If I Didn’t Index

I’ve owned stock-index funds for more than three decades—and that’s made a huge difference in my financial life. What if index funds didn’t exist? I can think of five key ways my financial life would be worse:

I’d allocate less to stocks. With broad market stock-index funds, I know I’ll get whatever the market delivers. If the alternative was actively managed funds or individual stocks, there would be far more uncertainty—and I’m not sure I’d have the confidence to allocate as big a portion of my portfolio to stocks. Result: My long-run returns would have been lower.

I’d spend more time on my portfolio. Picking a few low-cost, broadly diversified stock-index funds is a cinch. By contrast, trying to identify winning individual stocks and actively managed funds is a ton of work—and history tells us it’s a loser’s game.

My financial life would be more complicated. Because the performance of individual stocks and active funds is so uncertain, I’d want to hedge my bets—and that would mean owning far more investments.

I’d pay more in taxes each year. Because of their low portfolio turnover, broad stock-market index funds tend to make minimal taxable distributions each year, especially if you buy exchange-traded index funds. Buying and holding individual stocks can also be a tax-efficient strategy. What about actively managed stock funds? They’re notorious for making large taxable distributions each year, which is why these funds are best held in a retirement account.

I’d almost certainly pocket lower long-run returns. Heaps of data tell us that the vast majority of actively managed stock funds lag behind the market averages over the long haul, thanks to their fund expenses and trading costs. What about individual stocks? If folks are careful, the costs can be minimal.

Still, most investors who favor individual stocks are likely to lag behind the market averages, thanks to a phenomenon known as skewness. In any given year, the market averages are skewed higher by a minority of stocks with huge gains, so most stocks—and their owners—end up with below-average returns. What if you happen to own the year’s big winners? Count yourself among the lucky few.