Investing in Low-Cost Index Funds

Why Many Investors Have These in Their Portfolio

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As you embark on your journey to build wealth through mutual funds, you may wonder which to choose: actively managed mutual funds or passively managed mutual funds. If you are new to investing, the idea of a passive fund might seem odd, maybe even lazy. In fact, the idea of paying a trusted fund manager to monitor and trade your investments might seem like a better option if you're not quite sure what you're doing, but the choice isn't quite that simple.

Here are some reasons why you might want to think about passive index fund investing as a long-term strategy.

What Is An Index Fund?

Before you add an index fund (or any other investment) to your portfolio, you should know what it is and how it works. An index fund is a mutual fund or exchange-traded fund (ETF) designed to mirror the performance of a major index like the Dow Jones Industrial Average, S&P 500, or Nasdaq. When you purchase a share in one of these funds, you are actually buying a small piece of a number of stocks at once.

Index funds are passively managed. This means the fund manager picks an index to track and then simply copies its holdings. They may check in when the index has changed its holdings, or some other major event, and rework the balance of your holdings. But for the most part your portfolio will stay as it is.

For instance, an investor that buys a Vanguard S&P index fund designed to mirror the S&P 500 will adopt the S&P risk. When the S&P gains, then the investor's S&P index fund will rise by almost exactly the same amount. When the S&P falls, their portfolio will suffer the same decline.

In funds that are actively-managed, the fund manager plays an active role in choosing stocks. They study many single stocks (and the market as a whole) based on complex factors, and make choices and trades to try and do better than an index. Of course expert advice comes with a price tag.

How Index Funds Can Help You Skip the Analysis

Index funds are ideal for those who are new to the market, and who may lack the skills or knowledge to assess a company's finances or compare corporations. With an index fund investment strategy, you don't need to pour over income statements from a balance sheet. You don't need to calculate discounted cash flows or any analysis ratios. In fact, if these terms seem daunting, rest easy because you can simply follow the lead of an index.

Diverse Holdings

The point of watching all these metrics in the first place is to avoid placing your money with risky companies. With an index fund, you don't need to worry too much about the risk from a single company. This risk is reduced by the fact that you're buying dozens or even hundreds of companies with a single fund share.

How Index Funds Can Help Lower Your Costs

Actively managed mutual funds rely on a team of managers and analysts that decide what trades to make. All of these people must get paid, and even if a single fund manager handles most of the duties, the fees will still add up. Your costs amount to a percentage of the fund's assets each year, and they are taken from the fund before you receive your share. This is known as the expense ratio.

Small Expense Ratios

Index funds may have a manager, but that manager will do far less. All they have to do is check in on the holdings form time to time, and ensure that they still mirror the underlying index. Since they do less, these managers get paid less. This means that you can reduce the amount of your portfolio that goes into a fund manager's pocket. This effect compounds in the long run.

For a closer look at fees, take for instance Vanguard's passive index fund that tracks the S&P (VOO). The expense ratio of this ETF is only 0.03%. Compare that to Vanguard's Growth and Income Fund (VQNPX), which attempts to beat the S&P 500 and comes with an expense ratio of 0.33%.

No Broker Fees

Another way that index funds save you money is how they reduce brokerage commissions. If you wanted to replicate the portfolio of an index fund (without simply buying shares in the index fund), you would have to buy all those companies on the index, one by one. That could mean dozens or hundreds of trades, which would not only cost a large amount of cash, but would also be charged a broker's fee for each trade.

How to Combine Dollar-Cost Averaging With Index Funds

Index investing works well with a dollar-cost averaging strategy. This is a tactic that consists of making small and steady investments over the long-term, and sticking with it, no matter how the market is doing. In practice you might buy a few shares of a single stock (or fund) at frequent intervals. When stocks are up, you buy. When stocks are down, you buy. The goal is to reduce risks related to market timing by investing regardless of how stocks are performing.

This concept of spreading market timing risk is much like that of spreading the company-specific risk. Combined, even the most inexperienced investor can develop a well-balanced portfolio that doesn't expose itself too heavily to any one risk.

Key Takeaways

  • Index fund investing uses passively managed funds to invest in major stock indices.
  • You won't need an in-depth knowledge of accounting, financial theory, or portfolio policy, to invest in index funds.
  • You can count on a diverse array of holdings, since index funds contain dozens or hundreds of companies. This diversification reduces company-specific risk.
  • Index funds have very small expense ratios, which provides a major edge over actively managed funds. The money you save on fees will compound over time, and add to your fund's gains.