95% Of People Should Invest In Index Funds
Index funds have long been regarded as one of the smartest investments. It's affordable, enables diversification, and generates attractive profits over time.
According to Morningstar, index funds work better than actively managed funds. In 2019, index funds held assets worth $4.27 trillion compared to just $4.25 trillion in active funds.
But before we explain how an Index fund works, it's paramount that you know what an index fund is.
Investopedia's definition of an index is that it is a method used to track the performance of a group of assets uniformly.
Index funds are funds that are invested in similar stocks within a specific market index. It tracks the aggregate trends of a total market index like the Dow Jones Industrial Average, S&P 500, or Nasdaq. It's a type of mutual fund or exchange-traded fund.
The History
An active mutual fund is an investment made by multiple people who purchase bonds, stocks, and other securities. It's operated by a mutual fund manager who handles the day-to-day management to ensure the portfolios stays on track with the end-of-day sales and purchase.
In comparison to this, an index fund is meant to work as a passive investment option instead of one that will be monitored against the market constantly. These funds offer access to thousands of assets in a managed investment, minimizing the total risk by a wide margin.
The first index fund was created almost 50 years ago by Jack Bogle, the founder and then CEO of the Vanguard Group. He created the funds for everyday investors to compete with professionals. Index funds are designed to be a simple all-in-one investment.
Instead of picking stocks you think will outperform the market, you will own all of the stocks in a certain market index.
A good instance is the S&P 500 index which tracks the performance of the stocks of the 500 biggest corporations by market capitalization.
Bogle's aim is about something other than beating the market - being sure to keep up with it. And considering the stock market has historically increased in value over time, it pays off those investing for retirement.
There are many reasons this fund will be a huge win for retirement savers and other non-finance professionals.
Fee structure
Firstly, you aren't going to pay someone to pick stocks for you anymore, coupled with its cheapness compared to other actively managed funds. It also makes trade less often than active trade, which leads to lesser fees and taxes.
The first cost of a mutual fund is the management fee each fund manager will collect from you. The amount to collect usually varies based on the value of your holdings.
In an actively managed fund, the fund's expense ratio determines it. If your expense ratio is 1% and you hold $1000 in a mutual fund, you will have to pay $10 as the management fee.
Actively managed funds usually range their expense ratio between 1% and 2% because the fee goes towards portfolio managers that make buy and sell decisions to outperform the overall market.
However, the index funds expense ratio often falls between 0.05% and 0.07%. Since it passively managed and tracked the index by buying and holding all the stocks in that index, the index's holdings rarely changed.
This expense ratio is relatively low because there is little or no work for the index fund manager to do.
Surprisingly, the expense ratio may even be 0%.
Now, if you hold $1,000 and pay 0.05% as the expense ratio, you will pay just $0.50 as the management fee compared to $10.
Aside from that, index funds tend to perform well over the long term than actively managed funds. So it makes them the ideal option for people investing for retirement.
Benefits
Although it's incredibly hard to pick stocks that will beat the market and even more complex to pick one that will do so for years, the fact that the majority of large capital funds have underperformed the S&P 500 for many years shows that it isn't profitable after outperforming for a year or two.
One of the obvious benefits of investing in an index fund is that your portfolio becomes instantly diversified. This will help you minimize your likelihood of losing some or even all of your money in a line of investment.
Consider an index fund that tracks the S&P 500.
This index fund would hold about 500 different stocks from different companies. While these performances fluctuate differently, your portfolio holds all of them since you have invested in a fund that holds all of them.
By investing in just one index fund, you've ensured the diversification of your portfolio between many companies. Ensure that the value of your portfolio doesn't correlate so much with the fortunes of any one company listed in the index.
It’s as if Warren Buffet knew he would win when he made a $1 million bet in 2007 that the S&P 500 index fund would defeat the returns of an actively managed fund for over ten years. He won the bet by a landslide.
