I believe index funds are an investor’s best choice.  And I’m in good company.   In addition to Vanguard’s John Bogle, index fund advocates include Warren Buffet, Peter Lynch, Charles Schwab, The Motley Fool, Knight Kiplinger and even Jim Cramer.   Yet even with that all-star fan club, index funds currently attract only 20 percent of new investment dollars, which means that 80 percent of investors are still buying individual stocks and actively managed funds. 

An index fund attempts to replicate the investment results of a target index or an asset class by investing in all the securities in that index or in a portfolio that closely approximates the index.    That gives investors the overall return of that particular index or asset class.   And while “average” might not be your goal in most areas of life, actually achieving average market returns could make you an above-average investor.

Here’s my list:

No. 1: Index funds do better than individual stocks.      

Despite magazine-cover claims to the contrary, the best academic research shows that investors in individual stocks underperform the market averages.   

No. 2: Index funds do better than actively managed funds.   

Fund managers who try to pick market-beating stocks have the same problem as individual investors: Fewer than 10 percent of them can consistently do it over the long term. And there is no reliable way for investors to know in advance which managers will be in that winning 10 percent.

No. 3: Index funds reduce your risk.       

Index funds give you more stocks for your money – typically 10 to 20 times as
many as in actively-managed funds.   More diversification means lower risk, which is particularly important in asset classes like small cap and emerging markets.

No. 4: Index funds are cheap.  

According to the academic community and Morningstar, cutting expenses is  the most reliable way to achieve higher returns.  Index funds are the cheapest way to invest in the market.

No. 5: Index funds have lower portfolio turnover.

The average actively managed mutual fund turns over 100 percent of its portfolio per year in an effort to beat the market, generating higher costs in the form of commissions and spreads.   John Bogle estimates that such activity costs investors a full percentage point per year in returns.  Indexing is a passive approach with typically less than 20 percent annual turnover.

No. 6: Index funds are tax-efficient.

Low portfolio turnover means fewer taxable capital gains. Index funds let you keep more of your money working for you instead of diverting some of it to Uncle Sam.

No. 7: Index funds let you know what you’re getting.

Academic research indicates that asset allocation accounts for 97 percent of investment returns.  Actively managed funds often drift from their advertised asset classes in an attempt to boost returns.   American Funds’ Growth Fund of America, for example, is classified as a U.S. large-cap growth fund, but according to Morningstar the fund holds 18.7 percent of its portfolio in international stocks and another 9 percent in cash. That alters the fund’s objectives and blurs its role in an asset class allocation strategy.   
 
No. 8: Index funds save you time.

With index funds, you never have to research and worry about a manager’s stock-picking abilities. Nor will you ever need to ponder what to do if a manager leaves or seems to lose his touch. Warren Buffet’s Berkshire Hathaway is full of value oriented companies, but you could have more than doubled his performance over the past five years by investing in a portfolio of value index funds. If you did that, you wouldn’t have to wonder about if and when you should ditch Buffett.

No. 9: Index funds are based on the best academic evidence.

Every piece of empirical evidence I know of indicates that indexing generates superior returns.   When the markets periodically go down  and your mettle is tested, index funds let you be confident that you’re doing the right thing. That makes you much more likely to stay the course, stick to your strategy and not bail out in panic at the wrong time. Indexing has an 80-year verifiable track record. In contrast, actively-managed funds’ performance records of five to 10 years are not statistically meaningful.

No. 10: Index funds give you all that you need to succeed.

Over the past 40 years I’ve talked with thousands of investors and I’ve never met a good saver who would have failed to reach his or her investment goals by simply achieving achieved market returns and staying the course.  You don’t need to beat the market.  You just need to capture the returns of the market. Index funds are an easy way to make sure you do that.