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ADVERTISING DISCLOSURE Anyone who’s been to our site for longer than 3 seconds knows we LOVE index funds. In fact we rely on index funds as our primary investments. However, some investors fear that index funds will cause the stock market to break. Namely, what if everyone invested in index funds? But before we dig into that, let’s define explore the benefits of index funds and then define what they are.
4 Reasons We Love Index Funds
- You are guaranteed to earn market returns (something that half of PROFESSIONAL investment professionals can’t do)
- You pay much lower fees and taxes than if you were moving in and out of individual stocks
- It’s so simple to choose awesome index funds to invest in.
- With the advent of target date funds, you can even simplify your investments and own a single index fund.
What Are Index Funds?
A stock index fund is simply a group of stocks that you can buy as a single bundle. The most popular index funds are built to track a specific index like the S&P 500. By purchasing an index fund, you will own a whole group of stocks. (Bond index funds also exist, but let’s focus on stocks to keep things more simple.)
Owning an index fund like an S&P 500 index fund provides diversification because you will, in essence, own small slivers of 500 different companies, instead of only a handful. Diversification basically means spreading your money out among many investments. By doing this, you reduce the riskiness of your portfolio. In other words, you lower the chance that you’ll lose A LOT of you wealth due to a few of your investments losing value while not meaningfully lowering your returns. The power of diversification will protect your portfolio from the risk of picking the ‘wrong’ stocks. In your index fund, some stocks may go up while some will go down in value. But historically, the broader stock market has always increased over long periods of time. This is why they are such a wonderful way to invest.
Here’s why you shouldn’t buy individual stocks!
Could The Stock Market ‘Break’ If Everyone Invested In Index Funds?
In theory, yes. But in reality that won’t be happening any time soon for a few reasons.
The prices of stocks in the stock market are set via supply and demand. There’s essentially an invisible electronic middle man who matches buyers and sellers who place bids for stocks at certain prices. As the computers match buyers and sellers, the current stock price will move up and down to the current price at which people are willing to buy and sell.
For example, let assume you own Tesla stock that you want to sell and it’s currently trading for $280. You are welcome to place a sell order at a price of $350. However, if no one else believes that Tesla is worth $350 then you probably will not be able to sell your shares for $350. You’ll then have to keep lowering your asking price until someone is agrees with your price. This is a high level example of how the market determines stock prices.
Some people worry that if everyone decides to only invest using index funds, then the stock market will stop working. For example, if everyone buys index funds, the values of the stock prices of the underlying companies won’t reflect the fair value of the companies in the stock market. Instead the prices of stocks will simply reflect the the inflow of funds to indexes.
Do Index Funds Help Determine The Fair Price Of Stocks?
No, index funds don’t participate in the price discovery process in the same way as the traditional practice of buying and selling individual stocks. At a basic level, index funds are pools of money that buy groups stocks in certain proportions at the current stock market price. They don’t take a view on what the price of a stock should be. They simply buy an entire group of stocks when investors invest money into the index fund.
What this means is that if every investor in the world only purchased the same index fund, then the market of buyers and sellers would no longer set the fair market price of the stocks in the stock market. In a sense, the stock market would no longer be a “market”.
Remember, picking individual stocks is for dummies.
What If Everyone Invested In Index Funds Funds?
In theory, it’s a valid concern that uniform adoption of index funds could cause the market to stop working efficiently. However, the vast majority of the public stock market would have to be held by index investors for the market to break down and stop working as intended. Economist Larry Swedroe, for example, believes that index fund ownership would need to account for more than 90% of all stock ownership for index funds to cause a problem.
According to Bloomberg, index funds only own 18% of the stock market. In other word, we still have a long way to go before we really need to worry about index funds causing problems. Index funds were created by John Bogle at Vanguard in the mid 1970’s, so if the past 45 years are any indication, there is still A LOT of time before index fund ownership gets anywhere close to 90% of all stocks.
Do You Own Index Funds?
FAQs
For example, if everyone buys index funds, the values of the stock prices of the underlying companies won't reflect the fair value of the companies in the stock market. Instead the prices of stocks will simply reflect the the inflow of funds to indexes.
What happens if everyone invests in index funds? ›
That's because as long as we have a stock market, we WILL have active traders trying to beat the market. If the market becomes less efficient as more investors shift to index funds, it only increases the likelihood that some investors will shift to active investing to take advantage of the inefficiency.
