Using index funds to create a cost-effective, diversified, easy-to-manage portfolio
For most of us, the world of financial investing can seem complex and intimidating. No load mutual funds, asset-backed derivatives, ETFs, REITs, commodity futures, currency trading – the list goes on and on. And if you listen to the sales pitches, every investment out there is perfectly suited for your needs.
Yeah, right!
As average investors, few of us have the time or expertise to navigate the confusing and ever-evolving world of financial markets. What we’re looking for are affordable, solid investments that don’t require tons of research and huge ongoing time commitments. If this sounds like you, then learning a bit about index funds is a smart move.
Index Funds Defined
A financial index is simply a measurement of the performance of a specific group of securities (most commonly stocks and bonds). The S&P 500 index, for example, tracks the 500 most widely held stocks on the New York Stock Exchange (NYSE). Other indexes include the Dow Jones Industrial Average and the NASDAQ. Indexes are typically associated with a geographic area (US, Asia, Europe, emerging markets), industry sector (technology, financial services, manufacturing), company size (large, mid and small capitalizations), or any combination of these. The S&P 500 is a large cap, US stock index that includes about three quarters of the entire US stock market’s value.
Index funds are investments with the primary objective of matching the performance of a particular index. And index funds accomplish this by maintaining a portfolio that contains the same components of that index. Using the S&P 500 example again, a fund that wants to match that index’s performance would simply hold stocks of all the companies that make up the S&P 500.
Why Index Funds Rule
For the average investor who wants a decent return without doing tons of homework or PhD-level math, index funds offer lots of advantages.
Index Funds Are Top Performers – Despite the lofty claims in money magazine ads, you may be surprised to learn the majority of actively-managed funds can’t match the performance of the S&P 500 index. A 2008 study showed that only about 10 percent of fund managers beat market rates of return. And after expenses and fees are accounted for, that number dropped to around 1 percent!
So what’s the lesson here? Don’t believe the hype – almost no one beats the market. And if you want to one-up 90 percent of the fund managers out there, simply invest in an S&P 500 index fund (where you can match market performance). The annual average return (including dividends) for the S&P 500 index is 11.4 percent (from 1900 through 2009). That figure includes the Great Depression era and lots up and down years. But if you’re a long-term investor (and you should be), an 11.4 percent average annual return on your investments is not bad at all!
Your Eggs Are Safer in Many Baskets – Remember in 2001 when Enron’s stock plummeted to nearly zero in the wake of an accounting scandal? The unfortunate employees who had their retirement nest eggs in company stock learned a sad lesson about lack of diversification. One of the biggest advantages of index funds is they allow you to invest simultaneously in hundreds of companies across an entire industry or market. This spreads out your risk so you’re not exposed to the poor (or Enron-like catastrophic) performance of a single company.
Passive Management Means Low Cost – Actively managed, non-index funds can rack up huge fees for conducting research, paying staff salaries and constantly changing the fund’s investments. And guess who these costs are passed on to? Right, the fund investors.
Index fund managers, however, simply make sure their funds always holds the same securities as a particular index. This ‘passive management’ approach is highly cost-effective, since the asset turnover is low (saving on transaction costs) and there’s no need for large research and management staffs. Passive management keeps index fund fees to a minimum, typically half (sometimes less) of their actively managed counterparts. And lower fees means higher returns for investors.
Low Maintenance Is a Good Thing – Allocating your portfolio across a mix of index stock, bond funds and cash reserves is a great way to create a cost-effective, diversified portfolio that requires very little ongoing maintenance aside from annual rebalancing. A moderately diversified portfolio can even be created by carrying as little as two investments: a ‘total market’ index fund (a mix of stocks and bonds) and a cash savings account. How’s that for low maintenance?
Index funds aren’t for everyone, though. If you like to jump in and out of stocks like a day trader, then they probably aren’t for you. Many index funds have policies that discourage or even prohibit frequent trading to keep out short-term, market-timing investors. But if you’re an average investor who prefers a long-term, low-maintenance approach, you don’t really want to live like a day trader anyway, right?
For most of us, life is complicated enough already, and finding ways to simplify our schedules and make smarter use of our time are more than welcome. Investing in index funds offers a simple, easy-to-manage approach to create a solid, diversified portfolio with healthy long-term returns.
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