Why We Always Recommend Low Cost Index Funds

by David Ning · 18 comments


We here at MoneyNing.com recommend low cost index funds for the individual investor. Sometimes we write out a good argument, and sometimes we simply state it as fact. This article illustrates what happened with one of our reader’s investment portfolio so you can judge for yourselves whether low cost index funds is for you.

MoneyNing,

I am in the west coast and the US stock market is already open when I get to the office. Sometimes I check the performance of my stocks, and other times I do not (actually, I check it all the time). When I did check it this morning, I noticed that the money in my taxable account went down by 12%. I looked into the details and realized what happened. One of my stocks just reported earnings and the stock went down 20%. Since I had a ton of money in this stock, I was hurt bad. Really bad. Panicking, I sold everything along with Apple because I was afraid Apple was going to down too. I’m really pissed off right now because I checked after hours and Apple is up more than 10% since I sold it. I realized I was being dumb and really want to see if you can recommend some low cost index funds for me to own since I am clearly not cut out for stock picking.

Regards,
MoneyNing Reader


His story is all too familiar. I made similar mistakes when I first started investing because I too panicked when a stock didn’t go the way I thought it would. The beginning of my investment career were filled with moments of me selling low and buying high because when stocks go down, I will sell and then when they go up, I will buy them again thinking I will miss the boat otherwise. Over time, I managed to learn from my mistakes but the early lessons were very costly.

When stocks go down significantly, some of us almost get this sickening feeling in our stomach. Sure, any individual stock could go up significantly and boost our portfolio’s performance, but the risk is also very high.

Some people who pick individual stocks don’t even know much about the company. In essence, many of these people are treating the stock market like a casino. Furthermore, many of us don’t have the tolerance to properly manage the emotional roller coaster of individual stock prices going up and down. We end up buying high, and selling low because of greed and fear.

Everyone who have individual stocks in their portfolio should examine their risk tolerance not when times are good (when stock prices are soaring) but when times are bad (the day the price drop significantly). Only in adversity can we truly determine our risk tolerance, and thus our asset allocation.

Low cost index funds on the other hand are much less volatile. No one will become rich overnight, but it is a much more dependable way of investing in equities. The strategy gives us comfort that the portfolio wouldn’t get crushed if something horrible happens to any particular company (e.g. Enron), and will help us better see the long term benefits of investing in the stock market.

Here are ten more specific reasons why you should invest in total market index funds.

1. Investing in total market index funds is a bet on the future economy.
Since a diversified all market index fund tracks a wide variety of industries, you are essentially betting on the whole economy to continue making money for you when you invest in such an index fund – historically an extremely profitable bet. The real benefit comes when stock values take their routine dive down, because it’s much easier to hold onto the securities and not panic sell when the likelihood of the values coming back up are extremely high. Contrast that with owning individual stocks, where any company can turn for the worst and your investment never coming back because of mismanagement or simply changing of the times.

2. This is as close to a set it and forget it approach as investing can be.
And it is the realization that index investing is a bet on the whole economy growing through time that any index fund investor can treat this as passive investing if they want to just ignore the market noise and stay the course through the thick or thin.

Side Note: I’ve been investing in index funds for quite a few years now, and I know that this is the best way to grow wealth for me even if I can beat the index investing on my own because investing any other way takes time. Time away from other activities I enjoy, and even time away from other money making activities. I’ve made far more than the excess investment gains I can generate by spending that time on my improving my website. Many people can benefit too if they just spend more time working on a side hustle or investing in themselves to propel their own career.

3. It’s been shown again and again that the index strategy beats other ones over time.
You’ll always hear about people who’ve made a killing investing in stock A, or B, but the vast majority of people lose their shirts betting on individual companies. Those who invest in funds pretty much have no chance, because studies have shown over and over again that active funds have a very tough time beating its index fund benchmark in any given year, and the odds get worst as time goes on.