Even the smartest and most diligent portfolio managers can rarely steer actively managed funds and outperform the market, but in general, the overall stock market rises in value over time.
As a result, index funds give high returns for low cost, and this makes it an excellent value proposition for any investor. This may be why many investors started adding index funds to their portfolios.
How to make the most of index funds
So, now you know the many benefits that index funds can bring, how do you make the most of it?
Before investing, you must know your situation, your life goals, and how to accomplish them. When will you retire, and how far are you from that milestone? What does your risk tolerance and budget look like?
If you understand all these well, it will help you understand the role of index funds in your life.
Andrew Rosen, a certified financial planner and president of Diversified LLC., said a short time horizon shows a lower ability to take risks and will lead you to weigh yourself with a high bond index. However, if you have a long time horizon, you can take on more risk and likely increase your stock allocation.
Ask yourself what your take-home pay is, what your current expenses are, how much your debt is, and your net worth.
Getting answers to these questions will give you a big image of your finances and insight into how much you can invest.
Knowing your aims will help you give your money a job and keep you motivated. You should know beforehand that you can't do it without risk, as risk is a part of investing.
But there are ways to invest within your comfort zone. Once you settle on your goals and targets, you can now decide which index fund strategy will give you the best chance to reach these goals.
The right asset allocation
Julian Schubach, an investment advisor and Vice President at ODI Financial, explains that:
index funds generally benefit an investor by providing relatively low fees and diversification compared to actively managed funds. They are designed to track and follow a wide sector, such as large capitals, emerging markets, and broad indexes like the S&P 500.
To set your index fund strategy, you will have to choose the right asset allocation or the percentage of your portfolio, which comprises stocks versus bonds.
After that, you must elevate your risk appetite, regardless of how long you plan to stay invested. If you can't stand losing your money, you might opt for a more conservative investment, even for a distant goal. This option will be possible with you adding more money instead of depending on investment growth to reach your goals.
Then you will have to decide your potential index fund because it takes a lot of burden off investors by investing in hundreds or even thousands of different stocks in a single fund. That means you won't have to worry about picking any one winning stock and rather benefit from the general growth of the market or industry your fund is tracking.
With that said, you will want to research what type of index you plan to invest in. Is it one with a higher risk or a lower risk? As well as specific funds that track them.
Although most funds tracking a certain index contain the same securities, each may have different percentages, impacting how well they copy an index performance.
Schubach explains that each fund and company may have different fees and portfolio construction. So it would be best to research the differences between each offering within a broad index.
He concluded that a good way to start is to research the assets under management of a given index fund. The fee structure, ease of trading, access to the fund, and the background of the managers in charge should also be considered.
Open an account
Next, you should open an investment account if you don't have one already.
You can invest in index funds using different accounts built for different goals. If it’s an education savings account such as a 529 plan, or a retirement account like an IRA or 401k, among others, you can pick one according to your needs.
When choosing which account to open, look for any account-related fees. For instance, will your account be charged every time you make a trade? If yes, finding a brokerage without these fees might be better.
Once your account is set up, you are off to a good start. You will have to fund the account and ensure the fund you intend to buy is available.
Always check any fund minimums and ensure you are ready to invest at least that much. Your broker will have you round off a trade ticket, and you will choose how your money is invested there. You will dictate whether you want to purchase at the market price, the current value the fund is trading at, or at a limit price, which is usually lower than the current market price.
Once your trade is completed, your money works in the funds of your choice.
You should make sure this isn't a one time thing. Make sure it's an ongoing strategy to build wealth for the future. And that's it.
Index funds are an investment opportunity that doesn't require setting up a workplace. Whether you are new to investing or already a professional, it’s a great addition to your portfolio. Finding the right index fund takes a little time, but once you do, you can sit back and let your money grow over time.
After reading this article, I'm sure you've seen why 95% of people should invest. Are you going to be one of them?
- Ivan