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Index Funds - If You Can’t Beat ‘em, Join ‘em

Investing in Low-Cost Index Funds Can Be a Great Strategy

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Index funds might be a better choice for most investors than actively managed mutual funds

When you invest in an index fund, you can effectively buy an index such as the Dow Jones Industrial Average or the S&P 500. Index funds offer extremely low costs, low tax turnover, and virtually no thought, making them a great choice for many investors.

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As you work your way through our Complete Beginner's Guide to Investing in Mutual Funds, you may wonder which you should choose: actively managed mutual funds or passively managed mutual funds.

According to the folks at the Motley Fool, only ten of the ten thousand actively managed mutual funds available managed to beat the S&P 500 consistently over the course of the past ten years. History tells us that very few, if any, of these funds will manage the same feat in the decade to come.

The lesson is simple: Unless you are convinced you are capable of selecting the 0.001% of mutual funds that are going to beat the broad market, you would best be served by investing in the market itself.

How? By beginning a dollar cost averaging plan into low-cost index funds, you can be absolutely certain you will out perform a majority of managed mutual funds on a long-term basis.

Indeed, the most successful investor in history, Warren Buffett, advocates that those unwilling or unable to intelligently evaluate individual stocks should invest in a low-cost index fund such as those offered by Vanguard.

Why? Index funds boast three distinct advantages over their actively-managed counterparts:

  • They do not require corporate analysis or an understanding of accounting, financial theory, or portfolio policy.
  • They have almost non-existent expense ratios, providing a significant competitive edge over actively managed funds and almost completely ensuring superior long-term performance.
  • They are made up of dozens or hundreds of companies. This diversification reduces company-specific risk.

What Is An Index Fund?

An index fund is a mutual fund designed to mirror the performance of one of the major indices (e.g., the Dow Jones Industrial Average, S&P 500, Wilshire 5000, Russell 2000, etc.) Unlike traditional, actively managed mutual funds where portfolio managers evaluate, analyze and acquire individual stocks, index funds are passively managed. Basically, this means they consists of a pre-selected group of stocks that rarely, if ever, changes.

An investor that bought an index fund designed to mirror the DJIA, for example, would experience price movements almost perfectly in sync with the quoted value of the Dow Jones Industrial Average he hears on the nightly news. Likewise, an investor who built a position in an index fund designed to mimic the S&P 500 is, in essence, acquiring stock in all five hundred of the companies that make up that index.

Index Funds Don't Require Corporate and Financial Analysis

Index funds are ideal for those who have no idea how to evaluate competitive advantages of various corporations, differentiate an income statement from a balance sheet, or calculate discounted cash flows. Because company-specific risk is diversified away thanks to the dozens or hundreds of companies that make up each of the major indices, such analysis is not necessary. In addition, an index fund is a cost effective way to acquire hundreds of stocks while avoiding the thousands of dollars in brokerage commissions that would otherwise result.

Index Funds Generally Have the Lowest Mutual Fund Expense Ratios

Actively managed mutual funds must pay portfolio managers, analysts, research subscription fees and the like. The percentage of a fund's total expenses including its 12b-1 fees divided by its average net assets is known as the expense ratio. Because index funds are non-managed (and require none of the aforementioned expenses), the expense ratio is almost nill compared to the average mutual fund. This means that less of the investor's money goes to paying overhead, compensation and sales charges. Over the long-run, the lower costs associated with index funds can result in significantly improved performance.

Consider the following: A quick glance at Yahoo Finance reveals the average expense ratio for growth and income style mutual funds is 1.29%. As a result, approximately $1,883 of every $10,000 invested over the course of ten years will go to the fund company in the form of expenses. Compare that to the Vanguard 500 fund, designed to mirror the S&P 500 index, which boasts an annual expense ratio of only 0.12%, resulting in ten-year compounded expense of $154 for every $10,000 invested. In other words, by investing in the Vanguard fund, the investor will have $1,724 more working for him. Compounded over an investing lifetime, the difference is significant.

Index Fund Investing Works Best When Paired With Long-Term Dollar Cost Averaging

At the height of the roaring stock market of the 1920's, the Dow Jones Industrial Average reached a peak of 381.17.  In 1932, the Dow crashed to 42.22. It took over thirty-three years (1929 to 1955) for it to return to the 1929 level. An individual investing all of his money at the height would have waited more than three decades to merely break even! If, however, he had started a dollar cost averaging program, he would have made a tremendous amount of money thanks to his significantly lower average cost basis by the time the market returned to its previous level.  Combined with reinvested dividends, he would have broken even in only a few years, and by the time the market reached its former level, have done very well.

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