4 Reasons Why Low-Cost Index Funds Are the Best Way to Invest

When it comes to investing, you’re going to want the option that’s going to minimize risk (to a degree), require minimal effort, and provide maximum reward. And who could blame you? For investing, there are several choices out there, but hands down one of the best ways to invest is through low cost index funds.

Before getting into the why, it’s important to briefly touch on index funds, and how they work. An index is a sample of either stocks, bonds or both that usually represent a particular industry segment and/or geographic location. A great example of an index fund would be the S&P 500, which represents some of the largest blue-chip companies in the United States.

Now that that’s out of the way, here are four reasons why you need to start investing in index funds.

1. You know exactly what you’re getting

And who doesn’t love certainty, right? While some people like to take risks to reap a potentially higher payout, for those that are of the mind that ‘slow and steady wins the race’ then index funds are a fabulous option. Index funds are easy to track, and if you’re buying into funds that follow the S&P 500, then your investment will rise and fall based on the S&P 500 in the market.

Sure, you won’t outperform the market, but you’ll also have the advantage of avoiding underperforming in the market, which is a risk you take when investing in other options.

2. Passive management helps to avoid human error

People make mistakes — it happens. With investing, those mistakes can be compounded.

The annual Dalbar study claims:

“The biggest reason for underperformance by investors who do participate in the financial markets over time is psychology. Behavioral biases that lead to poor investment decision-making is the single largest contributor to underperformance over time.”

With index funds, large mistakes can be minimized or altogether avoided. When it comes to the index funds’ counterpart, the mutual fund, the funds have the option to be actively managed or passively managed, while index funds are only passively managed. If you’re buying into a mutual fund that is actively managed and your broker is trying to ‘beat the market’ by buying and selling stocks on behalf of your account, there is a chance that their decision making (this is where human error comes in) will lead to the fund underperforming the market — costing you money in the long run.

But when it comes to passively managing an index fund, it’s an entirely different story. The manager of your passively managed index funds are going to only be looking to either buy or hold existing securities, in an attempt to match the market’s performance. When you’re trying to stick with the market averages, you (or your in this case your manager) will be making more level-headed, and less risky decisions with your index funds. This will lead to consistent, stable growth over the long haul.

3. They’re more cost effective

The point of investing is to make money, and not to spend excessive amounts of money in the process of doing so on fees. One of the many advantages of low-cost index funds is in its name — specifically that the cost to manage the fund is low. This means a higher rate of return for you, and more ‘bang for your buck’. You’re probably wondering why the cost for index fund management is low, and the answer is the passive management element of their operations.

With index fund managers not needing to spend loads of time research stocks or bonds, or spending time buying and selling on your behalf, the management fees on those funds are lower. There’s also the added bonus that generally index funds don’t rack up as much in taxes each year as the actively managed funds out there. So if your goal is to keep expenses down on your investments, low cost index funds are definitely the way to go.

4. You have many options to diversify your portfolio

You’ve probably heard the word ‘diversify’ a million times when people talk about investing. And while you’re probably tired of hearing it, it is true — diversification is key to having a healthy investment portfolio. One of the beautiful things about an index fund is that it has the ability to represent a huge industry segment in specific geographic markets, all in one fund.

That means that if you’re investing in an index fund, you’re investing in many holdings in several companies — far more than the around 50 or so holdings that you see in other types of actively-managed funds. By having a diversified index fund in your portfolio, you’re going to benefit for a lower risk in the market, and get more exposure. So for those that can’t get enough of diversification (and you should definitely be one of those people) then index funds are a smart choice.

Before going any further with your investing into low-cost index funds, make sure that you’re doing your research and finding reputable firms or avenues to get started. There are several great companies out there that will manage low-cost index funds, and you want to make sure you’re working with a company that fits your needs and investment goals.

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