What Is an Index Fund?
Index funds keep you from having to study individual stocks and run with the “big boys” on Wall Street in the stock market, and they offer solid, competitive returns. An index fund is a type of mutual fund (a diversified group of investments in stocks) whose goal is to match the performance of a specific index. An index fund that seeks to match the performance of the Dow Jones, for example, owns shares in the same stocks as those in the Dow Jones market. Index funds are passively managed, but they are also considered to be active and believed to garner better results than other actively managed funds.
Active management involves making skilled decisions when choosing stocks and making well-timed decisions. Most plain old mutual funds are actively managed. Keep in mind that if someone is actively managing a fund – that is his/her job and you will pay for the work they do. Therefore, actively managed funds ask higher fees from you to pay their analysts.
Passive management refers to funds that do not have a specific goal of beating the market. And, passively managed funds do not have the same analysts to pay. Instead, their goal is to match the risk and return of a segment of the stock market (or the market in general). These funds, and those who invest in them, believe that outperforming the market is very difficult to do and somewhat overrated. They are happiest matching the market. Passive management most truly reflects the traditional “buy-and-hold approach” to investing.
Why Invest in Index Funds?
Index fund investors believe in the “efficient market hypothesis.” This is a theory stating that since all markets are efficient, you (the investor) can never realize higher than normal gains; so instead of trying to beat the market, index fund investors simply join it.
Index funds generally have low expense ratios. The benefits of these lower percentage expense ratios are especially noticeable in bear markets. They are low cost because they do not have employ analysts and experts to try to outperform the market. They simply follow the trends of a particular index, which keeps maintenance costs down for them and for you.
Common reasons not to invest in index funds:
You believe that you can get better returns than the general market can provide.
You want to invest in the latest “hot” stocks that could skyrocket (or crash) your portfolio.
You don’t want to settle for “average” returns.
A well-known statistic: common knowledge states that the S&P 500 outperforms eighty percent of the actively managed mutual funds. How can this be common knowledge?
Most mutual fund managers cannot come out ahead of the market, especially once sales charges (fees) are taken out of the returns that they do achieve. The expense in both time and money to pick stocks and time their trades that accompanies mutual funds simply is too much; it makes their results less than average.
Strangely, if you set a goal of “average” returns, you may actually come out ahead of active investors!
In summary, if you are investing for the long term, and you would like to put your money somewhere and then not think much about it anymore, index funds are a great option. The combination of low costs and “average” capital gains make them a very comfortable way to build your wealth.
Do you invest in index funds within your 401k or IRA?