Everybody will tell you “buy low, and sell high”. Sounds pretty simple right? Yet, nobody will tell you WHAT to buy exactly, and HOW long to hold it for. Investing money in stocks has been one of the best wealth-generating vehicles in history. But, a lot of people have missed out and will continue to miss out on this opportunity out of confusion. Essentially by not having a good plan to pick their own stocks. But, simply investing in index funds might take care of all of that!
The truth is, you need a strategy to determine what stocks to invest in. If you don’t have one, you could end up losing a lot of money in bad investments. A man with no plan, has planned to fail! BUT, as I will illustrate in this article, the best strategy of all might be to buy the “entire market” with an Index Fund.
I encountered this conclusion after rigorously studying the returns generated by different approaches over the decades. My studies are based on data and statistics, not my personal subjective opinions. This is not my advice, nor my recommendations, this is simply a compilation of past historical data. Everything I say in this article is a statement of verifiable facts (you can check some references at the end of the article). I even realized that my original beliefs were mostly wrong!
This cost me a lot of money at the beginning of my journey, while I learned the “hard way” about the risks of investing. One of the things I learned is that investing in Index Funds has yielded very healthy returns and is a very straightforward approach!
In fact, long-term investing in Index Funds has beaten most investing/trading strategies out there!
SP 500 Index Funds usually yield more money than 90% of the other strategies/gimmicks executed by investment professionals. These funds have defeated most money managers and stock traders at their own games. They have defeated Wall Street professionals who are cherry-picking stocks and actively trading them. These professionals have failed to generate higher returns than buying and holding a SP 500 Index Fund (9 times out of 10).
This is a very interesting conclusion because investing in Index Funds is incredibly simple. Holding them long term is also super easy! Simply buy and hold them for decades, just like you would with a Real Estate investment property! This approach enables anyone to theoretically achieve great returns in the stock market! This past decade, “Average Joes” following this simple strategy generated better returns than Warren Buffett himself. Again, these are facts, not my opinions!
Let’s understand what exactly happens when you buy an individual stock. This will help us understand why investing in Index Funds could be a such a great strategy.
When people buy a stock, they are purchasing a tiny piece of that company. Consequently, you don’t want to own a little piece of a crappy company; you want to own a little piece of a great company. Therefore, people should put their money in solid companies that are financially robust. Inventors tend to buy industry leaders. They purchase fragments of companies with a solid track record of doing things right.
Because of this, a lot of people embark on a desperate quest to try to find “great companies”. They perform tons of analysis trying to discover the best possible stocks to invest in. Sometimes they perform “fundamental analysis”. This analysis consists of evaluating a company’s financial metrics. The goal is to try to determine how robust the company is financially. It includes looking at a company’s balance sheets, income statements, and cash flow statements.
Others times they look perform “technical analysis”. This analysis focuses on evaluating the graph of the stock’s price over time. It consists of looking for patterns, in a search of “resistance” and “support” points. Some even perform a hybrid of both analyses.
Unfortunately, the results obtained after performing all that analysis are generally subpar compared to the Index Fund approach! That is the harsh truth.
To invest in SP 500 Index Funds none of that analysis is needed!
The reason is you’re not picking individual stocks. You’re picking a group of high performing stocks that has already been pre-determined (Standard & Poor already picked it for you). The beauty of this is that someone can be “lazy”, and still obtain better results than a “hard working” person! You don’t have to crunch numbers day-in and day-out! With this approach you’re not trying to find the “next best thing”. You simply take action and invest in various “great things” all at once!
Another risk of doing too much analysis is that you can suffer from what I call “analysis paralysis”. Meaning you’re churning information, but you’re not acting on it. Please consider that being busy doesn’t always mean being productive. You can end up sitting on the sidelines! If you’re too busy doing your analysis and predictions you can miss on a lot of valuable opportunities! In economics this is known as opportunity cost.
Instead of trying to find your own set of winning company stocks, simply invest in a group that has already provided consistent returns for decades!
