Index funds are built to match the performance of the market instead of trying to outperform it, and that strategy has historically beaten most actively managed funds over long periods of time. Actively managed funds have higher costs because they rely on teams of analysts, research, trading, and management decisions in an attempt to outperform the market. Those expenses directly reduce investor returns. Index funds are much less expensive to run, which is why their expense ratios are often extremely low, sometimes only a few basis points. Over decades of investing, keeping fees low can dramatically increase how much money an investor ultimately keeps. Even a seemingly small 1% fee can reduce long-term wealth by a significant amount because costs compound just like investment returns do.
Broad-based index funds also provide instant diversification by owning hundreds or thousands of companies across the market. Funds that track indexes like the total stock market or the S&P 500 allow investors to own nearly the entire market in a single investment. That means investors will inevitably own both successful and unsuccessful companies, but over time they capture the overall growth of the market itself. Narrow sector funds or specialty index funds exist as well, but they are much less diversified and carry greater risk. For most investors, broad-based index funds provide a simple, effective strategy that avoids the need to constantly research stocks, predict market movements, or chase performance.
Index funds are also highly tax efficient because they typically have very low turnover. Since the goal is simply to track an index, there is much less buying and selling happening inside the fund compared to actively managed funds. Lower turnover means fewer taxable capital gains distributions passed on to investors. This becomes especially valuable in taxable brokerage accounts, where taxes can quietly erode returns over time. Index investing also works effectively regardless of portfolio size. Whether someone is investing a few hundred dollars or several million dollars, the same principles still apply. Investors do not necessarily need more complicated strategies simply because they accumulate more wealth. Broad, low-cost index funds remain one of the simplest and most reliable tools for building long-term wealth while minimizing unnecessary costs, taxes, and complexity.
This is the White Coat Investor Podcast, Financial Boot Camp, your fast track to financial success.
An index fund is a type of mutual fund that, instead of trying to beat the market, just tries to match the market. A mutual fund's a great way to invest, right? You get economies of scale, you get professional management, you get daily liquidity, you get broad diversification with only having to buy one investment. They're wonderful, but there's two types, right? There's the type that's actively managed, trying to beat the market. There's the type that is passively managed, or just trying to match the market, or the index, and it turns out in the long run that just matching the market beats most investors, because most investors, including most professional investors, including most actively managed mutual funds, do not beat the index in the long term, and that's before taxes. Once you add in the effective taxes, even more funds underperform index funds, so index fund investors tend to acknowledge that I'm better off just taking the guarantee that I'm going to beat the vast majority of investors, even if I'm not going to, you know, beat all of them, or I'm not going to outperform the index. Those returns are going to be good enough for me to reach my financial goals.
Now, index funds can be traditional mutual funds, they can also be exchange traded funds, right? They're just two different types of mutual funds, really. And index funds can use either type, but they differ from actively managed funds. And actively managed funds can also be traditional mutual funds or exchange traded funds. So, you know, it's not index funds and ETFs, it's not index funds and mutual funds. Index funds are a subcategory of both mutual funds and ETFs.
Okay, the indices, these indexes, or whatever you want to say the plural of that is, are created by index providers. Okay, so there are classic ones, right, that have been around for decades and decades, like the Dow Jones Industrial Average, right, or the S and P 500. There are others, the Russell 2000. There are all these different kinds of indexes, and they were produced for different reasons historically. These days, many of them are produced so the index funds can be used that follow them, so you got to be a little bit careful, right?
When I'm talking about index funds, I'm generally talking about pretty broad-based index funds, right? Things like the total stock market index fund that tries to track all of the US stocks. You know, that fund might have 3,800 different stocks in it, whereas there's probably an index fund out there that just follows, you know, kitchen stove makers, you know, that sort of a thing, whereas a very narrow index, and thus a very narrow and non-diversified fund. When I'm talking about investing in index funds, those are not the type of ones I'm talking about. I'm talking about the broad-based ones.
Now, so maybe you want to put a slice of your portfolio into real estate or something, and you want an index fund that focuses on those real estate companies in the stock market, and I think that's fine, but recognize that there are indexes out there that are not very broad at all, and that's not what we're talking about when we're saying most people should invest most of their money into index funds. We're talking about buying all the stocks as a strategy, recognizing that yes, you'll own the losers, but you're going to own every single one of the winners, and over the long run, it's going to get you the market return, and that's going to get you to your financial goals.
Part of the reason why these index funds outperform active funds is because they have low costs, right? It isn't that it's impossible to beat the market, it's just that it costs a lot of money to beat the market. You got to hire all these analysts, you got to send them out to research these companies and talk to these people working these companies and do all this research and have all these high-powered computing resources, right? And it turns out when you add in the costs of doing that, you can't outperform by enough to cover your costs, and that's not because these people aren't smart, they are smart, there's just too many smart people, and so at the end of the day, the market is the compilation of all these smart people and their opinions about what stocks are worth.
