Just Start Investing has written a great guest post about index funds. Learn more about him and his website at the bottom of this article.
Would you rather travel to different stores to buy every item that you need this week, or would you prefer to shop at one store? You could either go to one or two grocery stores to get everything you need.
It is not a joke question. The answer is the second choice.
The same principle should also apply to investment.
You can invest in fewer stocks and still get the results you want, rather than having to buy 10, 20, or 100 different stocks. This takes time and effort.
Index funds are the best strategy for beginners. Below we’ll go over 7 major benefits, but on a basic level, index funds are easy to use and highly effective. Stock selection is simplified.
Investing in index funds allows you to buy the entire stock market (or bond market) instead of buying individual stocks or bonds. You can be assured that your performance will mirror the S&P 500 market with little effort! Anyone can do this.
This is not my opinion alone. Index investing is also supported by many expert investors like Warren Buffett.
Buffett said to CNBC: “Buy an S&P 500 index fund at low cost… It’s what makes sense almost always.”
What is Index Fund Investing?
You can read my comprehensive guide on index fund investing here.
This is the Cliffnotes version for index fund investing:
“A mutual fund and an index are combined to form an index fund. In reality, an index fund is just a mutual fund. It is a fund that mirrors a particular index rather than what the manager of the fund feels like picking that day.
As you will see below, this simple index fund has many advantages over actively managed funds.
Ask yourself these simple questions before investing in index funds or the stock market. These questions are essential to help you choose and prepare the best investments.
Index Fund Investing: 7 reasons to do it
Here are some of the advantages of investing in index fund. The list may not be exhaustive, but it highlights the main reasons that smart investors should invest in index funds.
- Low Expense Ratios
Low expense ratios are the first and perhaps most important benefit of investing in index funds.
A fee is charged to maintain the index fund or mutual fund. This is your cost.
Index funds are known to have low expense ratios. You can find funds that have expense ratios of between 0.0% to 0.1%.
Some actively managed mutual funds can charge as much as 1% or more!
This can be a costly mistake over a 40-year investing cycle. Consider the example of two investors investing $10,000 each year in an index fund that returns 7% per year.
The expense ratios of the two funds are different. One has a ratio of 0.02% and the other 1.00%.
Index Funds: 7 reasons to consider investing today
The fund with a low expense ratio has grown to nearly $2 million! The 1% expense fund is worth just under $1.5 million.
This is about a 25 percent difference in return, or about $500,000.
- Index funds do not (usually) have hidden fees
After the example I’ve given, it should be clear that fees can have a negative impact on your investment portfolio.
The fee structure for index funds is a simple idea.
There are other types of fees that can be charged. There are:
Charges for loading
12b-1 Fees
There’s more…
In general, index funds minimize or eliminate these fees, allowing you to keep more money over the long term.
- Free Trade
This is my last point about fees. ….
When investing in the right index funds, there are no transaction fees.
Brokers (such as Fidelity and Scottrade) typically charge $5 to $10 per trade.
You must pay the fee each time you purchase a group of stocks, bonds, or funds. You will also have to pay the same fee each time you invest in the market. And again. And again. You can reinvest every time.
If you choose the right broker, you can even trade index funds at no cost!
Charles Schwab or Vanguard both offer index funds you can trade free of charge (and with low fees).
- Simplicity
Investing in index funds is easy and simple. Anyone can do it. Yes, anyone!
This means that you won’t need to pay a high-priced financial adviser to steal your money. They call it “investing for your future”.
It’s important to note that not all financial advisors want your money. Sometimes, it is perfectly acceptable to consult one. Make sure that they are fiduciaries. As a fiduciary the advisor owes a duty to loyalty to the client. They must, in a nutshell, act in their client’s best interest. Here’s more on this.
It also means that you won’t have to waste time or stress over investing. Index investing is an “set it, and forget it” investment strategy.
You don’t need to continually monitor stock performance or decide what to buy or sell.
- Your Returns are “Guaranteed”.
You are not guaranteed positive returns, but you will match the market. Which historically has shown positive long-term returns?
S&P 500, an index that is often cited, has historically returned +7% per year. At that rate, $10,000 invested today will be worth $138.426 in forty years (assuming a 0.03 percent expense ratio). It’s not bad at all!
You are not guaranteed to receive this return on your actively managed fund. Your manager will try to beat the market over time, but this is rare. They’re also charging you 1% for the whole time.
If an actively managed fund consistently beats the market, even by 1 percentage point, you are still in the same position as if your index fund investment route was stress-free.
- The Tax Efficiency of These Products
Because index funds have a low turnover, they are tax-efficient.
The turnover is the frequency with which stocks are traded within your fund. If your fund consists of 10 stocks, each with a 10% share, and two of those stocks are traded and replaced by 2 new stocks in a given year, the turnover is 20%.
Any capital gains from the sale of these two stocks would then be passed on to investors, who would have to pay tax on their gains.
The turnover is usually higher in active funds, as the manager actively trades. You will pay more capital gains tax if you have an active fund.
Index funds are less likely to change because the indexes don’t change as often. You’ll pay less in capital gains tax and have fewer capital gains. This will allow you to keep more money in your fund.
- Diversification
Diversification is another benefit of investing in index funds.
Diversification is an important principle of investing. It involves having multiple investments in order to reduce the risk that one investment will go down.
You’d be in trouble if, for example, you only owned Enron during the late 1990s and early 2000s. You would have literally lost all your money.
You would have made a fortune if, however, you had owned Apple and Amazon between the early 2000s and now. Diversification can help you achieve a balance between the extremes, and ensure steady gains over time.
Diversification is the best way to avoid being screwed. The cost of this is that it limits any large, rapid upswings within your portfolio.
With just three simple funds, you can create a portfolio that’s easy to maintain and manage.
The index funds are a great investment vehicle that new investors, as well as average and experienced investors should use.
Don’t delay, get started today!
Just Start Investing, a personal finance site that simplifies investing. Discover simple ways to invest today and how to maximize your budget, credit cards, and banking.