Historically, the easiest way to obtain great returns with stocks is to invest in Index Funds, and let the money grow for several years. An “Index Fund” might sound intimidating. But it is actually really simple! It is just a fund that holds stocks from all the companies that constitute a specific index such as the SP 500.
The SP 500 is a compilation of the 500 largest companies in the United States. All major industries are included. Some of the companies included in the SP 500 are Industry leaders such as:
Apple, Google, Netflix, Facebook, Caterpillar, MMM, Bank of America, AT&T, Verizon, Disney, Merck, Microsoft, Delta Airlines, Domino’s Pizza, Goldman Sachs, Morgan Stanley, Nike, Hasbro, Honeywell, HP, Intel, Johnson & Johnson, Kellogg, Kinder Morgan, Marriott, Hilton, McDonald’s, Coca-Cola, Pfizer, PepsiCo, Procter & Gamble, Starbucks, Tiffany & Co, Visa, etc.
Because the index fund holds shares of all the companies in the SP 500, it “tracks” or “mimics” the SP 500’s performance. So, if you buy an SP 500 Index Fund, you’re essentially purchasing a little piece of ALL the 500 companies included and reaping the returns of all of them.
Investing in Index Funds could take care of the two main questions involved with stock investing:
1.) What to buy?
You don’t have to pick a specific company. You’re buying all the best ones. The fund is conformed by some of the most successful companies within their industries. These companies are solid and have an outstanding track record. Hence, they will most likely continue to succeed in the future. To join the SP 500, a rigorous set of criteria needs to be met. The criteria include:
- Over 8.2 billion dollars in Market Capitalization.
- Aggregate profit in the previous 4 quarters.
- Positive earnings in the most recent quarter.
If a company starts “slacking”, they simply get booted out of the index. Perhaps the most notorious example of this happened to US Steel. This company was founded by Andrew Carnegie, and made him one of the richest men in history. US Steel was at one point the largest company in the world, but when it started struggling it got kicked out of the SP 500. More recently, the same thing occurred to Macy’s.
Another benefit is that you’re diversifying your risk of individual stock ownership.
Your spreading your money over 500 companies. With this approach, you’re essentially investing in the US economy. The SP 500 covers approximately 80% of the US equity market! Last time I checked; it was worth 28 Trillion dollars in December 2019. That is the reason some people refer to the SP 500 as “The Market”.
Essentially, you’re putting your eggs in 500 of the best baskets available, not 1 or 5 or 10. You don’t have to go on a desperate quest trying to find “the next best thing”. That quest is most often futile. Stop suffering from what I like to call “shiny object syndrome”. There is no need to try to discover which specific company might be “undervalued”. There is no need to look at various graphs to try determine to determine which specific stock is approaching a support point. With this approach, you’re buying 500 of the best companies out there. Why cherry-pick?
2.) When to buy, how long to hold, and when to sell?
The goal with Index Funds is usually to be a passive investor, and think long term (avoid actively “trading”). After all, you’re purchasing equity in a lot of great companies. Therefore, you should enjoy the benefits of those assets for a while. Let them make you money while you sleep. If you can reap the benefits year-after-year, why do you want to sell after a week?
I am not going to get in a big debate on whether you should invest long term in Index Funds (buy and hold for several years), or actively trade index funds. I already wrote an article comparing and contrasting trading vs investing. That article clearly explains the benefits investing has over trading.
All I am going to say here is that predicting if the SP 500 will be higher in 10 years is much easier than predicting if it will be higher in 10 days. Look at any great company out there. For example, Apple, Google, Netflix, Microsoft. They ALL had their share of ups and downs through the years. But, in the long run, over a 10-year span their graph is ascending.
The main benefit of holding great stocks long term is that the stocks might lose a couple of battles but will usually end up winning the war.
Analogous to a great sports team, which might lose a couple of games and end up winning the championship. Staying in the market enables investors to reap the benefits of all the good days.
People that are trading, are essentially trying to stay in the market for the good days, and avoid the bad days. That is why they are constantly buying and selling, jumping in and out. The problem is they end up missing a bunch of great days because they had recently sold their positions. Sometimes they end up sitting on the sidelines during the best days! To eliminate risk of missing out, and feeling that “the ship has sailed”. Investors should always try to be on the ship.
