HAVE YOU EVER played a round of golf? If so, how many holes-in-one do you have? I’ve been playing since age 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 4¼-inch hole that’s 200 yards away.
I got close once. It was a windier than normal day in Iowa, when I hit my first shot on a par three. It went left into the tall weeds. I let my college teammates know I was taking a penalty, and I replayed the shot. This time, the ball was struck perfectly, landed in front of the hole and hopped in. Because of the penalty, I couldn’t count it as a hole-in-one.
What if you could change the game a little? Suppose that, instead of hitting one shot at a time, you could hit thousands simultaneously. Now, your odds of hitting a hole-in-one start to look far better.
Picking individual stocks is a lot like golf. No matter how long you play, all the stars may never align. But what if you could also change the investing game?
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 step up and make the initial investment. But after that, the heavy lifting is done for you.
Index funds own a basket of stocks that track a predetermined market index. For instance, the Vanguard Total Stock Market Index Fund has exposure to the entire U.S. market—some 3,500 individual stocks. 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.
Sure, you’ll end up owning the market’s clunkers. But you’re also guaranteed to own the market’s big winners—those rare stocks that are like a hole-in-one—and these days you can do so at an extraordinarily low investment cost. Indeed, beyond being far easier than trying to pick winning stocks, index funds help in a host of other ways:
Diversify broadly. As you can see from the Vanguard example above, index funds can provide exposure to an entire market with a single investment. This sort of broad diversification has been called investing’s only free lunch, because it gives you the same expected return as a handful of individual stocks, but with far less stomach-churning volatility.
Reduce risk. In economics class, you learn about two types of risk: systematic and unsystematic. Systematic risk is the uncertainty of the overall market. If you invest in stocks, you can’t get away from that. Unsystematic risk is the uncertainty that comes with owning any one individual company. Index funds allow you to diversify away this unsystematic risk. That means that not only will you have a less volatile portfolio, but also you won’t get badly hurt if one or two individual companies get into financial trouble.
Avoid behavioral mistakes. Yes, mistakes happen when owning index funds. But individual stocks tend to exacerbate behavioral problems. You may become too attached to an individual stock, leading you to invest too much and to ignore signs of trouble.
Save time. When you try to beat the market by picking individual stocks, you’re competing against the world’s best investors and fastest computers. To find a winner, you’ll have to devote considerable time to research—and, even then, you need to hope you get lucky. Want to save time and avoid headaches? Consider using a few index funds to invest your money across the globe.
Ross Menke is a certified financial planner and the founder of Lyndale Financial, a fee-only financial planning firm in Nashville, Tennessee. He strives to provide clear and concise advice, so his clients can achieve their life goals. Ross’s previous articles include Seeking Certainty, Spending Happily and Picture This. Follow Ross on Twitter @RossVMenke.