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ADVERTISING DISCLOSURE Anyone who’s been to our site for longer than 3 seconds knows we LOVE index funds. In fact we rely on index funds as our primary investments. However, some investors fear that index funds will cause the stock market to break. Namely, what if everyone invested in index funds? But before we dig into that, let’s define explore the benefits of index funds and then define what they are.
4 Reasons We Love Index Funds
- You are guaranteed to earn market returns (something that half of PROFESSIONAL investment professionals can’t do)
- You pay much lower fees and taxes than if you were moving in and out of individual stocks
- It’s so simple to choose awesome index funds to invest in.
- With the advent of target date funds, you can even simplify your investments and own a single index fund.
What Are Index Funds?
A stock index fund is simply a group of stocks that you can buy as a single bundle. The most popular index funds are built to track a specific index like the S&P 500. By purchasing an index fund, you will own a whole group of stocks. (Bond index funds also exist, but let’s focus on stocks to keep things more simple.)
Owning an index fund like an S&P 500 index fund provides diversification because you will, in essence, own small slivers of 500 different companies, instead of only a handful. Diversification basically means spreading your money out among many investments. By doing this, you reduce the riskiness of your portfolio. In other words, you lower the chance that you’ll lose A LOT of you wealth due to a few of your investments losing value while not meaningfully lowering your returns. The power of diversification will protect your portfolio from the risk of picking the ‘wrong’ stocks. In your index fund, some stocks may go up while some will go down in value. But historically, the broader stock market has always increased over long periods of time. This is why they are such a wonderful way to invest.
Here’s why you shouldn’t buy individual stocks!
Could The Stock Market ‘Break’ If Everyone Invested In Index Funds?
In theory, yes. But in reality that won’t be happening any time soon for a few reasons.
The prices of stocks in the stock market are set via supply and demand. There’s essentially an invisible electronic middle man who matches buyers and sellers who place bids for stocks at certain prices. As the computers match buyers and sellers, the current stock price will move up and down to the current price at which people are willing to buy and sell.
For example, let assume you own Tesla stock that you want to sell and it’s currently trading for $280. You are welcome to place a sell order at a price of $350. However, if no one else believes that Tesla is worth $350 then you probably will not be able to sell your shares for $350. You’ll then have to keep lowering your asking price until someone is agrees with your price. This is a high level example of how the market determines stock prices.
Some people worry that if everyone decides to only invest using index funds, then the stock market will stop working. For example, if everyone buys index funds, the values of the stock prices of the underlying companies won’t reflect the fair value of the companies in the stock market. Instead the prices of stocks will simply reflect the the inflow of funds to indexes.
Do Index Funds Help Determine The Fair Price Of Stocks?
No, index funds don’t participate in the price discovery process in the same way as the traditional practice of buying and selling individual stocks. At a basic level, index funds are pools of money that buy groups stocks in certain proportions at the current stock market price. They don’t take a view on what the price of a stock should be. They simply buy an entire group of stocks when investors invest money into the index fund.
What this means is that if every investor in the world only purchased the same index fund, then the market of buyers and sellers would no longer set the fair market price of the stocks in the stock market. In a sense, the stock market would no longer be a “market”.
Remember, picking individual stocks is for dummies.
What If Everyone Invested In Index Funds Funds?
In theory, it’s a valid concern that uniform adoption of index funds could cause the market to stop working efficiently. However, the vast majority of the public stock market would have to be held by index investors for the market to break down and stop working as intended. Economist Larry Swedroe, for example, believes that index fund ownership would need to account for more than 90% of all stock ownership for index funds to cause a problem.
According to Bloomberg, index funds only own 18% of the stock market. In other word, we still have a long way to go before we really need to worry about index funds causing problems. Index funds were created by John Bogle at Vanguard in the mid 1970’s, so if the past 45 years are any indication, there is still A LOT of time before index fund ownership gets anywhere close to 90% of all stocks.
Do You Own Index Funds?
FAQs
For example, if everyone buys index funds, the values of the stock prices of the underlying companies won't reflect the fair value of the companies in the stock market. Instead the prices of stocks will simply reflect the the inflow of funds to indexes.
What would happen if everyone bought index funds? ›
Individuals and institutions would still pick individual stocks to try to beat the market, just over a longer time frame. If all money (or a significant portion) was only invested in index funds, liquidity of individual stocks would decrease.
Does Warren Buffett believe in index funds? ›
Berkshire Hathaway CEO Warren Buffett has regularly recommended an S&P 500 index fund. The S&P 500 has been a profitable investment over every rolling 20-year period in history. The S&P 500 returned 1,800% over the last three decades, compounding at a pace that would have turned $450 per month into $983,800.
