Simple Investing – Index Funds

Recent statistics from a Wells Fargo survey indicated that talking about finance is more daunting than talking about death, religion, politics, or taxes.* So, let me make you even uncomfortable for a few paragraphs!

I invest in stocks and I invest in index tracking funds. I love stocks, but the index trackers are what keep me sane and happy.

I can see your eyes glazing over now! Stop that. Focus. Come back to me. That’s right. It’s all going to be okay (and brief).

I’ve made some great investments: Pixar, Marvel, Netflix, Monster Beverage. Those investmens are sexy, and fun, and really helpful to my bottom line, but it’s not where I make most of my investment returns. They’re great to talk about with friends, but I always try to hold myself back, because those are just the winners.

Instead, when people ask me about investments in my personal life, I generally start with the one piece of advice that has served me well over the years. If they don’t want to fall head-over-heels in love with individual stock investing like me, then I recommend simply buying an index fund that tracks broad market indexes like the S&P500, the S&P 1500, or the Russell 2000. Heck, even though I love stock investing, this is exactly what I do with most of my family’s retirement money.

I also recommend they buy automatically and/or regularly in their 401(k), 403(b), IRA, Roth, or whatever tax-advantaged account they have. This allows them to make savings a habit.

Index investing accomplishes three very important things:

Immediate Diversity

Broad market indexes, like the well known S&P500, tend to have more stocks in them than most mutual funds, and more stocks than an individual investor can buy on their own. The purchases allow you to own fractional (often very small) percentages of those companies. This allows you to basically ride the success or failure of the entire economy, or large segments of it, not just a few companies.

Low Fees

Mutual funds offer diversity, and sometimes they offer charismatic Wall Street talking heads to entertain you. Very few actually track and advertise their achievements against broad market indexes. Many charge high fees. What’s high? To me, anything over about 0.5% feels really high, because I’m used to index investing. Indexes are based on computer models that reallocate money to track the published indexes. No human management really necessary. They just program a trading computer and forget it, so you can get pretty low fees compared to funds that pay salaries to managers.

Indexes Usually Beat Managed Funds

There’s some comedy to be had here, but unfortunately, it’s at the expense of investors who are paying money so they can have the privelege of underperforming. Funds that use human managers are trying to beat a group of stocks automatically generated using a simple formula (yes, that’s all indexes really are).

The reasons why are complex, but studies show the results are pretty clear. Indexes beat funds most of the time, by a few percentage points.

Now, this isn’t true of all mutual funds, and you may notice that some of the comparisons in the sample articles above are more dire than others. This is because the time period you choose to use to measure success or failure is arbitrary, and has a large effect on the results. Still, nobody should have a one year, or even a three year investment time horizon, unless they’re near the very end of their life span.

That means, over the long term, those 1% fees, taxes on trades, and short-term investment swaps combine to make it very difficult for a human fund manager to win, on a large scale, against the market.

Next time, I’ll talk about risk. Isn’t investing risky? Totally. So’s walking down the street. It’s all about how we manage risk, and what the alternatives are.

 

Disclosure: I work at Wells Fargo, but these opinions are mine, and not those of Wells Fargo. Also, please note that I provide this advice as a fellow investor, and someone preparing for my own retirement, and not as a financial advisor. I and my family own shares of S&P500 and Russell 2000 index tracking funds. Investing is never a guarantee. You can lose money.

 

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