Have you ever played a round of golf? If your answer was yes, how many hole-in-one’s do you have? I’ve been playing the game since the age of four and have yet to make one. Even the best players in the world know how difficult it is to make a tiny ball go into a 4 ¼ inches round hole in the ground that is two hundred yards away.
I did get close one time. It was a windier than normal day in Iowa when I hit my first shot on a par three left into the tall weeds. I let my college teammates know I was taking a penalty and replayed the shot. This time the ball was struck perfectly, landed in front of the hole, and hopped in. Due to the penalty, I had to count it as a par and not a hole-in-one.
What if you could change the game a little bit? Instead of hitting only one shot at a time, you could hit thousands simultaneously. Now your odds of hitting a hole-in-one start to look better.
Picking individual stocks is a lot like golf. No matter how long you play, you may never have all the stars line up in your favor. But what if you could change the investing game as well?
This is where index funds enter the picture. Index funds are like hitting a thousand shots at the hole at the same time. You still need to make the initial investment, but the heavy lifting is done for you after that.
Index funds are a basket of stocks made up to follow a predetermined market indice, country, or sector. The Vanguard Total Stock Market Index Fund (VTSAX) has exposure to the entire U.S. equity market. This is 3,611 individual holdings as of 11/30/2018. Instead of researching every company in hopes of finding a few individual winners, you can receive the returns of the entire market with very little effort.
Beyond the ease-of-use that index funds provide over stock picking, they also help you improve as an investor in the following ways:
Instant diversification. As you can see with the Vanguard fund example above, index funds can provide exposure to an entire market. Owning individual stocks lacks diversification, which is known as one of the only free lunches in investing.
Avoid behavioral mistakes. Not that behavioral mistakes don’t happen when owning index funds, but individual stocks tend to exacerbate the problem. You may feel more attached to an individual stock than a market as a whole. I see this often when someone has inherited a stock like AT&T, Apple, or Disney from their grandparent.
Reduce risk. In economics class you learn about two types of risk: systematic and unsystematic. The first being market risk, or the uncertainty of an entire market. The latter is considered a specific risk, or the uncertainty of an individual company. Unsystematic risk can be diversified away by investing in multiple companies at the same time, instead of just one.
Save time. When you are trying to beat the market by picking individual stocks, you are competing against the world’s best investors and fastest computers. To find a winner you will have to devote a considerable amount of time to research, and pray for good luck. Using a few index funds to invest your money across the world will save you time and headaches.