Why Index Funds?

The first time I heard about low cost index funds was at a personal development seminar hosted by Tony Robbins. He was adamant on transforming retirement accounts from costly mutual funds into low cost index funds (like the S&P 500 index fund). This was very different than what I had heard or been taught through college and in my career, because the only education that society was sharing was to “get a financial advisor”, “save”, and “invest in a mutual fund in a 401k”. These in of itself are not bad advice, but there is a HUGE caveat. Mutual funds often have hidden management and adviser fees that’ll compound over time, and create much less returns overall.

Let’s take a look at an example. Using NerdWallet’s mutual fund calculator, we can see the difference between a low cost index fund and an actively managed mutual fund with higher fees. On average, mutual funds have fees between 0.5–1%. Index funds have much lower fees at around 0.02–0.2%. I’ll use 1% (mutual fund) and 0.2% (index fund) as worst case scenarios.

If I were to invest $10,000 initially into an investment account, and contribute $5000 per year into it (e.g. a Roth IRA), this is what the portfolio will look like after 30 years with a 10% return.

Low cost index fund with 0.2% fees
- In your pocket $1,034,788
- Fees paid $44,423

Mutual fund with 1% fees
- In your pocket $875,553
- Fees paid $203,658

If both funds performed exactly the same, at the average market return of 10%, then… I just paid $150k more in fees because it was in a mutual fund.

Mutual funds have higher fees because they are an “actively” managed fund, meaning the higher fees pay for the salaries of the fund managers that actively buy and sell fund shares to generate a return. Index funds have lower fees because the fees cover the cost of running the infrastructure that use software algorithms to rebalance the portfolio based on some index (like the S&P 500 index). In the real world, many index funds have much lower fees than 0.2%. The Fidelity S&P 500 index fund I invest in (FXAIX) has a fee of 0.015%.

Now truth be told, there are fund managers out there that can beat the average return of the market to get you better returns. But statistically speaking, most fund managers cannot beat the S&P 500 index consistently after 15 years. The fund managers that can consistently beat it offer portfolios most of us cannot get into, because the entry cost is enormously high.

So the next time you ponder about investing in either a retirement, or actively traded account, use this fund calculator from Nerd Wallet to do some quick research of the various fund options at your disposable. You’ll be surprised at the results.

Lastly, I think GREAT financial advisors do a fantastic job of helping folks create financial goals, with tangible steps to achieve them. But please do yourself a favor and don’t just blindly invest in mutual funds they suggest, without doing a little bit of research first.