The Beauty of Index Funds
Feb 25th, 2008 by Nut
Trent over at The Simple Dollar wrote a post on index funds the other day and I felt compelled to add my two cents in the comments section. I found I had more to say about them and how great I think they are so I’ve decided to write a whole post about them here.
First of all, index funds are a mutual fund that isn’t actively managed—in other words they are simply “tied” to an index like the S&P 500 or the NASDAQ. If those indexes go down, this fund will go down. If it goes up, same thing. Here are the main benefits of index funds as opposed to picking out your own stocks or mutual funds:
- They’re cheap: Index funds are much cheaper (I pay around 0.2%, on average) than mutual funds (which can go up to 1–2%). Compounded over the long term, this small percentage difference means you are losing out on some serious dough.
- They’re easy: You don’t have to kill yourself studying up on which fund managers have done what and what they may do in the future. You’ll never see “Top Ten Index Funds of 2008″ on the cover of Fortune magazine. That’s the beauty of holding an index fund—you won’t be wondering when it’s time to sell either.
- The best investors in the world recommend them: Go to Trent’s post and check out how many pros think index funds are the way to go. My favorite investors of all time are Peter Lynch and Warren Buffett, and they are loud advocates on index funds so that makes it an easy call for me. Check out this interesting article posted by GE Smith on how Google recommended index funds to their employees.
- They’re diversified: Right away you’re buying huge swaths of the market. The S&P 500 index means you now own 500 companies in one fell swoop. Not only that, by holding a few different kinds of index funds you can diversify yourself even further to get a better return. I hold three index funds right now: the S&P 500, a Mid Cap index fund, and an international index fund. I am looking to add a couple others, but with those I’m already well diversified.
- They’re perfect for beginners: If you don’t know much, index funds are the perfect place to start. They are easy to understand and offer you the best way to get started in the market. Owning an index fund can teach you a lot about investing.
Of course, there are many out there that think index funds are simply “OK,” but don’t give them “enough.” Here are some commonly stated disadvantages of index funds and my response to each:
- They’re not exciting: True, they’re not. That’s what keeps most people away. They like to believe that the stock of mutual fund they picked has some magic to it that will give them a big rush when it does well. “I picked it,” they want to say. Well, sometimes you have to go boring to get results.
- They don’t outperform the indexes: Right, they are the averages. But if you pick a good mix of index funds (international, large cap, small cap, real estate, dividend) you can get yourself a nice return that may beat the S&P. And I have to repeat: The average mutual fund manager does not beat the indexes over the long term.
- I can’t pick my own stocks: I understand this and I have to say that I invest in stocks as well as in index funds. Jim Cramer makes a great point about having some “mad money” to use to invest in speculative stock plays: they help keep you interested and excited as you invest. I think having a small portion of your money (however much you feel comfortable with) to use on individual stocks is a great idea. If you make a few good moves, you can now “beat the averages.”
- They are built for the long-term investor: I agree, they are. If you are looking for short-term results, these are not for you. And unless you really know what you’re doing and are really good (and even then, sometimes that’s not enough) stocks themselves might not be for you.
In the end, index funds are merely on more option for the person looking to invest in stocks. In my opinion (and many many experts agree on this), they are one of the best options to participating in the market. If you don’t think they are for you, that’s fine, but for the average person (beginner or not), I can’t think of a better, convenient way to own stocks.
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The Wire, Season 4
Another advantage that index funds have over mutual funds are having to pay less in capital gains. Because mutual funds trade securities much more often, they have to make capital gains distributions every year (regardless of the funds performance). This in turn results in a tax bill for mutual fund investors. Index funds trade stocks much less often, so capital gains are deferred for much longer. The money saved from lower taxes in the index funds will be compounded right along with the money saved from the lower fees.
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