4. You’ll have less stress invested this way.
Knowing that you are betting on the economy as a whole, not needing to look at the values multiple times every single day, and the high likelihood that you are getting some of the best returns anyone out there will ever get is very comforting, especially when times get rough and all the media outlets are touting about the upcoming Armageddon again.

5. Add the potential tax loss harvesting opportunities and the odds of outperforming shoots up even more.
When an index goes down, an investor who have losses can sell it to offset other gains or take up to $3,000 off income to reduce their taxes. The IRS doesn’t want you to simply sell an investment and buy it right back for the tax benefit, so they came up with a wash sale rule to prevent someone buying the same or an substantially identical investment within 30 days of selling that security. Luckily, an index fund investor can still take advantage of any losses because they can simply sell an index fund, buy another index fund that tracks a different index but behaves similarly in terms of performance to reap the tax loss while still be fully invested.

6. You can actually pass the portfolio on to someone else to manage and the transition would be seamless.
I don’t plan to ever die, but it’s unfortunately not up to me to decide. One of these days I’ll have to pass the baton to my wife, our kids, or maybe even a third party advisor if my mental capacity declines due to old age. I don’t know how anyone believes they can have someone else continue their legacy of market beating returns, but I know that it’ll extremely straightforward for me to tell the successor how to manage our portfolio.

7. The decision to sell with index funds is much easier than individual securities.
I needed money lately from my portfolio, and I’m only now appreciating how much easier it is to sell my index funds instead of a few of the legacy individual stocks that I still own. Each individual stock go up and down differently, and selling one versus another can have vastly different results. Add to that the different tax cost you’ll have for selling each individual security because you have a different cost basis for each investment and you can quickly see that there’s really no way to know in the short term which one will be the better decision. You end up doing the sell and hope, which sets you up for quite a bit of potential regret.

8. The investments get a step up in basis at death.
All cost basis for appreciated assets get to be stepped up to market value upon inheritance, meaning that your heirs won’t have to pay taxes on much of the gains of your index funds. Sure, you’ll have to live on your portfolio at some point, but I bet you that the aim of your retirement is to have at least a bit of money left in your portfolio. On the other hand, you expect to buy and sell individual stocks multiple times since industry changes and different industries will outperform in the next few decades. Therefore, an individual stock investor not only has to outperform the index, but he or she has to outperform by a wide margin to account for the tax drag as well.

9. There are minimal yearly tax costs.
Fund investors on the other hand will be paying capital gains taxes as well, because there are unavoidable capital gains taxes for active mutual funds investors every year.

The huge tax benefit for index funds is most pronounce with Vanguard because the company has a patented way of handling the mutual funds and ETFs share classes of the same index fund to reduce yearly capital gains taxes, but they have been extremely good at keeping the capital gains tax cost of their total market index funds to a minimum.

10. No worries of a huge tax cost if an individual company were to start a long term decline and you have to sell.
Imagine you bought IBM decades ago, and then company spends a few decades dominating the computing market and thus giving you crazy good returns. You’ve got this million dollar position now and life is good right? But what do you do with the investment now? It’s been years since IBM has been a good investment. Yet, your cost basis is so low you are going to get a gigantic tax bill if you sell. You can wait things out and the company may reinvent itself again, but what if IBM is the next Kodak and your entire investment grinds to $0?

This is actually a lucky scenario, because those who bought IBM, or Microsoft, or any other company that turned out to dominate its respective market right from the beginning made a killing and got really lucky if they held on. But still, what I just described doesn’t sound like a fun situation to be in decades after the initial investment.

Imagine buying any stock now. You can argue that you see a bright future for a company and it’s going to trounce the index for many years, but what is going to happen in a decade? Two decades? There’s simply no way to know what any company will be like in a few decades. And what happens then will greatly determine whether you actually benefit financially from the decision you make today. It’s entirely possible that even a ten bagger you don’t sell can end up underperforming a simple index through time if things don’t go well for that firm in a few decades. You just don’t know.

You can roll the dice and hope for the best, or you can get the steadier returns while freeing up all your time to pursue other activities.

