index funds

Everyone says you should be investing in Index Funds. Apparently they’re all the rage but how does one get involved in index funds. To answer that let’s start with the basics.

What is an Index Fund?


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To understand what an index fund is we have to know what a stock market index is. You already know what a stock market index is; two of the most popular stock market indices are the S&P 500 and the Dow Jones Industrial Average. Each index is made up of an amalgamation of stocks and the value of this group of stocks is reflected by a number. For example, the S&P 500 is a basket of 500 stocks that is considered to approximate the overall U.S. market. The value of the S&P 500 reached record highs recently and stands at $2129.20 at the time of writing.

An index fund is a specific type of mutual fund (where money is pooled by investors) that is constructed to match the performance of a specific market index. For example the Vanguard 500 Index Fund (VFINX) approximates the make-up of the S&P 500. Index funds can also be constructed to track particular sectors like consumer staples or utilities.

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Index funds are different from traditional mutual funds in that they are not actively managed. There’s no fund manager calling the shots behind the scenes. There’s no one selecting stocks or changing the makeup of the portfolio. What you buy is what you get. Instead of a fund manager you get a computer that tracks the market and rebalances the fund as needed so that it matches the market index it is following as closely as possible.

So by investing in an index fund you live and die by the market index you track.

Is that good? Don’t I want to beat the market? Why should I invest in an index fund?

Benefits of Index Funds

Outperformance

Investors will generally be able to beat actively managed funds in the long run by investing in index funds.

Warren Buffet himself requested that this estate be put into index funds.

Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.” – WB

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Studies have shown that the majority of actively managed mutual funds fail to beat the overall market in the long run. In the short run some may do better than others, but time does not paint a good picture. One study followed the performance of 2,076 actively managed mutual funds from 1976 to 2006. After fees, they found that 75% of the funds failed to generate a return greater than the overall market.

By investing in an index fund you’re already doing better than 75% of the mutual funds out there.

Low Fees & Passive Investment

Index funds don’t require much management as they are passive investments. Just set it and forget it. These types of investments also allow investors to invest in a large segment of the market – easily diversifying one’s portfolio.

Additionally index funds don’t have a lot of costs associated with them like mutual funds. There are no sales commissions and because they are run by computers the operating costs are way lower!

Ok, so I get why index fund investing is such a good idea but what index fund do I put my money in?

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There are no set rules to index fund investing but here are a few things to consider.

Diversify your investment

Yes, it is true that an index fund is already a diversified investment. You could invest all your money in the Vanguard 500 and be done with it, but why put all your eggs in one diversified basket?

Most financial experts will tell you to have some sort of allocation between stocks and bonds. They’re not wrong.

One strategy is to go with the two-fund portfolio. Two Vanguard funds that fit the above profile would be the Total Bond Market index fund, which holds U.S. Treasuries, home mortgage securities and high quality corporate bonds, as well as the Total World Stock index fund, which gives you access to stocks from around the globe. Both funds comprise of thousands of securities – meaning you’re safely diversified.

Another strategy is to have international and domestic exposure in the same portfolio, as well as equity and bond exposure. This allows you to mitigate swings in the stock market. Split your portfolio equally between the Vanguard 500, which mimics the S&P 500, the Vanguard Total International Stock Index Fund, which gives you exposure to both developed and emerging international economies, and the Vanguard Total Bond Market Index fund. This way you’ve got a bit of everything. Once a year, rebalance your portfolios so that there are equal amounts in each of the three index funds you’re good to go.

Plan for the Future

If you are incredibly lazy you could even invest in a lifecycle index fund. Most finance experts recommend an allocation between stocks and bonds, an allocation that should shift more towards bonds as time goes on and retirement draws closer.

Rebalancing between equity and bonds like that can be time-consuming, unless you own a lifecycle fund. Also known as target-date funds, these investments rebalance themselves over time – shifting to more conservative assets as you age. By the time you are ready to retire your portfolio will have gone from 90% stocks, 10% bonds to 90% bonds and 10% stocks.

There you have it. The simple guide to index fund investing. There are many slight variations to the strategies outlined above but the principles are always the same. You can’t go wrong with simple portfolio choices!

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