By Lee Sherbakoff, CPA/PFS™, CFP®, RICP®
We’ve all heard of the tortoise and the hare. The hare is quick and sure-footed, while the tortoise is slow and cautious. They enter into a race, and the hare is certain he will win—so certain that he decides to take a nap midway through. The hare oversleeps, lo and behold, the tortoise wins the race! From this simple fable came the age-old advice: Slow and steady wins the race. Though it’s meant to teach children about the virtue of hard work and patience, the lesson can also be applied to investing.
Despite the fast-paced, get-rich-quick messaging of the 21st century, slow and steady investments like index funds often perform better over the long term than the actively managed funds that promise huge returns. Many people don’t realize the benefits of passive investing, both in terms of risk and reward. Here are some key features to keep in mind if you are thinking about adding index funds to your portfolio.
What Are Index Funds?
Index funds are a type of passive investment in which a portfolio of assets is built to mimic the returns of a specific financial index. There are many different financial indices, including the Dow Jones Industrial Average (DJIA) and the S&P 500, and each one tracks a certain sector of the market.
When you invest in an index fund, you are essentially buying shares of all the stocks that make up that particular financial index with the expectation your return will match the market return for that segment of the economy.
Index funds make it easy to understand what you are investing in and which part of the market you are tracking, which aids in decision-making. With the complexity of some of the investment vehicles available today, many investors appreciate the simplicity and clarity of investing in index funds.
Risk Management Through Indexing
In single-stock investing, you pick a stock hoping it’s the next big thing. If the company you select makes a big advancement, the value of your stock may go up and you could possibly make a nice return on your investment. If the company turns out to be a dud, then the value of your stock could drop and your investment may turn into a loss. Because of this, single-stock investing is not for the faint of heart and it can carry significant risk.
Index funds, on the other hand, are designed to bet on all of the stocks in a particular market sector instead of just one, thereby giving you a return based on the overall winning and losing of the sector as a whole rather than a single stock alone.
Take the S&P 500, for instance. It is an index fund that invests in the top 500 largest companies in the U.S. If 100 of them have a negative return but 400 of them have a positive return, then you will more than likely have a positive net return on your investment.
This is called diversification. By putting your eggs in many baskets instead of just one, you avoid single-stock risk. Perhaps more importantly, you stand to gain all the advances of all of the companies in the index, which can amount to more consistent growth over time. The bottom line is that index funds greatly reduce the risk of loss through diversification.
The Time Factor
A common strategy used by active investment managers is timing the market. They attempt to “buy low and sell high” by analyzing current market trends for inefficiencies. But, as research has shown, most investment managers are unsuccessful. In fact, more than 90% of active fund managers underperformed their benchmark between 2001 and 2016. (1) That means that while some actively managed funds had higher returns than their comparable index, the vast majority did not.
Index funds are favorable because they do not try to beat the market. Rather, they rely on time in the market instead of timing the market. The longer you stay invested in a particular asset, the more likely you are to experience growth over the long term. Considering the S&P 500 Index has averaged around 10% for nearly a century, (2) this strategy doesn’t seem all that bad. Indexing often results in much lower stress and a more secure investment experience for the average investor.
Perhaps the greatest advantage of investing in index funds is their lower cost. With an index fund, there is no one researching companies and trying to figure out which stocks to buy. There are generally lower manager salaries to pay. Because of this, index fund fees are usually significantly lower than those of actively managed mutual funds.
Fund fees can have a big effect on returns over time. Even if an actively managed fund is able to beat the market, they have to do so by a wide enough margin to cover their higher costs and more. As such, even some funds that beat the market end up with lower returns once fees are taken into account.
Learn More About Indexing
If you’ve been looking for a better way to invest, then indexing may be right for you. With less day-to-day management, lower fees, and more consistent returns, index funds can add significant benefits to your investment plan. To learn more about your options and how The Nalls Sherbakoff Group can help, reach out to us today. Call (865) 691-0898 or contact us online to set up a complimentary appointment so we can see if our services are the right fit for you.
Lee Sherbakoff is principal and financial advisor with The Nalls Sherbakoff Group, LLC, an independent, fee-only financial planning and investment management firm. He specializes in serving pre-retirees and retirees, helping them create and execute financial plans and retirement income plans that lead to sustainable long-term, real-life returns that meet their deepest and most important financial goals and objectives. Lee has a Bachelor of Science in Finance from The University of Tennessee and a Master of Strategic Studies from the U.S. Army War College as well as the Certified Public Accountant (CPA), Personal Financial Specialist (PFS™), CERTIFIED FINANCIAL PLANNER™, and Retirement Income Certified Professional® (RICP®) certifications. Lee spent over 31 years in the U.S. Army Reserves, including serving at the Army’s highest levels on the Department of Army staff at the Pentagon and being deployed in support of Operation Desert Storm (1991) and Operation Iraqi Freedom (2008-2009). When he’s not loyally serving his clients, Lee enjoys giving back to the community and to his profession. He served as a council member of the Tennessee Society of CPAs and is a member of the American Institute of CPAs. In addition, he is past President of the Knoxville Chapter of Tennessee Society of CPAs and past President of the East Tennessee chapter of the Financial Planning Association. To learn more about Lee, connect with him on LinkedIn.
DISCLOSURES: The information provided is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal, or tax advice. The Nalls Sherbakoff Group, LLC makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of, or reliance on the information. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of The Nalls Sherbakoff Group, LLC. Past performance does not guarantee future results.