You’ve heard the saying before: index funds are safe for the long term.
But is that still true?
2022 was a year that shook up this belief with low performances throughout the entire economy. Here’s the performance of the S&P 500, one of the largest stock market indexes, in 2022:
The S&P lost 19.4% in 2022! That’s the worst year recorded for this index since 2008.
The performance of 2022 left many investors wondering if index funds are still safe investments.
Throughout the previous bull market, this was an obvious yes. After 2022, however, ideas may have changed.
Are Index Funds Safe Long-Term?
The short answer is yes: index funds are still safe in the long term.
But…
Only the right index funds are safe. There may be some on the market that you want to avoid.
Index funds are safe for three reasons:
Diversification
Instead of investing in one company, you can have many from the same industry.
Take the S&P 500, for example. An index fund that tracks this market indicator includes 500 companies. That’s 500 of the top companies in the United States!
Diversification allows you to lower your risk in the stock market. If 5 of those 500 companies in the S&P 500 plummet, you still have 495 companies that can perform well. Those are pretty good odds.
Remember this line: “never put all your eggs in one basket”.
A family member of mine learned this the hard way when he invested 100% of his portfolio into one cannabis stock in 2019. I suggested that he diversify across industries. However, he was confident in this one stock.
If you know what happened to cannabis stocks, you know how hard of a lesson that was for him to learn.
Low Expense
One advantage of index funds over mutual funds is that the managers of these funds don’t actively buy and sell stocks.
To clarify, all funds include an expense ratio charged by the people (or company) that put the fund together. It’s typically a small percentage that is subtracted from your gains.
With mutual funds, managers pick stocks for you. They may buy and sell stocks occasionally, which means more work for them. More work for them means you’ll pay a higher expense ratio.
With index funds, the fund is tracking an index. And indexes don’t buy or sell stocks as often as mutual funds do. Index funds are more hands-off for managers, meaning they can charge a lower expense ratio.
Not only can you sit back and let index funds do the diversification for you, but you’ll also pay a lower fee than other fund types would charge.
Simplification
Index funds are simple. You know exactly what you’re investing in.
Take Vanguard’s Healthcare index fund (VHT). Can you guess which industry this fund covers?
One index fund can cover an entire industry. If you wanted to invest in ten industries in total, your portfolio would only have ten slices in it.
This makes tracking both your portfolio and each industry easy.
Back to VHT. It has 423 different holdings.
Imagine hand-picking 423 stocks to invest in one industry…
Now multiply that by ten to cover ten industries.
Skip the hassle. Choose index funds and make your life easier.
Are Index Funds Safer ThanStocks?
Yes. Index funds are safer than stocks because of diversification.
Still don’t believe me?
Let’s break down VHT, Vanguard’s Healthcare index fund.
Its top five holdings are:
VHT’s top holding, UnitedHealth, makes up 8.03% of the entire index fund.
8.03%! Talk about diversification.
This means that if its number one stock suddenly dropped, only 8.03% of your investment would be affected. 91.97% could still do well.
I’m no financial advisor, but each of those companies listed above is an ideal hold for the long term.
How Long Should You Keep An IndexFund?
You should keep an index fund for the remainder of your life as an investor. If you plan to invest until you die, then you should never sell your index funds.
Keep your index funds indefinitely.
Index fund creators designed them this way. Since they track an entire index, index funds should increase in value over decades.
Thinking about VHT, do you think you will outlive the healthcare industry?
I plan on my index fund holdings to outlive me.
I intend to pass down my index fund investments to my children.
That means my index funds are a part of my investments for the rest of my life.
And I’m in my 20s right now... what does that say?
Can You Lose With An IndexFund?
Absolutely.
Regardless of what any financial advisor says, every single stock and index fund on the market can lose.
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That’s the risk you must accept when putting money into the stock market.
However, index funds allow you to minimize that risk.
Remember the talk about diversification? Exactly.
Are Index Funds Safe During A Recession?
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.
Recessions are short-term. They come and go. Index funds are long-term. They stay with you for life. Play the long game, and short-term events matter little.
You might even hear some financial gurus yell: “Buy the dip!”
I must agree. As a long-term investor, short-term dips are great buying opportunities. Think “stocks on discount”.
The Best IndexFunds
Some index funds are better than others. Investors should only hold the best index funds long-term. The best index funds are the ones you do your own research on.
Remember: I’m not a financial advisor. These are only suggestions. Do your own research.
Some index funds cover a wider range of the stock market than others.
Take VTI, for example. VTI is Vanguard’s Total Market index fund.
That’s right, VTI covers the entire U.S. stock market.
If you had to invest in a single index fund for your entire portfolio, VTI is not a terrible option. It offers diversification (3,972 holdings), a low expense ratio (0.03%), and simplification by covering an entire market.
You can also pick index funds by industry, such as healthcare, FinTech, consumer goods, and many more.
Again, do your own research.
Takeaway
The right index funds can set up your portfolio for decades to come.
Even though 2022 was a shaky year for the economy, it’s only one year. Invest for a lifetime, and it's hard to lose.
I showed you the S&P 500 performance of 2022. Now, let me show you the S&P 500 since its inception:
Now, the dip in 2022 doesn’t seem like a big deal. In fact, if you had been investing in the S&P five years ago or prior, the dip hardly affected you. Long-term investors didn’t even notice!
Diversify, play the long game, and stay the course.
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