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Index funds are one of the best things you can invest in. Warren Buffett has repeatedly said that the average person would do best financially if he or she would just invest in an S&P 500 index fund.
They’re low-cost, easy to manage, and have historically guaranteed a chunk of return on your money – much better than saving money in a savings account.
But are you aware of the cons of index fund investing? It’s important to understand and weigh the pros and cons before you do anything with your money.
Today, I’m going to explain to you the pros and cons of investing in an index fund. By the end of this article, you’ll have a complete grasp of whether or not index fund investing will suit your financial goals.
What is an index fund?
An index fund is like a bag full of different stocks that act as a single investment.
For example, if you wanted to invest in the top 500 companies in the United States, all you would have to do is buy an S&P 500 index fund. The index fund acts as a single investment, but it’s the same thing as investing in all 500 stocks.
If you wanted to invest in companies in the oil sector, but don’t know which companies to invest in, all you have to do is find an “oil sector index fund” from a reputable brokerage company.
By investing in this index fund, you would effectively be investing in multiple different companies within the oil sector.
Check out my full guide on index fund investing if you want to learn more.
Pros of investing in an index fund
Now that you understand what an index fund is, let’s go over the pros of investing in one.
Convenience
The first pro of index funds is that they’re super convenient. There’s a wide selection of index funds, ranging anywhere from the oil sector, financial sector, or the market as a whole.
There’s an index fund for nearly every market sector. According to Statista, at the end of 2021, there were 78 S&P 500 index funds and more than 2,400 domestic index funds.
This can make it super easy, especially when it comes to decision-making. Instead of investing in individual stocks (which can be risky if you don’t know what you’re doing), all you have to do is find a good index fund to invest in.
Let’s say for example you want to invest in the EV sector. You’re aware that petroleum is of limited supply, and therefore, think that electronic vehicles have a bright future ahead.
Instead of spending hours doing research on which EV stocks to invest in, all you have to do is find an EV index fund.
Your money would then be distributed among all the stocks that the index fund carries.
Predictability
Individual stocks do not guarantee any profit.
Just because the business of a stock is doing well, does not guarantee the stock continues on an uptrend into the future.
However index funds have historically yielded positive returns. Although no index fund can guarantee returns into the future, we can easily look into the past to see how they’ve yielded historically.
For example, an S&P 500 index fund has historically returned 10% per year. That’s a solid chunk of change, especially considering that the national average for savings accounts hovers around 0.23%.
The reason why an S&P 500 index fund has been able to consistently generate returns is that it’s made up of many different stocks from different sectors.
Even though some companies here and there may go bankrupt, as long as the economy as a whole does well, so will the S&P 500 index fund.
The same concept goes for index funds specified in certain sectors. Even though the EV sector as a whole does well, some EV companies will still fail, but an EV sector index fund will do as well as the sector as a whole.
Affordability
The third pro of index funds is their affordability. Unlike real estate investments which have a ton of upfront costs, anyone can afford to invest in an index fund.
They’re probably one of the cheapest things you can invest in. Let me explain why.
Every index fund has a fund manager. It’s his or her job to make sure the fund is properly tracking its benchmark. The fund manager won’t work for free, so he charges a small fee called an “expense ratio.”
The average index fund has an expense ratio of around 0.015% – 0.04% of your portfolio per year. The expense ratio is deducted from the amount of dividends you get paid.
In other words, if you have $10,000 invested in the fund, you would only have to pay $1.50 – $4.00 per year. In my opinion, that’s a bargain.
The reason why index funds are so cheap is that they’re passively managed. Instead of actively trying to beat the market average, all the fund manager has to do is make sure the fund is tracking its benchmark.
Anyone can get started investing in index funds since the cost is so cheap. Strategies such as the 3-fund portfolio make it even easier to maintain.
Cons of investing in an index fund
Now, it’s time to jump into the cons of index fund investing. The cons are just as important as the pros, so make sure to keep them in mind.
Rate of Return
The first con we’re going to go over is the rate of return.
While stocks can yield a 500% return on investment in one month, don’t expect an index fund to yield anything near that.
Stocks can yield a high return on investment because it’s a single stock. The business can do well and the stock can soar in price.
An index fund is a basket full of different stocks. Even though a single stock does well, the index fund will be held down by other “average” performers, and therefore, won’t reflect the performance of that one stock.
The more stocks an index fund has, the harder it is for an outlier to cause the fund to go up in price.
Index funds provide a slow but steady return on investment. Although they’re safer than individual stocks, you won’t get any extraordinary returns.
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Control of Investment
The next con we’re going to talk about is having less control over your investments.
While you can choose the type of sector to invest in, you cannot choose the individual stocks that go into the fund.
If you choose to invest in an index fund, your money will get distributed among all the stocks – you cannot take out or add additional stocks.
If you buy an S&P 500 index fund, you’ll be invested in all 500 stocks.
Most index funds are also weighted by market cap. This means that your money will get distributed more to the larger companies.
For example, as of today, Apple, Microsoft, and Amazon are three of the biggest companies in the S&P 500. By investing in an S&P 500 index fund, your money would get distributed more to these three companies compared to the smaller ones.
Risk Management
Another con about index funds is the limited ability on changing risk management to fit your financial goals.
Since you cannot change the type of stocks in the index fund, you also cannot change the level of risk you take.
This is a con because different people have different risk tolerances.
For example, if you’re younger, you generally can afford to take more risk. The more risk you take, the more potential for a higher return on investment. On the other hand, you may not be able to take on as much risk if you’re getting closer to retirement.
Risk management is a personal decision and it’s a decision that everyone must make for their own financial goals. However, index funds fall short due to their inability to change the level of risk.
Conclusion
Today, we went over the pros and cons of investing in an index fund.
Now that you understand the pros and cons, ask yourself if index fund investing is right for you.
If so, I have a ton of information on this website about long-term investing, all free of charge.
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