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There are lots of good reasons to buy many different stocks rather than just one or a handful. But if you set out on your own to buy a set of stocks, you'll face brokerage commissions and other expenses. Especially for small investors, this is why a mutual fund is often better then directly buying stock.
When you send your money to a mutual fund, the fund pools your money with that of many other investors, then puts the money into the stock market. You share in the gains and losses of the fund, according to how much money you have put in.
Key fact: Typical mutual funds incur a lot of cost trying to find stocks that will return more than the market ("beat the market.").
Some mutual funds are actively managed, meaning that their managers try to pick stocks that will do better than the general market, or "beat the market." It's costly to hire analysts and trade frequently trying to beat the market.
How do they know when they succeeded in beating the market? They calculate how well their fund did, then compare that with how well an index of stocks did. An index is a collection of stocks. Indexes are averaged using different methods, but the intent is the same: to indicate how "the market" is doing.
For example, the Dow Jones Industrial Average is an index made up of 30 stocks. The performance of the Dow Jones is widely reported and you can easily calculate whether you're "beating the Dow."
You could make your own holdings duplicate the performance of the Dow Jones by buying small amounts of the 30 stocks in the Dow, in the same proportion they're in the Dow. Of course, you'd spend a lot on commissions and transaction fees.
Key fact: An index fund avoids the cost of trying to beat the market, by just matching the market.
The Standard and Poors 500 is a collection of 500 big stocks. You could duplicate its performance, too, just by buying small amounts of those 500 stocks in the same proportion they're in the index. But you would have to pay the commissions and fees associated with buying 500 different stocks! That would be impractical for a small investor.
Here's where an index fund comes in. As a special kind of mutual fund, it pools funds from you and other investors, then invests the money in the stocks that make up an index. Because it has millions of dollars to deal with, it avoids the high commissions and fees that would be faced by an individual investor. Better yet, it can easily invest in 500 or more stocks.
So if you invest in a Standard and Poors 500 index fund, you'll get something like the average return of those 500 stocks. Some will do well, some will do poorly, and you'll get the average.
What's so good about that?
Key fact: An index fund gives you average returns at a below-average cost. That's why index funds usually beat conventional actively managed funds.
What matters to investors is a fund's net return. If a high gross return is eaten up by big expenses, that means a low net return -- your bottom line. With an index fund you get average returns, by definition. But you get to keep a bigger part of those average returns, because your fund hasn't incurred big expenses trying to beat the market.
Key fact: In most years, index funds outperform more than half of the actively managed funds.
Sometimes conventional actively managed funds do well. Their managers spot good stocks, buy them up, and hold on to them long enough for superior returns. But they incur expenses in doing this. In most years, these funds don't do well enough to outperform the indexes.
The Wall Street Journal quotes a leading analytical service as reporting that over a 10-year period, an astounding 86 percent of diversified U.S. stock funds lagged behind the Standard and Poors 500 Index (May 12, 1998, p. C1). There are some technical reasons why that figure is a little exaggerated, but the basic truth remains: In most years, actively managed mutual funds do not beat index funds.
Key fact: It is very difficult to find any investment strategy that outperforms buying and holding index funds.
This is one of the most obvious facts among those who have carefully studied investment markets. The more you know, the more likely you are to see the advantages of holding index funds. Nobel laureate William F. Sharpe is the author of financial market theories that highlight the advantages of indexing. Sharpe was asked whether he invests his money in keeping with his own academic work:
Q: Do you invest your own money in broadly diversified stock index funds?
A: I certainly do.
Q: Do you try to pick individual stocks or time the market?
A: No. I invest in various funds covering bonds, large stocks, small stocks and international stocks.
(Source: Interview with William F. Sharpe in Classrooms and Lunchrooms, Spring 1992.)
On the other hand, people who know less about financial markets are likely to underestimate the advantages of indexing. It's hard to call index fund investing a "secret," but it's surprising how many people get inferior returns each year because they don't know about it.
Further reading:
This is an excellent book on investing, updated in 1999. Not only is it authoritative and complete, it's witty and well-written. I once assigned this for extra "light" reading in an Investments class. The students loved it! . . . and, to tell the truth, they weren't usually fond of extra reading.
Or, to save a little money, order the paperback edition.