Investing for Beginners: Index Mutual Funds

Aug 7, 2014 11:19:20 AM / by Jason Shaw

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If you are new to investing, an index mutual fund is a logical place to begin.  Index funds have comparatively low costs and carry less risk than actively managed funds.  They obviate the need to pick outperforming stocks, since the fund’s purpose is simply to mirror its index through diverse investments.  Index funds also make it easy to maintain the asset allocation that is most appropriate for your needs.  Warren Buffet touted the virtues of the index fund in his 2014 letter to shareholders:  “The goal of the non-professional should not be to pick winners – neither he nor his "helpers" can do that – but should rather be to own a cross-section of businesses that in aggregate are bound to do well. A low-cost S&P 500 index fund will achieve this goal.”

Cost

Investing at a lower cost is a simple and foolproof way of increasing your return on investment.  Index funds are available at very low cost – sometimes just 10% of the cost of actively managed funds in the same asset class, according to Marketwatch.  Also, because index funds rarely replace the stocks and bonds they contain, turnover remains low, saving you in both transaction fees and capital gains tax.  All in all, Marketwatch claims that index funds can add 1-2% to an investor’s annual return in reduced expenses alone.

 

Performance

Index funds have proven to be steady performers over time, in contrast to actively managed funds.  A recent Chicago Tribune article reports data from the Vanguard Group that illustrate index funds’ outperformance of actively managed funds.  The Vanguard Group’s study indicated that last year, well over half of the actively managed funds in the U.S. performed below the average index fund for the same category of assets.

One reason for the performance of index funds is the wide diversification they allow.  Owning a broad assortment of stocks reduces risk and may increase return as well.  Another factor contributing to index funds’ performance is that, unlike actively managed funds, they tend not to keep investors’ money in cash.  Active fund managers need cash to enable them to purchase hot stocks and cover shareholder sales.  As a result, it is common for them to keep 2-10% of the portfolio in cash.  Marketwatch estimates that this can cost shareholders 0.5% of their annual return.

 

Simplicity

The simplicity of index funds makes them especially attractive to beginning investors.  Once you have chosen your fund, the only decisions you need to make are when to add or withdraw money and when and how to adjust your allocations.  A qualified financial advisor can help you decide the best allocation of assets for your portfolio, based on your age and financial goals.

An index fund makes it easy to set the asset allocation you choose and stick to it.  An actively managed fund seeks to chase the hot stocks and pick winners.  At some point, however, any actively managed fund will underperform, which often leads to emotional decision making.  According to Forbes, many investors respond to market fluctuations by buying and selling too often and at the wrong times, destroying their long-range returns.  An index fund should very closely mirror its index.  Over time, these funds have withstood the market’s ups and downs.  This relative stability helps take the emotion out of your investment decisions so you can have the discipline necessary to make wise choices.

 

Boelman Shaw Capital Partners in Des Moines can provide the knowledgeable investment planning advice you need to begin making your money work for you.  Contact us for a free consultation if you would like to discuss how we can serve your financial planning and investment needs.

 

Material discussed herein is meant for general illustration and/or informational purposes only.  Because individual situations will vary, the information shared here should be used in conjunction with individual professional advice.

Topics: Financial Planning

Written by Jason Shaw