The Two Reasons Index Funds Perform So Well

I recently read The Little Book of Common Sense Investing: The Only Way to Guarantee Your Fair Share of Stock Market Returns (Little Book Big Profits) and simply LOVED it. Here's one of their thoughts that I especially liked:

The two sources of the superior returns of the index fund: (1) the broadest possible diversification; and (2) the tiniest possible costs.

The diversification eliminates stock risk, style risk, and manager risk (market risk is the only one it doesn't eliminate), thus earning investors a good, solid return on their money versus other investment alternatives. Then with low costs (all costs -- including investment and tax costs), investors get to keep more of the money they earn than with most other investments.

So you make more money and keep more of it, huh? Sounds like a great deal to me! ;-)

For a few more thoughts on investing in index funds, see these links:

• Why Index Funds Deliver Such Great Returns

• Another Expert Endorses Index Funds

• How to Invest Using Only Index Funds

Comments

[Edmund]

It's really hard to argue against buying an index fund.

Maybe with the exception of an even cheaper index fund ;)

[Skott]

Did anyone else read James Stewart's column in Smart Money that talks about "enhanced" index funds? I thought it made some interesting points about the psychology involved with settling for "just average" returns with index funds. And the idea that you can "enhance" an index fund and still use the term index fund!

[Edmund]

Attempting to beat the index fund is usually a pretty dangerous game.

One exception maybe a tax advantage fund. It tries to mimics an index while trying to minimize your tax burden.

Sounds good in theory with what they do. I haven't spent enough time to know how, in the long run, they won't stray too far away from an index. It also hasn't been on the scene for long enough to show that it won't stray too far from the index.

[Lord]

I wouldn't really say it avoids style risk. That small value outperforms large growth over the long term is well known and an S&P index will overweight large growth and expensive stocks in general. That is the price of going with the flow. You will be buying tech stocks in 2000. It does form a solid base to start from though.

[Amanda]

My husband and I are beginning start our 401k and his company offers 12-15 different fund options. There is only one index fund. We are thinking of putting 85% in the index and 10% in an international fund with 5% in a small & mid cap. But after reading some of your posts regarding index funds, should we do 100% allocation in the index fund?

[Edmund]

There is something else crucial here, especially when it comes to your 401k.

The expense ratio (the fee that they charge you) pays a huge role in how much return you get. Your investment return is unpredictable, but your fees are pretty much set. So be really careful with how much you are paying!

Personally, my 401k offers one index fund and a bunch of other funds. Only the index fund offers a "reasonable" expense ratio. I put all my money into that one because they charge me an excessive amount for everything else.

That's just me though.

[FMF]

Lord --

You know you can get an index fund for almost any purpose, right? You can get a small cap index, for instance.

[FMF]

Amanda -- It depends on your goals, timeline, etc., but there's certainly nothing wrong with spreading around your money a bit. If you don't have small, mid, and international index funds, you'll have to go with what you can to get into those other areas of investment.

FYI -- I am NOT 100% in index funds myself. Not even close (though they make up a large part of my portfolio.)