Do billionaires invest in index funds? ›
There are many ways to start investing, but one that's worked for billionaires like Warren Buffett is investing in low-cost index funds.
What are 2 cons to investing in index funds? ›
The benefits of index investing include low cost, requires little financial knowledge, convenience, and provides diversification. Disadvantages include the lack of downside protection, no choice in index composition, and it cannot beat the market (by definition).
Why doesn't everyone invest in index funds? ›
Another reason some investors don't invest in index funds is that they may have a preference for investing in a particular industry or sector. Index funds are designed to provide exposure to broad market indices, which may not align with an investor's specific interests or values.
Why I don't invest in index funds? ›
Indexes are set portfolios. If an investor buys an index fund, they have no control over the individual holdings in the portfolio. You may have specific companies that you like and want to own, such as a favorite bank or food company that you have researched and want to buy.
What is the Warren Buffett 70/30 rule? ›
A 70/30 portfolio is an investment portfolio where 70% of investment capital is allocated to stocks and 30% to fixed-income securities, primarily bonds.
What is the 110 minus your age rule? ›
A common asset allocation rule of thumb is the rule of 110. It is a simple way to figure out what percentage of your portfolio should be kept in stocks. To determine this number, you simply take 110 minus your age. So, if you are 40, then the rule states that 70% of your portfolio should be kept in stocks.
What does Warren Buffett not invest in? ›
Gold. Buffett is also uninterested in gold. In his 2011 letter to shareholders, he noted that gold has two significant shortcomings, “being neither of much use nor procreative.” “If you own one ounce of gold for an eternity, you will still own one ounce at its end.
Once you have $1 million in assets, you can look seriously at living entirely off the returns of a portfolio. After all, the S&P 500 alone averages 10% returns per year. Setting aside taxes and down-year investment portfolio management, a $1 million index fund could provide $100,000 annually.
Why doesn't everyone just invest in the S&P 500? ›
That's because your investment gives you access to the broad stock market. Meanwhile, if you only invest in S&P 500 ETFs, you won't beat the broad market. Rather, you can expect your portfolio's performance to be in line with that of the broad market.
What is the highest paying index fund? ›
Eight top dividend index funds to buy
| Fund | Dividend Yield | Expense Ratio |
|---|
| Invesco S&P 500 High Dividend Low Volatility ETF (NYSEMKT:SPHD) | 4.31% | 0.30% |
| iShares Core High Dividend ETF (NYSEMKT:HDV) | 3.39% | 0.08% |
| ProShares S&P 500 Dividend Aristocrats ETF (NYSEMKT:NOBL) | 2.04% | 0.35% |
| Schwab U.S. Dividend Equity ETF (NYSEMKT:SCHD) | 3.38% | 0.06% |
5 more rowsApr 9, 2024
While there are few certainties in the financial world, there's virtually no chance that an index fund will ever lose all of its value. One reason for this is that most index funds are highly diversified. They buy and hold identical weights of each stock in an index, such as the S&P 500.
Do index funds lose value? ›
As with all investments, it is possible to lose money in an index fund, but if you invest in an index fund and hold it over the long-term, it is likely that your investment will increase in value over time.
Is it better to invest in index funds or stocks? ›
Lower risk: Because they're diversified, investing in an index fund is lower risk than owning a few individual stocks. That doesn't mean you can't lose money or that they're as safe as a CD, for example, but the index will usually fluctuate a lot less than an individual stock.
What would happen if everyone indexed? ›
For example, if everyone buys index funds, the values of the stock prices of the underlying companies won't reflect the fair value of the companies in the stock market. Instead the prices of stocks will simply reflect the the inflow of funds to indexes.
What happens if everyone invests in the stock market? ›
If everyone invested equally in the stock market, the value of these stocks would neither go up nor down. This is because an equal investment in the stock market results in the lack of prices, which are the driving forces of stock value.
What happens if everyone buys ETFs? ›
If a preponderance of investors do not trade individual stocks but invest in index ETFs, price discovery for the stocks constitute and index may become less efficient. In the worst case, if everybody owns just ETFs, then nobody is left to price the component stocks and thus the market breaks.
What happens if all investors are passive? ›
What's worse about this is not that you as an investor have no choice but to expose yourself to bad companies but that, if we were all passive investors, there would be no mechanism to adequately value companies in the market based on their business, and therefore, it would be virtually impossible to trust the values ...
