Finance Friday: Index Funds

"Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees" -Warren Buffett- 

Okay, good to know. One of the most financial knowledgeable and best investors of our lifetime said this. So, I should probably pay attention and at least understand what he’s saying and why he’s saying that. 

So…

What is an index fund and why would Buffett recommend this as a winning financial strategy? 

I mean, my Uncle Jay or Aunt Judy are saying they made a ton with Apple stock and my cousin Eddy was talking about Game Stop or some advice he saw on Reddit. 😏 

There is so much advice out there and it’s all so different. Stock, Mutual Funds, Crypto, ahhh! Lions and tigers and bears all sound dangerous to me. 

Let’s start with what an index fund is, and then we can explore some facts. Facts are always your friend when making a decision. And, with financial decisions, I like to always say only make a financial decision based on your own knowledge, research, and understanding vs just taking someone else’s advice blindly. Knowledge is power. 

According to Investopedia, “An index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses, and low portfolio turnover. These funds follow their benchmark index regardless of the state of the markets.” 

So, let’s take the S&P 500 index fund. It is made up of, meaning the money invested inside the fund, is all inside stocks that are a part of the S&P 500. The S&P 500 index is a market-capitalization-weighted index made up of 500 leading publicly traded companies in the U.S. So, the index fund follows the returns of the S&P 500 index almost exactly. If the index is up +15% in a year, the index fund is also up +15%. And the weight of the investment is spread out over the 500 stocks inside of the index. If one company is way up, and another is way down, they counter each other to give you diversity. 

The S&P 500 was modified in 1957 to its current form, 65 years ago.

Since then, here are some stats:

• It has returned a historic annualized average return of around 11.88% since its 1957 inception through the end of 2021. 
• 40 of the past 50 years it had gained value. 
• During the 2008 financial crisis and the Great Recession, the S&P 500 fell 46.13% from October 2007 to March 2009.
• By March 2013, the S&P bounced back from the crisis and continued its 10-year bull run from 2009 to 2019 to climb more than 250%.
• The COVID-19 pandemic in 2020 and the subsequent recession caused the S&P 500 to plummet nearly 20%.
• The S&P 500 recovered during the second half of 2020, reaching several all-time highs in 2021, but dropped more than 1,100 points in 2022 before rebounding in June.

[I wanted to show some of the ebbs and flows, dips and comebacks above to show that yes, the "market" does have times where it loses money, but historically, it has always come back within 1.5 years on average and then gained even more from there.]

• The Vanguard S&P 500 ETF (VOO) in the last 10 years has a compound annual return of 11.66%.
• Fidelity’s S&P 500 fund (FXAIX) was created in 1988 and has delivered a return of 10.10% over those 34 years and 11.69% over the last 10-years. 

The reality is that over the past 65-year period, you can pretty much count on making between 9%-12% in many of these index funds if you research and look at the ones that have performed where the S&P 500 has performed. Nothing is guaranteed, but we have a good long track record in index funds that can give us a little more confidence than single stocks and other investments like crypto.

“By periodically investing in an index fund, the know-nothing investors can actually outperform most investment professionals.” -Warren Buffett-

Buffett claims that with index funds, he believes that they can outperform even the most well-respected financial institutions and investors out there. And he put his money where his mouth is. 

In 2008, Buffett issued a challenge to the hedge fund industry that an index fund could outperform a hand-picked portfolio of hedge funds over a 10-year period because of the high fees, costs and expenses a hedge fund incurred. Protege Partners LLC accepted Buffett's challenge. Both parties put up $1 million in the bet that would go to the winner's charity of choice.

The result?

When they started on January 1, 2008, the market tanked. The result didn't look promising for Buffett as the index fund lost 37% of its value vs 23.9% for the hedge fund. However, from 2009 through 2014, Buffett outperformed Protege every year (it took Buffett 4-years to pull ahead of the hedge fund in terms of cumulative returns). There were a few years of back and forth, but ultimately in the end, Buffett ended up winning big!

Buffett's pick, The S&P 500 (OEX), gained 125.8% over the ten-year period, while the Protege hedge funds added and average of only 36%.

Buffett's advice is to "Stick with big, 'easy' decisions and eschew activity."

But again, what about all these people telling me about specific individual stocks to invest in? Well, with those come a little more risk.

Number one, they are not as diversified as an index fund with hundreds of stocks or investments inside of them. You cannot dispute that. And, because of lack of diversification, you have higher risk with any one individual stock.

Let's take one of the most famous stocks stories out there. Enron. Enron was an energy-trading and utilities company out of Houston, TX. In the early 2000's their stock was a hot ticket. It began to increase in value and make a lot of people, many of whom had it in their company 401k, very wealthy on paper. But then, the top executives at Enron got caught doing some illegal accounting practices and bankrupted the entire company. Their stock price went from a high of $90.75 on August 23rd, 2000 and by January 11th, 2002, the price was down to $0.12. People lost everything. Many people had 100% of their retirement savings invested in Enron. It was heartbreaking.

This is one of the best examples of the risk of having all your eggs in one or a small amount of baskets. This is a great reason for diversification. Spread out your risk. Sure, you may have a friend that makes more on their investments in a short-term period by playing the market or a single stock, but when you look at the story of the tortes and the hare, the tortes always wins. And such is the case in personal investments. Slow and steady usually is the safest bet. Sure, you can name examples of the person who risked it all and bet on a company and won, but those are extremely rare, and they are very risky. It really comes down to your risk tolerance and the question to ask yourself is: if I lose all of this money I am investing, does it change my life? If the answer is yes, then I would be as educated as possible to place your life-changing investment into a risky investment.

I hope this helps you understand what an index fund is and why it might be a good investment and choice for your portfolio over the long run.