Why index funds should be the foundation of your portfolio

Warren Buffet advises people to invest in index funds. But he himself also invests in individual stocks. Why? Because everyone should invest in what they know well. For Buffet, it’s primarily US businesses because he and his team have studied them for decades. But for most people who don’t have the skills, time, and passion for doing hours of research on specific businesses, investing in index funds makes perfect sense.

Index funds provide diversification by including a large number of stocks, which reduces portfolio risk. When you invest in one index fund, you’re often indirectly investing in hundreds of companies all at once. This lets you enjoy the high average returns of equities, without the risk that comes with investing in individual stocks.

An individual stock represents a single company. If you invested all your money in Amazon in 2000? Congratulations. But if you invested in Pets.com, Webvan, or Boo.com … Well, we’re sorry. Even most professional fund managers can’t beat the S&P 500.

Index fund benefits include:

• In general, higher average returns than CDs, bonds, and real estate.
• Low expense ratios, which can improve returns over time.
• Consistent investment strategy, which can make index funds more stable and predictable.
• Accessibility, since index funds don’t require much time or expertise to provide a healthy portfolio return over time.
• Minimal time investment, so you can focus on what’s important for you and your family.

You can think of investing a bit like dieting: once you have the right inputs, time is the most important ingredient. Extending the metaphor further, index funds are the vegetables of an investment portfolio. Should index funds be your only investment class? No. But to end up in a strong financial position, index funds should probably comprise the bulk of your portfolio, especially while you’re young.

Some examples of common index funds include:

• S&P 500 ETF (VOO, SPY, IVV): These ETFs track the S&P 500 index, a collection of 500 large publicly traded companies in the United States. VOO has an average historical return rate of around 13% per year. Apple, Microsoft, and Amazon make up the greatest share of the S&P 500 funds based on their market caps, but companies across industries are represented, including McDonald’s, Walt Disney, Johnson & Johnson, Home Depot, and Procter & Gamble.
• Total Stock Market ETF (VTI): VTI tracks virtually all of the publicly traded companies in the U.S. stock market. VTI has an average historical return rate of around 7.5% per year and includes stocks from companies across industries, including Apple, Wells Fargo, Chevron, Microsoft, and Target.
• Vanguard Growth ETF (VUG): VUG tracks a selection of large-cap growth companies that are expected to grow faster than the overall market. VUG includes companies such as Amazon, Meta, NVIDIA, Visa, and Google. It has an average historical return rate of around 9% per year, and its risk profile is considered to be moderate to high, as growth companies tend to be more volatile than value companies.
• Vanguard International Stock Index Fund (VGTSX): VGTSX includes a wide range of stocks from developed markets outside the U.S. It has an average historical return rate of around 4% per year since inception. There are nearly 8,000 companies included in VGTSX, and nearly 68% of those are large-cap firms. Japan, the United Kingdom, and China make the top three countries in terms of the headquarters location of companies represented in VGTSX.

While index funds are an important part of any investment portfolio, it is important to diversify and invest in other asset classes as well. Just as eating only vegetables won’t get you to optimal health, investing exclusively in index funds probably isn’t a good idea either (though by no means is the worst investment mistake).

Does that mean you should never invest in individual stocks? No. It just means an index fund should be the foundation of your portfolio. But if you know a particular industry or business much better than almost anyone else in the world, it might make sense to own individual stocks for such businesses.

Striking the right balance is hard, but Xillion can help. Our 401(k) Optimizer scans your account to look for all the inefficiencies. We’ll suggest simple changes that add up to a big difference over time. We have investment mentors with expertise in real estate, stocks, bonds, angel investing, and (of course) index funds.

To get started, set up your Xillion account today. Navigate to the Portfolio tab to see suggestions for how you can optimize your path to financial independence.