The choice is up to you.

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{ read the comments below or add one }

  • Jeff says:

    Unless you are a stock market Guru or know more than anyone about an individual stock (at which point you may legally have insider knowledge and cannot trade it), if you want to invest in the stock market then there are only two symbols you should consider: SPY and VTI.

    The S&P 500 and the Wilshire 5000. Total diversification and as the master Bogle long ago proved, you will beat the majority of ‘professional fund managers’ year in and year out, again and again.

  • Leo McHale says:

    Vanguard Total Stock Market Index Admiral Fund, .05% expense ratio. Remember, markets are unpredictable, costs are forever

  • Mark Hersey says:

    Because index funds have comparatively little realized capital gains (due to not having turnover except for net shareholder sales days), they accumulate unrealized capital gains much more so than actively managed funds. Thus the distributions are generally smaller than for actively managed funds, and you generally pay taxes for more of your gains at the time you yourself cash out by selling some of your shares. This is another seldom described reason why indexing is superior to most actively managed funds, at least the ones without a tax management sales strategy and similar low turnover. Such funds do exist and are usually found by having the words “Tax Managed” or similar wording in their names.

  • Mark Hersey says:

    FYI: NO, it’s not as unfair as you folks might assume. Mutual funds use realized capital losses to offset the realized capital gains BEFORE paying the net positive capital gains out as distributions. And they carry the net realized capital losses from year to year, in order to offset subsequent years’s realized capital gains.

    Obviously, they cannot make you pay IN the net realized capital loss come distribution time! Unless they made you “cash in” some shares to do it. This is what the inverse transaction would look like. But the government has never been as much interested in paying you for your net realized capital losses (thus the $3K limit per year), as in making you pay for net realized capital gains (no yearly limit).

    Which all becomes one big reason why investing in mutual funds near before, at, and near after, the bottom of the market is fabulous. You can go for years before paying any taxes on net realized capital gains on the mutual funds sales due to the net realized capital loss carry forward generated by panic and other selling while going downhill from the top to the bottom of the market. And you can read the various fund annual reports to find out who has large net capital losses being carried forward. Unfortunately, large net realized capital loss carryover usually means large turnover rate, and thus potentially won’t last as long as their size might otherwise suggest.

    While index funds will, due to low turnover rate, have little of such net realized capital loss carryovers compared to other types of funds, such losses still exist and, due to the same low turnover rate, will still take a similarly long time to consume the net realized capital loss carryovers as the average fund. Though maybe less so if the average index fund shareholder is less prone to panic selling than the average actively managed fund shareholder.

    One benefit of net realized capital gain distributions (or similar small yearly managed exchanges) is that it allows you to pay a zero (or nearly so) tax rate on smaller (especially index fund) gains made in children’s UGTM accounts as they grow (because of the children’s standard deduction), instead of paying for a huge gain (not fully offset by standard deduction) while selling just before paying for college or other “later grown up” expense. This can be used instead of a college savings fund, especially if you are not sure your children will be going to college.

  • Charles says:

    I too sympathize with your reader. Been there many times over and over again. I’m contemplating just quitting the market because it’s been such a frustrating year. But it’s almost like an addiction too. Every time I think about quitting, I end up depositing more money.

  • MoneyPerk says:

    I agree that index funds are very safe, and almost crash proof. But, it’s hard to find good funds that will give you the return on investment that you want. I like stocks because there are ways around to decreasing your risk involved. For instance, information you get about a particular company can significantly decrease your risk. Another way is to analyze stocks carefully. If done correctly, you can see how much the company has in debt, how much they continue to spend, or if they have enough invested in assets and have a promising cash flow statement.

    I don’t want to give the wrong impression and lead people to think that index funds are not a good investment. They are good investments and should be components within the portfolio for sure.

  • MoneyNing says:

    Pinyo: That’s true but you can always use something like Zecco if you are worried about fees.

