Why Index Funds Are Your Best Stock Investment Strategy
Are you confused by the many options available to you when investing in the stock market? One of your options – investing in mutual funds – brings you the benefit of spreading your risk over many different stocks, so you don’t “put all your eggs in one basket.”
Within this realm of mutual funds, one type of fund always performs as well as a standard index that measures various parts of the market as a whole – Index Funds.
What are index funds and, more importantly, are they a good investment for you?
‣ WHAT IS AN INDEX FUND?
An index fund is a mutual fund whose portfolio matches a stock index. Investing in an index fund is like owning a little bit of every stock in that index. So the market exposure is very broad.
For example, a United States-based index fund might match the stocks in one of these indexes:
‣ Dow Jones Industrial Average – tracks 30 of the largest publicly traded firms
- Dow Jones Wilshire 5000 – tracks all USA-based publicly traded companies
- S&P 500 – tracks 500 Large Cap corporations
- AMEX Composite – tracks all the stocks on the American Stock Exchange
- NYSE Composite – tracks all common stocks on the New York Stock Exchange
- Russell 3000 – tracks the largest 3000 U.S. companies
These indexes are widely used for index funds; however, there are also several more indexes in the USA, so you may find an index fund matching another index as well.
If you’re interested in investing in foreign markets, there are also index funds that match international or country-specific indexes.
‣ PROS AND CONS OF INDEX FUNDS
Some common criticisms of index funds are that they can never beat the market (true) and they are not professionally managed (also true, because the index determines which stocks to buy).
On the flip side, they never do worse than the market. Also, the fees for management expenses are minimal because you don’t have an expensive fund management team to pay. Additionally, the portfolio turnover is usually also quite low.
‣ INDEX FUNDS VS. MANAGED FUNDS
Interestingly, even though index funds never beat the market, they outperform 97% of the managed funds over time. Sound impossible? How can a professional money manager consistently do worse than the equivalent of simply buying and holding every stock available?
The New York Times published a story with research showing that for a managed fund to break even with the market, it has to outperform the market by 4.3%. Most financial experts concede that this is highly unlikely to be accomplished, and the research supports that.
Looking back over 20 years, it was found that only 13 out of 452 domestic mutual funds met that criterion. That’s less than 3 out of 100 when you include the fees and expenses!
Do you want to pay for guy in a fancy suit and a corner office who fails with your money 97% of the time?
‣ HOW TO CHOOSE AN INDEX FUND
Selecting an index fund is quite easy. The management talent to run one is usually not a consideration, and there’s no difference in performance between different funds based on a given stock index, so the only thing that really matters is the cost. Buying shares in an index fund is like buying a bag of white sugar; it’s all essentially the same – except for the price.
Consider these ideas when choosing an index fund:
1. Expense ratio. You’ll find this cost ratio in your materials that give the details of the fund. It helps you compare this company’s fees to those of other companies.
2. Transactional costs. The expense ratio doesn’t capture the transactional fees, so be sure to look at the trading frequency of the fund in question.
‣ Check to see that they aren’t buying and selling too frequently. Buying and selling stocks costs money, so your costs will go up if this company buys and sells its stocks more often than other companies with this same type of index fund.
‣ Compare the various index funds with the index you wish to follow to get an idea of what’s typical.
3. Which index will you follow? There are numerous indexes in which you can invest, including small-cap, international/foreign, bond, and large-cap. Study the descriptions of various indexes to determine one that fits well with your risk tolerance and goals.
4. Retirement fund options. While you may not have a lot of options with your 401(k), there is typically an index fund option.