By Richard Ferri

At times it seems like an impossible task to make the best of our investment portfolios. The economy is barely moving, stock prices are unpredictable, interest rates are low and there is uncertainty everywhere. Any help to increase our chance for success has to be seriously considered. That’s why learning about index fund investing is vital.

Index funds increase your probability for reaching financial success. They’re very low cost mutual funds that are designed to give you the return of a market, such as the U.S. bond or equity market. You could try to pick investments that beat the markets, but that’s a costly bet that has a low probability for success. Index funds are a better way.

I’ve put together the top 5 reasons why index funds help millions of investors reach their goals and how they can help you, also.

1. Performance

Index funds provided higher return on average than mutual funds that attempt to beat the markets. Over the last five years, stock index funds beat about 75 percent of actively-managed mutual funds and bond index funds outperform about 85 percent of active bond funds. These figures include active funds that go out of business. This index fund advantage increases over time. The Vanguard 500 was the first index fund available to investors in 1975. It has outperformed 90 percent of all actively-managed funds that existed since its inception, including hundreds that did not survive.

2. Portfolio Benefits

Owning one index fund is a great idea; owning many index funds that cover several asset classes is an even better idea. There are more than 1,000 index funds and exchange-traded funds (ETFs) available that track many different stock and bond indexes. When you put the two or more index funds together in a portfolio, the portfolio results are better than the individual category results. As you add more index funds in different asset classes, the odds of an all-index fund portfolio outperforming an all actively-managed fund portfolio move to the very top percentile.

The primary reason why index funds outperform is their rock-bottom cost. Expenses for index funds are just a fraction of actively-managed funds. Let’s look at these costs. Based on Morningstar Principia data (ending 12.31.12), a broad U.S. equity index funds cost about 0.1 percent per year. Compare that to actively-managed funds that charge about 1.1 percent per year. Bond index funds charge about 0.2 percent per year while actively-managed funds charge about 0.9 percent. It’s very difficult for active fund managers to make up the extra fees they charge and then beat the market on top of that. Some managers do for a while, but over time, the higher fees wear down fund performance and index funds outperform.

It is common knowledge that diversification lowers portfolio risk. Nobel Prize winning economists, such as William F. Sharpe and Merton Miller, have long argued that the least risky and most efficient portfolio is one that holds all the securities of a market. When a company goes bankrupt, the negative effect will be less on a well-diversified index fund than on an active fund that holds fewer securities. The S&P 500 index fund holds 500 securities. The average actively-managed large cap U.S. blend fund holds only about 150 securities, according to Morningstar Principia (data ending 12.31.12). Actively-managed funds are less diversified, therefore more risky. By definition, this makes index funds inherently less risky than actively-managed funds.

5. Reduced Taxes

No one looks forward to paying taxes on their investment gains. One way to lower the tax burden is to buy tax-efficient mutual funds in a taxable investment account. Index funds and ETFs are more tax-efficient than actively-managed funds. That’s because these products have low turnover of securities within the portfolio and this means lower capital gain distributions at year end. ETFs also have a special structure that lowers capital gain distributions by the way these securities are designed.

We’re all trying to make the best of our investments during this tough time. Index funds give you a return over traditional mutual funds that attempt to beat the market. Wise investors are taking advantage of the lower cost and tax efficiency of an all index fund portfolio. You can too!

Richard (Rick) A. Ferri. CFA is the founder of Portfolio Solutions. the low-fee investment management firm he founded in 1999, which currently manages more than $1 billion in assets. He is the author of six investing-related books. and shares his insights as a frequent news commentator, Forbes columnist, media contributor and public speaker. Rick holds a Master of Science degree in finance from Michigan’s Walsh College, where he has served as an adjunct professor. Prior to entering the financial industry, Rick served as a U.S. Marine Corps officer and fighter pilot before retiring from the reserves in 2001 with twenty years of service.