  • Pinyo says:

    I agree. There is one situation where mutual fund is better, that is if you have small amount of money to add regularly. With no load fund, you incur no trading expense. However, you will get to the point where you have enough money in the fund to make an equivalent ETF more attractive.

  • MoneyNing says:

    Pinyo: I think ETFs are much better than mutual funds in general because they trade like a stock which means they are much more flexible (cheaper, can be sold immediately if need be etc etc).

  • Pinyo says:

    Calvin: I was surprised too since it was a low turnover fund. I have since switched to ETFs.

  • Calvin says:

    Pinyo: Geez $600 dollars distribution for $4000?.? That’s a pretty big percentage. I guess you are buying those actively managed mutual funds huh?

    Carl: Umm. I wonder what’s the logic behind this since I assumed someone has thought about this scenario and deemed that it is fair to only tax gain distributions.

    All: Thanks guys for the explanations.

  • MoneyNing says:

    Carl: I think the book is called Unconventional Success: A Fundamental Approach to Personal Investment (I just did a search on Google).

    Actually I’m starting to think more and more that low cost index funds are the way to go even if I can pick individual stocks. Yes they are quite boring, but it is what I need since I don’t want to manage so much money since
    1) I’m not extremely good at it.
    2) I don’t have time to handle the research needed along with the blog, my job and my family
    3) read 1 and 2 a few more times…

  • Carl says:

    I think one problem with mutual funds is that they distribute capital gains, but they do not distribute investment losses. That means if they sell a position at a loss, the fund takes the income offset for itself, they do not distribute it to the fund holders to lower their taxes. When they sell a position at a gain, they distribute this gain so the fund holders must pay the usually short-term capital gains. It does not seem fair, and it is why I do not hold mutual funds outside my 401k.

    Even in a 401k index funds are a good idea. Seems many mutual fund managers are too smart for their own good, and waste a lot of money in transactions when buy-and-hold is usually the most effective equity strategy over the long term.

    There is an excellent book about this called by David Swenson. Does anyone remember the name?

  • Pinyo says:

    Calvin – yeah, it hurts when the fund goes down and give you a distribution. It hurts to buy a fund late in the year, get the distribution, and essentially pay other people’s capital gain taxes. A fund can distribute even when it looses money because by law, funds have to distribute any taxable gains from investing to shareholders each year. So if the fund sell some of its winning stocks, you get stuck with the distribution. For example, my $4,000 holding in HFCGX distributed $600 last year. Luckily, it was in my IRA so I didn’t have to pay tax.

    MN – no problem. thank you.

  • MoneyNing says:

    Calvin: I believe whether someone should pick individual stocks or not will depend on how emotionally detached he can be with the market plus his knowledge of the stock and market (which can be learned).

    Mutual funds are required to pay out distributions if they sell a security at a profit no matter what happens to the overall fund performance. That’s why you are getting this. I probably should do a full write up on this just so everyone is clear. Stay tuned.

    Pinyo: Expense ratios are another one of those things that kill portfolio performances. Thanks for bringing that up.

  • Calvin says:

    Pinyo – Yeah seems like those management fees really eat up your portfolio. Imagine when your mutual fund goes down 5% that year and the management fee adds another 2%.

    I also heard that mutual funds can have captial gains even if they have a down year. I’m not sure how that happens but I just remember something like this. Maybe someone who knows more can share their take on this.

  • Pinyo says:

    This is a good story and low cost index fund is definitely a good way for beginners to get into the market.

    However, I would encourage everyone to at least use a small portion of their porfolio to learn more investing. If you are not up for it, create fake portfolios, track them, and see how they would perform.

    I recently did an analysis on how anything other than low fee funds can really destroy your wealth. For example, a fund with 2% expense ratio can take away almost half of your investment in 30 years. Personally, I am starting to transition from mutual funds to ETFs. This should save me a lot of expense fees in the long term.

  • Calvin says:

    I agree completely. Look at the market again today. If you are in it for the long term, there’s no reason to pick stocks since you never know how badly you will be hit.

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