How Index Funds Make Investing Easier

Posted by wadmin on Tuesday, January 12, 2016

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Investing money can be a daunting undertaking, especially you aren’t familiar with buying and selling stocks. However, investing money is probably much easier than you might expect. Investing your money in an Index Fund is a low risk, long-term investment, which pays off down the road. 

What Is an Index Fund?

You’ve probably heard the word fund before in the context of investing. There’s the complicated, official definition, but in basic, what-you-need-to-know terms, a fund is simply a group of smaller investments you buy in a single package. Depending on the type of fund, those smaller investments might be big companies like Google, Apple, or Microsoft. They might be government bonds. Either way, a fund is one big investment made up of smaller assets. It’s sort of like buying an entire compilation album of your favorite artists instead of purchasing each track separately, one at a time.

An index fund is a fund that mirrors a certain index, and an index is just a measure of a financial market. For example, you’ve probably heard of the S&P 500. It’s an index that measures 500 of the most economically powerful companies in the United States. It would be a nightmare to buy and sell the right amount of stock in each of those individual companies on your own. Or worse, research your own companies from scratch. Who has time for that? Index funds do all of that work for you, you just buy a single investment. If the index does well, the index fund does well. If the index drops, so then does the index fund. And that’s why everyone loves them: the research is done for you, and so is the picking.

There are a ton of different indices, and here are some of the most common ones. Firms like Vanguard, Fidelity, and Charles Schwab have designed different index funds for all of these indices and more. Here are a few:

Index

Matching Index Fund

S&P 500 index

VFINX “Vanguard 500 Index Fund”

Nasdaq index

FNCMX “Fidelity Nasdaq Composite Index Fund”

International market index (EAFE)

SWISX “Schwab International Index Fund”

If the S&P is up, you can expect Vanguard’s VFINX to be up. If the S&P plummets, so will VFINX. The same goes for every index and its matching fund. Historically, the S&P averages 10% (before inflation) every year. So it’s no surprise that VFINX has a similar return.

Index Funds Are Awesome for Long-Term Investing

Index funds have a few advantages that make them great for long-term investing:

  • Diversification
  • Simplified, reliable performance
  • Low fees

Each of these advantages are key to a solid “set and forget” investment portfolio.

Diversification

Diversification is hugely important when it comes to investing. You’ve probably heard the saying, “don’t put all your eggs in one basket.” In money terms, this translates to: don’t invest all of your money in a single company, asset, or asset class.

For example, Google is a solid, steady investment. However, you still don’t want to invest every single dollar you have into Google. Despite how secure the company is today, it’s dangerous to bet on Google and only Google to fund your retirement. You’re at the mercy of anything that could go wrong with one company. If they decide to use their every penny to revive Google+, you’d get a little worried. Long story short: if something goes wrong, you lose everything, and you’re entirely screwed.

On the other hand, if you’re invested in a bunch of other assets, too, you’re still okay if Google somehow tanks. That’s diversification in a nutshell, and that’s how index funds work. You’re investing in hundreds or thousands of different assets, whether those are company stocks or government bonds. In short: index funds have built-in diversification. The banks and organizations that set the index specifically choose companies with diversification in mind.

Simplified, Reliable Performance

With an index fund, you’re making a simplified bet on a reliable index, like the S&P 500. Sure, that index has its ups and downs, but over time, it’s averaged a 6-7% return after inflation. That’s pretty good for long-term investing: namely, saving for your retirement.

Here’s how J.D. Roth puts it over at Get Rich Slowly:

Do index funds always come out ahead in a given year? Not at all. In fact, they’re usually in the middle of the pack. By definition, index funds produce an average market return — no more, and no less.

However, over the long term — ten years, or twenty, or thirty — a remarkable thing happens. Index funds float to the top. It turns out that average performance in the short term is actually above average in the long term.

In short, index funds are meant to be steady and boring. They’re not going to skyrocket and make you rich overnight, but nothing will, and these are a pretty safe bet over time.

Low Fees

With other funds, an advisor or investor picks and chooses your individual investments. He or she keeps a close eye on them, then buys and sells those individual investments according to their performance. They want to beat that average 6-7% return by actively managing your fund. We call this active investing, and you pay for the work that goes into this.

When you buy a fund, you pay an expense ratio no matter what, and this is a fee that includes all the expenses the fund incurs. With active investing, this ratio includes a higher management fee for the extra time and effort.

On the other hand, because index funds are designed to simply mirror an index, they don’t require much maintenance at all. Again, if the index does well, your index fund does well. If the index drops, your index fund drops. We call this “set and forget” investing, or passive investing. There’s no maintenance involved, so the fees are much lower.

This study from Morningstar found that, over time, index funds outperform actively managed funds. Active investors question these studies, but one thing is certain: index funds are generally cheaper than actively managed funds, and this can make a big difference in your return over time. Depending on the fund, active funds might very well beat the market, but you’ll pay a price for that. Sometimes it’s worth it, but you know what you’re getting with index funds: low fees.

Now the downside: Most index funds have a pretty high buy-in limit. It can be between $3,000 and $10,000. It’s a lot, I know. Consider that you’re investing in thousands of different assets at once, though—that costs money. If you want to start investing with index funds and you don’t have enough saved, you’ll have to save enough in your investment account until you reach that number. Once you do, it’s time to think about picking and buying your fund.

How to Pick an Index Fund

Before you choose your index funds, you need to know your asset allocation so you know what index to invest in. And you need an investment account, like an Individual Retirement Account (IRA) at a brokerage firm to actually purchase the fund.

A solid investment portfolio is well balanced in two basic asset categories: stocks and bonds. We’ve told you how to figure out your asset allocation in detail, but it depends on your risk tolerance and how long until you need the money (usually, that means retirement). As a general rule of thumb:

110 – your age = the percentage of your portfolio that should be stocks

That just covers the very basics, though. In order to buy your index funds, you need to know what specific asset classes to buy into: international stocks or U.S. bonds, for example. A tool like Personal Capital’s portfolio checkup or Bankrate’s Asset Allocation calculator can help you figure it out.

SRC: Read the entire article here: twocents.lifehacker.com/how-index-funds-make-investing-easier-and-less-scary-1751260409

 

 

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