Warren Buffett, one of the most successful investors in history, has repeatedly said the same thing for decades: for most people, the best investment is a low-cost S&P 500 index fund. Not individual stocks. Not actively managed funds. An index fund.
If Buffett’s advice is good enough for most investors, it’s worth understanding what exactly he’s talking about.
What Is an Index Fund?
An index fund is a type of investment that tracks a market index — a predefined list of stocks or bonds. Instead of a fund manager choosing which stocks to own, an index fund automatically owns everything in its index, in proportion to each company’s size.
The S&P 500 is the most well-known index: it includes the 500 largest publicly traded companies in the United States — Apple, Microsoft, Amazon, Google, Berkshire Hathaway, Johnson & Johnson, and 495 more. An S&P 500 index fund owns a tiny slice of all 500 of them.
When you invest in an S&P 500 index fund:
- You own a piece of 500 of the largest US companies at once
- When those companies collectively grow in value, your investment grows
- You’re automatically diversified — no single company’s failure destroys your portfolio
- The fund rebalances itself — as companies enter or exit the index, the fund adjusts automatically
You don’t research stocks. You don’t time the market. You own the market.
Index Funds vs. Actively Managed Funds
The alternative to index funds is actively managed funds — mutual funds run by professional portfolio managers who research companies, analyze earnings, predict market movements, and try to “beat” the market by picking the right stocks at the right time.
These professionals have Bloomberg terminals, analyst teams, and decades of experience. And they still mostly lose.
The data is stark:
According to the S&P Dow Jones Indices SPIVA report, over a 15-year period:
- More than 90% of actively managed large-cap US funds underperform the S&P 500 index
- Over 20 years, that number approaches 95%
The managers who outperform one decade rarely outperform the next. Their advantage, when it exists, is inconsistent and unpredictable.
Why do professionals consistently lose to a simple index?
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Fees: Actively managed funds charge 0.5–2% per year in fees. Even a 1% annual fee compounds into a massive drag on returns over 20–30 years.
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Transaction costs: Active managers trade frequently, generating transaction costs and tax consequences.
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The market is efficient: Millions of professionals and algorithms are analyzing stocks 24/7. It’s extremely hard to consistently find information “the market doesn’t know” to outperform.
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Compounding math: A fund that returns 8% instead of 10% annually doesn’t just fall behind — it falls further behind every single year.
Types of Index Funds
By structure:
Mutual funds — Traditional fund you buy at end-of-day prices. Minimum investment often required (though Fidelity has funds with no minimum).
ETFs (Exchange-Traded Funds) — Same underlying holdings as mutual funds, but traded on exchanges like stocks throughout the day. No minimum investment — you buy as little as one share (or fractional shares at many brokers). ETFs are often more tax-efficient.
For long-term investing inside retirement accounts, the difference between a mutual fund and ETF version of the same index is minimal. For taxable accounts, ETFs have a slight tax efficiency edge.
By what they track:
US Total Market: Owns virtually every publicly traded US company — large, mid, and small-cap. Examples: VTI (Vanguard), FZROX (Fidelity), ITOT (iShares)
S&P 500: Owns the 500 largest US companies. Slightly more concentrated in large caps than total market. Examples: VOO (Vanguard), FXAIX (Fidelity), IVV (iShares), SPY
International: Owns stocks in developed and/or emerging markets outside the US. Examples: VXUS (Vanguard), FZILX (Fidelity), IXUS (iShares)
Bond index: Owns US government bonds, corporate bonds, or a mix. Examples: BND (Vanguard), AGG (iShares)
Target-date funds: A blend of stock and bond index funds that automatically adjusts as you approach a target retirement year. A “2055 fund” starts equity-heavy and gradually shifts to more bonds as 2055 approaches. These are the most hands-off option.
How to Evaluate an Index Fund
Expense ratio (most important)
The expense ratio is the annual fee you pay, expressed as a percentage of your investment. It’s taken out of the fund’s returns automatically — you never write a check for it, which is why many investors ignore it, to their detriment.