What happens if everyone invests in index funds on Reddit? ›
Essentially, the more people invest in index funds the more opportunity there is for savvy investors to make money. It feels like there incentive for the system to balance itself out. Yeah, the more % of the market is based on index funds the more power does it given to individual stock-pickers to affect the market.
What is the main disadvantage of investing in index funds? ›
No Control Over Holdings
If an investor buys an index fund, they have no control over the individual holdings in the portfolio. You may have specific companies that you like and want to own, such as a favorite bank or food company that you have researched and want to buy.
Do billionaires invest in index funds? ›
Billionaires Are Selling Nvidia Stock and Buying 2 Top Index Funds That Beat the S&P 500 Over the Past Decade.
What would happen if everyone started investing? ›
If everyone invested equally in the stock market, the value of these stocks would neither go up nor down. This is because an equal investment in the stock market results in the lack of prices, which are the driving forces of stock value. Again, it is quite tricky always to have a win-win situation in the stock market.
What happens if all investors are passive? ›
What's worse about this is not that you as an investor have no choice but to expose yourself to bad companies but that, if we were all passive investors, there would be no mechanism to adequately value companies in the market based on their business, and therefore, it would be virtually impossible to trust the values ...
Why doesn't everyone invest in index funds? ›
Another reason some investors don't invest in index funds is that they may have a preference for investing in a particular industry or sector. Index funds are designed to provide exposure to broad market indices, which may not align with an investor's specific interests or values.
What is the safest index fund? ›
The Best Index Funds
- Vanguard Total World Stock Index Admiral. (VTWAX)
- Vanguard S&P Mid-Cap 400 Growth Idx I. (VMFGX)
- Vanguard Long-Term Corporate Bd ETF. (VCLT)
- Vanguard Extended Market Index Admiral. (VEXAX)
- Fidelity Total International Index. (FTIHX)
While they offer advantages like lower risk through diversification and long-term solid returns, index funds are also subject to market swings and lack the flexibility of active management.
The important thing to remember about index funds is that they should be long-term holds. This means that a short-term recession should not affect your investments.
Should I keep my money in index funds? ›
As with all investments, it is possible to lose money in an index fund, but if you invest in an index fund and hold it over the long-term, it is likely that your investment will increase in value over time.
Do index funds actually own stocks? ›
Definition of an index fund
Instead of hand-selecting which stocks or bonds the fund will hold, the fund's manager buys all (or a representative sample) of the stocks or bonds in the index it tracks.
Can I live off index funds? ›
Once you have $1 million in assets, you can look seriously at living entirely off the returns of a portfolio. After all, the S&P 500 alone averages 10% returns per year. Setting aside taxes and down-year investment portfolio management, a $1 million index fund could provide $100,000 annually.
Does Warren Buffett believe in index funds? ›
Despite his exceptional ability to select winning stocks, he emphasizes the value of a diversified investment portfolio, warning against unnecessary risks. His recommendation to consistently invest in low-cost index funds, especially during market volatility, resonates with investors of all levels of experience.
What does Warren Buffett recommend investing in? ›
If you don't, then dollar-cost average into index funds.” Buffett has long advised most investors to use index funds to invest in the market, rather than trying to pick individual stocks. By picking individual stocks you're working against the pros who have extensive intelligence on companies.
Is it safe to put all your money in an index fund? ›
Lower risk: Because they're diversified, investing in an index fund is lower risk than owning a few individual stocks. That doesn't mean you can't lose money or that they're as safe as a CD, for example, but the index will usually fluctuate a lot less than an individual stock.
What happens when a person invests in an index fund? ›
Index funds hold investments until the index itself changes (which doesn't happen very often), so they also have lower transaction costs. Those lower costs can make a big difference in your returns, especially over the long haul.
Is it OK to only invest in index funds? ›
If you're new to investing, you can absolutely start off by buying index funds alone as you learn more about how to choose the right stocks. But as your knowledge grows, you may want to branch out and add different companies to your portfolio that you feel align well with your personal risk tolerance and goals.
Is it bad to have too many index funds? ›
The addition of too many funds simply creates an expensive index fund. This notion is based on the fact that having too many funds negates the impact that any single fund can have on performance, while the expense ratios of multiple funds generally add up to a number that is greater than average.
