Why invest in an index fund? [duplicate]

Question

I want to start investing in the stock market (I am 26) and I am a bit confused about the advantages of index funds (I am sorry if my questions are very basics, but I just started learning about this).

As far as I understand, index funds allow you to invest in many companies at once. This has the advantage that, assuming that many of them have (almost) an independent behavior the overall variance is reduced (the more companies the smaller the variance) so you are pretty guaranteed to gain money, given that the market is constantly increasing.

However, from what I've seen (and here I looked only into the USA market), the average growth of these index funds is about 5%-10% per year. On the other side, there are some companies (e.g. Apple, Amazon, Microsoft, Netflix) which had a much higher yearly return.

So my question is: why shouldn't I invest my money in 10-20 companies with a big, constant growth over the past, say, 5 years, instead of investing in an index fund?

Of course the risk of losing my money here is bigger, but given the constant growth over the past years, and the fact that these are well known companies, which (based on my small amount of readings) are expected to keep growing, is that risk, in practice, actually overcoming the possible gains?

Moreover, if something happens and these stocks stop being productive, I imagine that won't happen over night, and once that trend is apparent I can take my money out and reinvest them in other stocks. And given the current growth of these stocks, even accounting for the taxes I would need to pay on the profits when selling, the return would be significantly bigger than just investing in index funds.

I obviously didn't do the math of what I said or any form of risk analysis, so I was wondering if someone with more experience can tell me if index funds would be better than a less varied (so more risky in theory) but much better paying portfolio.

Answer 1

Most people want to treat their stocks & shares investments in the same way as a bank savings account. Put yout money in, leave it for a few years, and end up with more money at the end. Index funds are nice and simple, and at the lower end of the risk scale.

It's very easy to pick shares that have done very well over the last 5 years, and assume that investing in them will give the same level of growth for the next 5 years. But there have been many companies that did exceptionally well for a few years, until somebody came along and did the same thing, but better. Think AOL, Yahoo, Nokia and so on. After a spell of growth and profitability, they went into decline until they were bought out at a fraction of their peak value.

Answer 2

There are two advantages of investing in a broad index fund as compared to an actively managed mutual fund

• management cost is low. For a bread and butter index like the S&P 500 you can get index funds with management costs <= 0.1% per year
• you buy the average. There is no risk of a fund manager blowing it all by doing something stupid. Of course this also rules out crazy above average gains by doing something really right. However, history has shown that most fund managers are not able to beat their comparison index, especially after considering management cost

Picking your own stocks is basically the same as the second bullet point. You may get better returns but you may also be considerable worse. After all, continued above average performance is not guaranteed and any expected growth is already priced in.
There surely are good investment opportunities, especially for smaller company stocks but finding the ones that are undervalued by the market is a lot of effort and nothing is guaranteed. Picking your stocks basically means that you will become your own fund manager, just without getting paid for it. If you consider stock picking fun, then go for it. If you just want to save some money for retirement, a monthly savings plan for an index fund is a low-cost, low-effort solution