategy — are so great.

Diversification + Buy and hold = Less risk

It’s impossible to predict what the market will do from year to year (otherwise so many retirement portfolios would have been salvaged when the market tanked in late 2008). Over longer periods of time, though, market volatility tends to even out, creating a less choppy experience for long-term investors. Let’s take a look at the average annual returns for the S&P 500 Stock Index, a proxy for the largest 500 U.S. companies.

Since 1926 (the earliest data available), S&P 500 annual performance has ranged from a low of -43.34 in 1931 to a high of 53.99 percent in 1933.

Compare that with five-, ten-, 15-, and 20-year time frames (below) and you can see how performance smooths out, over time. In fact, there are zero 15-year time frames in the history of the index that lost money. In short, the longer one holds an investment, the lower the risk of losing money.

(Quick graph explanation: Market low is the worst average annual return an investor could have ever gotten by investing across that time frame. Market high is the best average annual return an investor could have gotten over time frame. For example, if someone held an S&P 500 index for 10 years, the worst he could have ever done was lose an average of 1.39 percent a year if he held the S&P 500 from 1998 to 2008.  The best he could have done over 10 years is earn an average of 20.06 percent a year between 1948 to 1958.)

A similar risk reduction strategy works when selecting the number of securities in which to invest. For example, assume you purchase 10 stocks on the open market. If any one of those stocks performs poorly, it will have a significant impact on your overall portfolio, merely because you own only 10 stocks.

On the other hand, assume you invest the same amount of money in one index: the S&P 500. An index fund offers an investor with limited funds (like most of us) the ability to gain greater exposure to the markets than most of us could usually afford. Assume that same stock performs poorly. It now has a much smaller impact on your overall investment holdings because That one stock is just 1/500th of the overall portfolio.

Fewer investments = lower fees

They say you get what you pay for, but when it comes to investing, the maxim is just not true.

Most often, those who pay the highest fees for investment advice are also those who see the smallest gains over time. In The Little Book of Common Sense Investing, Vanguard founder John Bogle says, “We investors as a group get exactly what we don’t pay for. So if we pay nothing, we get everything.”

Fees are tacked on to many investment purchases including: mutual fund sales charges (to pay stock broker or financial planner commissions), management fees (to pay portfolio manager salaries, among other fund expenses), trading fees for discount- or full-service brokerages, flat fees commanded by registered investment advisors, and more.

Basically, the more one pays in fees, the less money there to compound into a larger pile of money. In a recent discussion on the importance of fees to a retirement plan’s success, Bogle admitted that fees are really all that matter.

“Fees easily wipe out a huge portion of the yields on stocks, more than 63 percent of your money,” he says.

Index funds from low-cost providers have among the lowest investment fees in the industry. There’s little need for most investors to diversify among stocks on their own when they can buy a couple of fully-diversified index funds for much less money.

It all adds up to more money in your pocket

Lower fees plus lower volatility can add up to greater investment returns, over time. Remember this chart from earlier?

Over every 15- and 20-year period since 1926, there’s never been one where an investor has lost money.

Large short-term gains and losses happen in the short term, which is why investing is commonly recommended for those who are in it for long-term. Even the most recent series of six 20-year annualized return numbers, all of which include the market crash of 2008, are all over 7 percent.

Okay, but what if you’re particularly good at picking individual stocks? There are certainly a couple of excellent long-term stock pickers out there but, overwhelmingly, most of us are more likely to underperform the index than to beat it. Add in the extra fees investors incur by buying and selling investments, and that’s quite a handicap to overcome.

In the end, passive index fund investing is easier, cheaper, and more likely to end in overall higher performance. Even if you are an expert in the frozen commodities market like our fictitious friends Winthorpe and Valentine, the exchange stopped trading pork bellies back in 2011. Why? In the end, they were just too volatile.

Where to start

To start investing in index funds, our top choices are below: