Investing in Index Funds

Passersby watch as the stock numbers are posted at the close of the market on the Nasdaq building in Times Square.
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Successful investing involves many factors, and often depends on avoiding major mistakes. You need to acquire a diversified holding of assets with promise (and at good prices), hold them in a tax-efficient way for a long time (often spanning 25 years or more), and let time and the market do the rest. Index funds are a tried and true way for investors to harness this approach.

Index funds are designed to track either a single index or the stock market's performance as a whole. Because there are no active managers trying to "beat the market," index funds can often provide strong returns at a very low cost.

Save Money With Low-Cost Index Funds

Most types of sponsored or managed funds or accounts charge fees to cover the work of their brokers or managers. It follows that those with less hands-on work cost less to maintain. When you invest in low-cost index funds, the fees can be as low as 0-0.1% of assets per year, compared to 1-2% for other types of mutual funds.

To see this effect in action, suppose you have $100,000 in a Roth IRA or 401(k) that invests in index funds. You might pay around $100 in fees to the money management company. In contrast, you might pay $2,000 in fees if you had a more actively managed fund. Simply put, you could save an extra $1,900 per year. Over a longer time period, savings can add to hundreds of thousands, or even millions, of dollars.

What Will I Lose Out On by Paying Lower Fees?

At times, the higher fees may be worth the benefits you'll receive from managed funds. For example, in many cases an investment advisor or private wealth management firm will offer added value in the form of advice, tax strategy, risk control, and even help with such niche issues as estate taxes and generational tax transfers (e.g., use of family limited partnerships and liquidity discounts to get around gift tax limits). But, in such cases, you should be wary of expense ratios over 1%, or paying more than 1% per year in fees. 

An expense ratio measures the amount that fund holders pay to fund managers annually, expressed as a percent of the fund's total assets.


What Upfront Costs Can I Expect to Pay?

If you are a small investor who wants to replicate the S&P 500, you take the DIY approach and directly buy shares of each of the 500 stocks. There's a reason people don't do this. To mirror a large index on your own, you would need to spend thousands of dollars in commissions to cover each fee of the many transactions, and invest millions of dollars. 

Many discount brokerages have started to offer index funds with small or even no minimum investment requirements. In 2018, Fidelity Investment made headlines when it began offering four index funds with no minimum investment and no transaction fees.

Low-Cost Index Funds Exist for All Asset Classes

Low-cost index funds have become so common that there are now funds that cover all types of investment mandates and asset allocations. You can invest in an index that tracks a certain asset class or sector of your choice, such as small-cap value stocks, consumer staples, energy stocks, and international pharmaceuticals. The expense ratios for these funds are often quite reasonable at less than 0.2%.

Are Index Funds Always Safe?

Not all index funds are built the same. There are index funds that are not suitable for new investors, such as those that hold assets in foreign currencies. For all intents and purposes, an index fund is no more safe or unsafe than the underlying investments that it holds. If you put 100% of your net worth in an index fund that favors junk bonds, for example, you are not truly diversified since you just own many securities within the same asset class.

When you own a passive index fund, you are investing in individual stocks, bonds, REITs, and more, but you do not have to research or follow each one, since the fund tracks how well the index performs as a whole.

The Perks of Passive Investing

Once you find the index fund that meets your needs and level of risk tolerance, the idea is to buy it so that you do not have to spend your free time in angst over any single asset. You don't have to decide whether Procter & Gamble is worth more than Colgate-Palmolive, or whether U.S. Bancorp is cheaper than Wells Fargo. You do not have to see your oil stocks go down 50% due to a glut in the commodity markets or global trade upset, your airline stocks go bankrupt after a major paradigm-shifting event, like the September 11 attacks.

In exchange for a small fee and trust in the index you invest in, you'll receive freedom from worry over every individual investment. And peace of mind can be a great asset for a new investor.