Who: This post is for people who have heard that it is best to invest in Index Funds. If you are skeptical about this claim, or just want to hear both sides of the story, this post is for you.
What: This post will discuss the reason for the “common wisdom” that Index Funds are the best way to invest for the long term. Some drawbacks about Index Funds will be mentioned as well as some assumptions which, if true, mean that index funds are not the best investment option.



Caveat: I had a feeling that I may draw some heat for this post, so I want to make sure my position is known. I like index funds. I think that they serve a specific purpose and are a solid investment choice for many people. However, I do think that many writers unjustly tout the benefits of index funds without explaining the assumptions that need to be true in order to make index funds the best option. So, this post is not saying that index funds are bad (they’re not) and it is not saying that they are the best thing since sliced bread (they’re not). It is recommended that you read the first part of the series about The Good of Index Funds.

Index Funds Sound Great! What’s the Catch?

Index Funds don’t beat the market. This one is simple enough… since index funds are meant to track a market, they obviously won’t beat the market on a consistent basis. In fact, on average index funds will *slightly* underperform the market because the expense ratio (granted they’re small on most index funds) erodes returns.

If you do not agree with the Efficient Market Hypothesis, then Index Funds may not be the best investment option for you. If you believe that it is possible to beat the market on a consistent basis with sound technical or fundamental analysis, then you would be better off trying to either beat the market yourself, or find money managers that can do it.

Finding someone that can consistently beat the market is not easy. If you think that it is possible for fund managers to beat the market over the long term, that does not necessarily mean that YOU can correctly identify those managers. If you think you can identify those managers, index funds are NOT your best investment option.

Conclusion

Ultimately, I hope that you do not blindly follow the “index funds are best” advice. I hope that everyone can make their own informed decision on whether or not they think index funds are best for them. That being said, I must recommend index funds to MOST investors. The only time I would not recommend index funds to investors would be if 1) they do not believe in the strong or semi-strong form of the EMH AND IF 2) they can consistently pick fund managers that can beat the market (or beat the market themselves). Keep in mind that many investors may think #2 is true about themselves when it is really not :-)

Final Verdict: B+
Note: This verdict reflects a highly complex algorithm which determines how awesome a financial product is. This is not limited to investment products.

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