Are Index Funds the Best Way to Invest?

April 10, 2020
index funds

If you’ve watched or listened to any Money Guy content about investing, you know we’re big fans of low-cost index funds. For the first time, passive investments are overtaking active investments as the most popular way to invest. Index investing is no longer the little guy on the block. Is the dramatic rise in popularity of index investing warranted, or are some actively managed funds being overlooked? With the amount of assets that are now passively managed, is there an index fund bubble?

Passive investing vs. active investing

Active investors believe they can consistently choose investments that outperform major stock indexes. It’s easy to understand why actively managed funds were so popular; it makes sense that someone, especially a professional stock trader, would be able to pick investments that beat indexes. There is nothing special about index funds. You don’t choose companies that you believe in or think will do well. With index funds, you’ll get the good and the bad of the market.

Yet index funds consistently outperform actively managed funds. Why is that? Well, index funds are special for the same reason they’re not special. You don’t choose specific stocks that you think will do well when investing in index funds. Instead, you get broad market exposure. If innovation continues and the economy keeps growing, your index funds will reflect that. Your success investing isn’t tied to a small handful of companies. You get both the good and the bad of the market, and since the market goes up in about 70% of years, most of the time you’ll be getting the good. With active investing, there’s no guarantee you’ll get any of the good, and you could end up getting more bad than you bargained for.

Is there an index fund bubble?

As recently as 2013, only 20% of invested assets were passively invested. Now that it’s about 50/50, there has been more talk of an index fund bubble. Those that believe in an index bubble think that index funds artificially inflate the value of stocks included in the fund. The theory is that active investors, or fund managers, do the hard work of price discovery, and that passive investors don’t need to evaluate the price of individual securities within an index because they can assume they are priced accurately. At a certain point, prices can become inaccurate. For example, if we had only one active investor in the world and everyone else was a passive investor, stocks would be priced pretty inaccurately.

Roughly 50% of invested assets are still actively managed, and we are nowhere close to having a shortage of active investors. If we did reach a point where assets were not priced as they should be, more active investors would emerge to take advantage of that inefficiency. Usually the ones shouting from the rooftops about an index fund bubble are active fund managers, like Michael Burry. Arguments made by those that stand to gain financially from inflows to actively managed funds should be evaluated very carefully.

Why is it called a bubble?

Every bubble must pop eventually, and those who believe there’s an index fund bubble also think it is going to burst. What does that supposed bubble bursting look like? Some believe that there will be a rush of investors looking to sell positions in passively managed funds all at once. Passive investors, though, are passive for a reason. It’s unlikely that there will be a huge rush of passive investors looking to sell their investments. Even if there were, it is unlikely that they would be unable to find buyers for their investments.

In the world of investing, it can be difficult to know who or what to believe. Make sure you’re being smart with your money; independently evaluate investments in your portfolio, and take a look at fees or commissions you’re paying and the historical performance of your investments. Index funds typically have lower expenses and fees than actively managed funds and usually outperform actively managed funds over longer periods of time. We recently recorded a full show all about index funds, “Why Every Investor Should Own This Fund!” Watch it now on YouTube below.

TAGGED WITH: index funds, Investing



Most Recent Episodes

What I Learned From Being BROKE!!! (And Why I Wouldn’t Change It)

No one disputes the fact that being broke isn’t great. We want to spread the word that no matter where you came from, you can build wealth. In this episode, Brian and Bo share personal stories about their journey to wealth and lessons they learned along the way....

Top 10 Mind-Blowing Money Stats (2023 Edition)

These 10 money stats will blow your mind! We’ll discuss the unbelievable amount of money Americans save, when most reach millionaire status, and how many Americans carry a credit card balance. Research and resources from this episode: Most Americans don't have enough...

Wealth Multiplier Revealed: The Magic of Compound Interest!

There’s a reason why Albert Einstein called compounding interest the eighth wonder of the world! Do you know exactly how it works and how much your dollars could turn into by retirement? The Money Guy Wealth Multiplier can show anyone just how powerful every dollar...

From $0 to Millionaire in 10 Years (Is it Possible?)

How can you become a millionaire in 10 years or less? We’ll discuss common ways we see millionaires build wealth quickly, including through real estate, entrepreneurship, and the stock market. Discover how real wealth is built and why building wealth quickly may not...

Financial Advisors React to INFURIATING Money Advice on TikTok!

Brian and Bo are BACK to react to some more TERRIBLE financial TikTok advice! Join us as we take a look at some of the worst financial advice on the platform and tell you what to actually focus on in your own financial life. Enjoy the Show? Sign up for the Financial...

Investing Showdown: Dollar Cost Averaging vs. Lump Sum!

It’s a debate as old as time: what’s better, dollar cost averaging or lump sum investing? In this episode, we’ll cover the nuances and pros and cons of both, including in-depth case studies comparing investors at different times. Research and resources from this...

Is Inflation Really Ruining Your Finances? (You Won’t Like the Answer)

Inflation has changed our daily living expenses dramatically over the last few years. While we can’t control all of our expenses, there are many things in your control that can help you become a Financial Mutant and build wealth better than your peers. Enjoy the Show?...

Are $1,000 Car Payments Becoming the New Norm?!

New data shows more Americans than ever have car payments over $1,000. Is this becoming the new normal? How much could having a car payment of $1,000 be costing you for retirement? For more information, check out our Car Buying Checklist!