And so the index fund investors are essentially free riding all these people trying to beat the market, and all the effort they're putting in to try to make sure stocks are priced appropriately, or to buy them if they're maybe a little too underpriced, or to sell them if a little too overpriced, and that makes the market efficient enough, not perfectly efficient, but efficient enough that the right thing to do as an investor is to act as though the market is perfectly efficient. The way you do that is just by buying all the stocks within index funds, and it turns out that this is relatively easy to do.
Right, it's not hard to match the market. I mean, there is some expertise involved in it, you know, there's computing resources, and if you talk to the people who run these big index funds at Vanguard, or wherever, there's a little bit of nuance to doing it, but the bottom line is it's dramatically less expensive than running an actively managed mutual fund, and so the expense ratios on these funds can be very low.
Now, it's not unusual to see them at 0.03% or three basis points, they might be five basis points, or 10, or 15 basis points. A few of them at Fidelity are even zero basis points, but the point is, when you've gotten your expenses for running that fund down below about 15 basis points, it's essentially free, right? Investing is free, you can buy every stock in the world in 30 seconds for free, right? Essentially free, right. And so that's why index funds are so inexpensive, because it just doesn't take that much in resources to match the market, especially as the fund gets really big, and you get all these economies of scale.
Now, fees do matter, right? They matter over a long investing lifetime. You've heard about compounding your returns, where you also compound your costs over time, and a lot of people talk about, you know, 1%. One percent is like what the average mutual fund charges. One percent is what a typical financial advisor charges, and over the course of 30 years that adds up to having about a third less money than you would otherwise have if you were investing for free, so fees do matter. The only place they can come out of is your return, right?
And fees, when it comes to a mutual fund, like an index fund, are generally expressed as an expense ratio, right? So, of the assets in the fund, what percentage of them was spent on running the fund this year, and that definitely ought to be less than 1%. It probably should be less than 0.1% when it comes to an index fund, but that's what the expense ratio is.
I mentioned taxes earlier. Index funds are generally considered more tax efficient than actively managed mutual funds, and that's simply an effect of the turnover, right? Because you're just trying to track the index, you're not trying to beat it, so you're not constantly buying and selling different stocks. Well, when you do that, you generate capital gains, and by law, those capital gains have to be distributed to the investors in the mutual fund every year.
So, if you're an actively managed fund with 60% or 90% or 150% turnover every year, you're going to send out a lot of capital gains to those investors, and they're going to have to pay taxes on them. They're going to have lower after-tax returns, whereas if your turnover is 3% like is often seen in something like the total stock market index fund, they don't have to distribute hardly any capital gains to you, and might not distribute capital gains for literally years or even decades, and so it's very tax efficient compared to active funds, and that makes it even harder for these active managers to beat the index funds in the long run on an after-tax basis when you're investing inside a taxable account.
Sometimes people wonder if there's a point in which you have so much wealth that you need to do something different than index funds, and the truth is, you don't. You can invest, you know, $50,000 or $500,000 or $5 million or $50 million into a total stock market index fund, and it works about the same, right? You know, you can do it with $500 or $1,000 right? Whatever the minimum might be for that particular fund. With ETFs, the minimum is usually just one share price, whatever the price of one share might be.
And so there really is not a time when you have to stop investing in index funds and you have to do something more complicated, or go into private investments. Now, sometimes there's a role for some of that stuff in a portfolio, and that's okay. And oftentimes it only makes sense to consider those things once you reach a certain level of wealth, but you don't have to stop using index funds. Even at our current level of wealth, I still have the vast majority of our money invested in boring old index funds.
Some people worry that indexing is getting too popular, and that could create problems when everybody's indexing. Well, now the market's not efficient, stocks aren't priced properly, and now we're running up the prices of, you know, the popular stocks way too much. Well, I suppose that is a risk if everybody is indexing, but the truth is, you can have the vast majority of people be indexing. You don't need that many active managers to make indexing the right thing to do. You just need enough that the market remains efficient enough that the right move is to just buy the market.
And so I wouldn't worry about indexing being too popular until certainly upwards of 90% or 95% or maybe even 99% of the money in the market is indexed, because there's still going to be plenty of opportunists and entrepreneurs out there trying to make a buck by finding stocks that are not properly priced by the market that they will move those prices to where they ought to be and make indexing the right move.
So don't make the mistake that lots of investors do, and abandon index funds, thinking that actively managed mutual funds are better in bull markets, or better in bear markets, or better once you have a certain amount of money. It is just not the case, right? The data is very robust that index funds outperform traditional actively managed mutual funds, so don't be afraid to invest in them, and you probably ought to be investing the vast majority of your stock investments into index mutual funds.
Hope that helps you understand the benefits of index funds and what they are.
The White Coat Investor Podcast is for your entertainment and information only, and should not be considered financial, legal, tax, or investment advice. Investing involves risk, including the possible loss of principal. You should consult the appropriate professional for specific advice relating to your situation.
Medical school may not have taught you about money, but we will.
We will never sell your information. Modify your preferences or unsubscribe at any time.
Get ready to take control of your financial life. You can do this, and we can help.
We won't sell your information. Modify your preferences or unsubscribe at any time.