With all the noise out there in the financial media, it's hard to know if index funds are a good investment.
Hot stocks that have had major spikes recently can be tempting to own. If you are looking for simplicity, consistency and proven growth over time, index funds may just be the everyday investor's best friend.
Award-winning blogger and podcaster (and major index fund fan), Paula Pant from Afford Anything, joins me to answer a listener's question about why index funds are better when it comes to her 401k investment options. Here is Beth's question:
“I’ve heard you and other podcasters talking about index funds being a good investment option. I’m looking into my 401k that I have at work. Can you help me understand why index funds are a good option to consider?”
Listen to Paula Pant and I discuss why index funds are a good investment option for Beth to consider.
LISTEN AND SUBSCRIBE ON:
How Index Funds Work
Fun fact: As Paula Pant pointed out right at the top of our chat, the technical term for index funds is actually “index mutual funds.” That’s because an index fund is actually a type of (you guessed it) mutual fund, which Paula describes as a “basket of stocks.”
Allow us to explain by regaling you with the tale of a new investor. We’ll call him Beginning Investor Bob for illustration’s sake.
Bob wants to start investing in the stock market to give his retirement savings a chance to grow over time. He doesn’t know much about the market but has heard of major indexes like the S&P 500, which tracks the performance of the 500 largest companies on the U.S. stock exchange.
Bob researches the average 10-year return of the S&P 500, likes what he sees, and wants to assemble an investment portfolio that yields similar results. But now he’s faced with a problem – if Bob wants to model his portfolio to mirror the S&P 500 exactly, does he have to purchase 500 individual stocks?
The fortunate answer is no!
Index funds give investors like Bob access to a basket of small portions of each stock in a particular index, all for one initial purchase price. This setup allows each fund to track and mirror the performance of its underlying index.
Rather than build his portfolio one stock at a time, Bob decides to purchase a share of SVSPX, an S&P 500 index fund created by State Street Global Advisors, for around $200. If the S&P 500 goes up (or down) a certain percentage, so will the value of Bob’s share.
Why Index Funds Are a Good Investment
One of the major perks of index funds is that they offer a simple, cost-effective path to broad diversification. In plain English, diversification is the art of not putting all your eggs in one basket.
As Paula puts it, “If one asset moves in some direction, up or down, you want another asset that doesn’t do the same thing.” To illustrate, let’s imagine the case of another investor called Intel Fan Irene.
As you may have deduced from her tell-tale name, Irene is a huge fan of the Intel Corporation (INTL) and invests exclusively in the company’s stock. In her fan fervor, Irene has constructed a portfolio that either lives or dies a fiery death based on nothing more than the performance of Intel alone.
Then there’s Irene’s co-worker, Diversification Donna, whose financial strategy is far more broad. Donna prefers to purchase index funds that track major indexes like the Dow Jones Industrial Average (DJIA). In case you’re unfamiliar, the DJIA index tracks the 30 large U.S. companies, one of which happens to include Intel.
If Intel happens to have a rough period, Donna isn’t nearly as prone to a heart attack as her cohort Irene. Even if Intel has a rough day, as long as one of the other stocks in the DJIA has a good one, it should even out the price of Doinna's index fund shares.
Types of Index Funds
If you decide to invest in index funds, you’ll quickly discover that there are plenty of different types to choose from. There are funds that track indexes, bond markets, or selections of stocks that share similar characteristics, such as investment style, sector, or market cap. Here are a few common examples to give you a better idea.
Broad Market Index Funds
These investment funds tend to track a very broad benchmark index. Examples include everything from NASDAQ index funds to total market funds, which track the performance of the entire stock market.
Market Capitalization Index Funds
Also known as market-cap weighted funds, these funds track a collection of stocks with a similar dollar market value or “market cap.” They are typically divided into small-cap, mid-cap, and large-cap index funds.
Sector-Based Stock Index Funds
Sector-based exchange-traded funds are baskets of top-performing stocks in a certain industry, such as the Healthcare, Consumer Discretionary, or Financial market sectors.
