All about the challenges of Midlife Finance

Index Funds: The Plodding Moneymaker

“Not the only investment guide you’ll ever need (but close):

     Make a budget, scrimp and save, pay off your credit cards, quit smoking, fully fund your retirement plan and start early — tomorrow, if you possibly can — putting away $100 or $500 or $5000 a month, whatever you can comfortably afford, in two places: short- and intermediate-term Treasury securities, for money you might need in a few years; into no-load low-expense stock market “index funds,” both U.S. and foreign, for everything else. 

      You will do better than 80 percent of your friends and neighbors.”

                     Andrew Tobias, from his memoir, My Vast Fortune

     When the author of the long-selling Only Investment Guide You’ll Ever Need only recommends index funds for “everything else” but short-term needs — well, I pay attention.

     So should you. 

 WHAT ARE INDEX FUNDS?

Wikipedia defines them as ” a collective investment scheme (usually a mutual fund or exchange-traded fund) that aims to replicate the movements of an index of a specific financial market, or a set of rules of ownership that are held constant, regardless of market conditions.”

      Think of it in a different way:

*Pick a stock market –any market. Or a trend.

*Now follow its movements as exactly as you can.

Sound difficult? That’s the beauty of computers: they automatically document this process better than humans (by themselves, at least) can.

     The index fund first appeared on the scene in 1976, with the Vanguard 500 Index (VFINX). More than three decades later, that same fund, which follows the Standard and Poor’s 500 Index, is still going strong. In fact, it’s done better than 80% of all large company U.S. stock funds in the past three years.

     Wow.

You now have nearly 2000 index funds to choose from, and more are forming every year. In fact, deposits in stock index funds have grown 70% over the past five years, to TWO TRILLION dollars. Meanwhile, deposits in actively managed US stock portfolios (versus the computer-driven index fund) have dropped by a jaw-dropping 18%.

WHY YOU SHOULD CONSIDER INVESTING IN THEM TOO

Returns. Index mutual funds, as well as exchange-traded funds (a variation) have done better in the long term than most actively-managed funds.

Fees.  Fewer managers in these ‘passively-managed’ funds mean lower feeswhich help preserve the profits you do make.

Stock Mix. Since index funds must follow the dictates of their mandate, you’ll know what’s in them. Actively-traded funds only have to reveal that info quarterly.

Tailored to Your Taste. Index funds used to primarily follow the stock market. Today, however, they track everything from technology to banks. You should be able to find an index fund (or its related fund, the ETF, or Exchange Traded Fund) to fit your particular interests.

Less Effort. No time to study up on the market? Index funds do the work for you, following the trends most important to you.

AND WHY YOU SHOULDN’T

Long Term Results. That’s exactly what index funds are for — to let you get the maximum out of the market over a longer period. (The profits help balance the losses.) If you enjoy in-and-out and frequent trades, these funds won’t be for you.

Profits Grow Slower...especially if the market is falling. After all, index funds generally mirror what’s going on in the financial world. If profits are droppingthe funds will be, too. And like any other fund, they’re not necessarily guaranteed. (Invest at your own risk.)

Less Flashy. Index funds have been overall more effective than the herd of actively-managed funds — but some actively-managed funds have done better. Just because your money is in an index fund doesn’t mean that it will be earning the maximum profits it could — especially in a healthy, growing market.

Other financial experts  recommend investing in index funds — but they also think you should have some actively-managed mutual funds in your portfolio, as well. That way, you’ll get a full mix of what’s going on in the financial world.

     Considering the wide range of financial pundits who mention index funds, though — including people likeWarren Buffett (and Bernie Madoff, of all people!) — it’s worth learning more about them. Buffett recommends buying shares gradually, to help minimize ups and downs. “If you have 2% a year of your funds being eaten up by fees you’re going to have a hard time matching an index fund in my view,” Buffett said. “People ought to sit back and relax and keep accumulating over time.”

 A basic starting guide to index funds is hereGood funds to consider? As mentioned, Vanguard’s index funds have had a steady run in the past. Fidelity’s and iShares’ funds also often come up in conversation. And Charles Schwab’s index funds have some of the lowest fees around. Do your homework and read carefully before committing any of your hard-earned money to any fund, passively or actively managed.

      Index funds may just be the slow-but-steady foundation your investments need.

5 Responses to Index Funds: The Plodding Moneymaker

  1. Great post! I am fully committed to passive investing and I write about it a lot on my blog. Ever since I got burnt chasing returns during the dot com boom, I’ve been investing passively and haven’t looked back. Do I lose money when the market drops, of course I do, but that is expected. I have a long term plan and invest for the long term. I don’t care what happens over the short term. The markets are always volatile over the short term, but the long term trend is positive.

    Also, now that index funds are becoming more popular, investors have to be cautious. I’ve seen some so-called index funds that charge a very high management fee. It seems as though the management company is just trying to get people to invest in their fund by seeing “index fund”.

  2. They’re not as fun, if you enjoy following hunches… but the steady gains are worth it. (I do keep some money for the guessing — it’s too much fun, and if you do your homework, does pay off!)

    I plan to switch much of my retirement account into index funds. No use trying to figure out this whacky up-and-down market…and it’s only going to get worse.

    Not only that — to have so many ‘experts’ recommending them! And there’s no financial gain for them to do so…especially Bernie Madoff.

    Thanks for writing, everyone.

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