Jumping in and out of stocks has other big problems:
- Investors could lose out on the dividends that a lot of these companies pay. Solid companies tend to give out part of their earnings back to their stockholders in payments called dividends. Sometimes they do this monthly, quarterly, or yearly. When people are trading, and jumping in and out of the stock they tend to miss out on this easy money. So, you might not only miss good appreciation days (where a particular stock goes up in value a lot)! You could also miss out days where the company is paying out dividends. SP 500 Index funds, pay dividends from the stocks in the fund.
- Investors will end up paying more money in taxes. This is because Short Term capital gains are taxed higher than Long Term capital gains. So, if you own the stock for less than a year, you will have to pay in taxes a bigger percentage of the stock’s appreciation, than if you owned it 1 year or more.
Long-term SP 500 returns have been great:
Now, you might be wondering, how much money can someone potentially make with this Index Fund approach? Well, the past results have been great. The yearly return of the SP 500 from 1926 to 2018 is approximately 10%.
Keep in mind this is just appreciation (without considering dividend payments). Also keep in mind this is through Great Depressions, Great Recessions, dot.com bubbles, and every bear market in between. This is why a long-term approach is important, so the great years balance out the bad years (note: bad years will happen).
For example, in 2019 the SP 500 returned approximately 30% per year, which took care of the roughly 5% drop of 2018. If you were trading and a stop loss had taken you out at the end of 2018, you could’ve missed out on the 30% recovery in 2019. Or at the very least a portion of the 2019 rally.
More recently, from 2010 to 2020, the SP 500 has returned approximately 20% per year!
Investing in Index Funds Conclusion & References:
If you skim through a couple of articles I am linking in this section, you will find some interesting supporting evidence. For example, Ray Dalio (who manages the world’s largest hedge fund), couldn’t beat the SP 500 in 2019.
Furthermore, Warren Buffet’s Berkshire Hathaway didn’t beat the SP 500 for the last 10 years. Buffet himself has stated he probably won’t outperform the SP 500 in the future either, and endorses Index Funds.
Many people put their money in fancy Hedge Funds. They pay a ton of money in fees to have someone pick their stocks, and when to buy and sell those stocks. The sad truth is that in 90% of the cases, those Hedge Fund Managers can’t pick a group of stocks that beats the SP 500. And even the incredibly crafty professionals that do beat the SP 500, can’t beat it by a high margin! They also can’t do it consistently – year after year.
And people are taking notes! A recent Bloomberg article, documented that passive Index Funds currently have more money invested in them than actively traded funds. Translation: people are now betting they would get better returns in passively managed Index funds!
What do you prefer? Putting your money in a fund that will most likely under-perform the SP 500 with high managing fees? Or putting your money in an Index fund that follows the SP 500 with low fees? For me, it is a no brainer.
My ACTIONABLE Tips:
While you’re doing some additional Index Fund research on your own, check out my article on the best discount brokers. They offer some great perks like “commission free” trades and free stocks when you sign up. My current favorites are Webull & M1 Finance. Both brokers offer SP 500 Index Funds.
SP 500 Index Funds can be purchased as “Mutual Funds” or “Exchange Traded Funds” (ETFs). Without getting extremely technical, both types of funds hold a portfolio of stocks that mirrors the SP 500. The main difference between mutual funds and ETFs is that ETFs can be bought and sold at any point during the trading session (just like a stock). Whereas mutual funds only trade once a day. I prefer ETFs over Mutual Funds since they are more “liquid”. Additionally, the fees associated with ETFs tend to be much lower.
Popular SP 500 ETFs have the following ticker symbols: “SPY”,“VOO” and “IVV”.
Note: Always consult with a licensed financial advisor that is fully aware of your specific situation before making any investment decisions. This article is NOT financial advice, it simply provides general information about Index Fund’s for educational purposes! For more information regarding investment risks, please read the disclaimer in the footer section below.