Bond Market Index Funds
Bond index funds replicate the results of a certain bond market, whether it be corporate or government bonds.
Why Index Funds Are Better Than Actively Managed Funds
If index funds are a type of mutual fund, then why are the two referred to in separate terms? Aren’t they the same investments? Not exactly.
Generally, the term “mutual funds” is used to refer to actively managed mutual funds. Actively managed funds, aka “active funds”, include a basket of stocks that are selected and consistently rebalanced by a team of analysts and fund managers.
Unlike active funds, index funds only require passive management since they seek to mirror a certain financial market index. An actively managed fund, however, attempts to beat the market and achieve even higher capital gains.
Because of the extra work required, active funds tend to have higher expense ratios than the average index fund. The idea is that it's worth paying a little extra for a fund manager to regularly rebalance the fund in hopes of achieving higher gains.
But is it, though?
Back in 2008, Warren Buffett bet a major mutual fund company that the S&P 500 could beat their actively managed selections over the course of ten years. Despite the fund manager's best efforts, Buffet won the bet in the end.
As Paula explains, “Almost nobody has consistently been able to beat the market over time. And even fund managers who have beat the market for a number of years, on average, tend to what’s called revert to the mean. Which means that even fund managers that have outperformed…eventually, they go back to average.”
How Fees Affect Your Portfolio's Growth Over Time
Many investors buy index funds because they typically offer even better returns than active funds – and at lower costs. That’s why it’s always important to take a good look at a fund’s expense ratio.
While expense ratios can vary widely, even the difference between a 1% active management fee and a 0.5% index fund fee can be substantial in the long run.
“That may not sound huge,” Paula explained, “But if you imagine your returns being chipped away by 1% compounding over time, as compared with your returns being chipped away by 0.5% over time, that adds up.”
Plus, the top index funds tend to offer low fees without the hassle of having to search for a fund manager with a solid track record. Because, as Paula wisely reminded us, “Picking a fund manager is itself a skill.”
Are Index Funds a Good Investment?
At the end of the day, it’s definitely worth talking to a certified financial planner about whether investing in index funds is the right choice for you. In the meantime, here’s a breakdown of some of the pros and cons of adding a few top index funds to your portfolio.
The Pros of Index Funds
- They are a solid way to mirror the performance of a broad financial market or sector.
- Due to their emphasis on diversification, there's no need to constantly track individual stock prices.
- Many of the best index funds offer low costs, low expense ratios, and no investment minimum.
- They make an excellent investment strategy for long-term investors of all experience levels.
- They typically offer a slow but steady return.
The Cons of Index Funds
- Investors who purchase index funds tend to do so as part of a long-term passive management strategy. If you're looking to get rich overnight, then the index fund is definitely not for you.
- You'll still be subject to the performance of whichever index your fund tracks. This means that the value of your shares will also take a dip during bear markets.
Final Thoughts on Why Index Funds Are a Good Investment
Hopefully, this info from Paula Pant and I has helped give you more insight into index funds and how they work. Be sure to take advantage of the wealth of financial wisdom that Paula has to offer when you follow her Afford Anything account on Instagram!
While you're in the neighborhood, check out our great collection of financial resources or head over to the Marriage Kids & Money blog for more tips on how to build a successful financial future for your family.
Guest Bio – Paula Pant
Paula Pant is a podcast host, writer, speaker, and media commentator on financial independence and real estate investing.
She is the creator and host of the Afford Anything podcast, which has more than 11 million downloads and 2,100 reviews and is ranked by Apple Podcasts as one of the Top 50 Business podcasts.
She is frequently quoted in financial media including Forbes, Kiplinger, Lifehacker, The New York Times, PBS, Marketplace Money, The Washington Post, The Globe and Mail, Inc Magazine, Yahoo! Finance, Business Insider, The Simple Dollar, Get Rich Slowly, AssetBuilder, Wisebread, the Huffington Post and many more.
Paula Pant Resources
- Website: AffordAnything.com
- Social: Twitter
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