At Fidelity: FZROX (zero percent) vs. a typical actively managed fund at 0.8% might seem like a small difference. Over 30 years at 7% growth:
- $10,000 in FZROX (0% fee): $76,122
- $10,000 in 0.8% fee fund: $61,680
The fee costs you $14,442 — nearly 50% of your original investment — in foregone returns.
Target expense ratios: Under 0.10% for US index funds. Many are 0.03% or lower. Fidelity’s FZROX is literally 0.00%.
Tracking error
Does the fund actually track its index? A good index fund should perform almost identically to its index, minus the expense ratio. Significant deviation (more than 0.2% beyond fees) suggests poor management.
Fund size and liquidity
Larger funds (>$1 billion in assets) are more stable and have better liquidity. The biggest index funds (VOO, IVV, SPY, FXAIX) have hundreds of billions in assets — no liquidity concerns.
The Best Index Funds for Beginners
At Fidelity (best for beginners):
- FZROX — Fidelity ZERO Total Market Index Fund — 0.00% expense ratio, no minimum
- FNILX — Fidelity ZERO Large Cap Index — 0.00%, tracks S&P 500 equivalent
- FXAIX — Fidelity 500 Index Fund — 0.015%, tracks S&P 500
At Vanguard (where index funds were invented):
- VTSAX — Vanguard Total Stock Market Index — 0.04%, $3,000 minimum
- VFIAX — Vanguard 500 Index Fund — 0.04%, $3,000 minimum
- VTI — ETF version of VTSAX, no minimum, buy one share
At Schwab:
- SWTSX — Schwab Total Stock Market Index — 0.03%, no minimum
- SWPPX — Schwab S&P 500 Index Fund — 0.02%, no minimum
The honest answer: For most beginners investing in the US market, any of these is fine. The difference between FZROX and FXAIX at Fidelity is negligible. Pick one, invest regularly, and leave it alone.
Where to Hold Your Index Funds
Where you hold your index fund matters as much as which fund you pick.
Roth IRA (first choice for most): Tax-free growth and withdrawals. $7,000/year limit. Best for most people under 50 who expect to be in a higher tax bracket in retirement.
Traditional IRA: Tax-deductible contributions, taxed on withdrawal. Better if you’re in a high bracket now and expect lower income in retirement.
401(k): Employer-sponsored, pre-tax contributions, taxed on withdrawal. If your employer offers index fund options (look for anything from Vanguard, Fidelity, or Schwab with a low expense ratio), this is excellent — especially up to the employer match.
Taxable brokerage account: No tax advantages, but no limits on contributions. Good for money beyond retirement account limits.
Priority order: 401(k) up to employer match → Roth IRA to max ($7,000) → back to 401(k) → taxable account.
What to Expect: The Rollercoaster Years
Index funds deliver excellent long-term returns. They are not smooth.
The S&P 500 has dropped:
- 57% from 2007 to 2009 (financial crisis)
- 34% in 6 weeks in early 2020 (COVID crash)
- 25% in 2022 (rate hike cycle)
Every single time, it recovered and reached new highs. But those drops feel terrifying if you’re watching your balance fall week after week.
The only way to experience the long-term returns is to stay invested through the short-term drops.
Strategies that help:
- Don’t check your balance daily. Monthly or quarterly is enough. Daily checking leads to emotional decisions.
- Set up automatic contributions. When the market drops, your regular contributions buy more shares at lower prices. This is called dollar-cost averaging — it turns volatility into your advantage.
- Remember you’re buying future wealth, not current value. A portfolio down 30% isn’t a loss — it’s a sale. You only lose if you sell.
Index funds aren’t exciting. They don’t have stories. They don’t have genius fund managers. They just quietly compound, year after year, owning the growth of the American and global economy. That’s enough — and for most investors, it’s more than enough.
Open the account. Buy the fund. Set up the automatic contribution. Then get back to your life.
