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 investing in mutual funds, you may wonder which to choose: actively managed mutual funds or passively managed mutual funds. The idea of a fund manager actively monitoring and trading your investments might seem like a better option, but the choice isn't quite that simple.

Here are some reasons why you should consider 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, it's important to understand what it is. 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.

Index funds are passively managed—the fund manager picks an index to track and simply replicates the holdings. These holdings are rebalanced only when the index has changed its holdings. That's as opposed to actively-managed funds, in which the fund manager evaluates individual stocks to try and do better than an index.

For example, an investor that buys a Vanguard S&P index fund designed to mirror the S&P 500 will add S&P exposure to their portfolio. 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, that decline will be replicated in their portfolio.

Skip the Corporate and Financial Analysis

Index funds are ideal for those who aren't confident in their ability to evaluate business 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.

The point of doing all those calculations is to avoid investing in risky companies. However, with an index fund, the company-specific risk is already reduced—you're buying dozens or hundreds of companies with a single fund share.

Lower Your Costs

Actively managed mutual funds utilize a team of managers and analysts that decide what trades to make. All those people must get paid, and even if a single fund manager handles most of the duties, those fees will still add up. These costs are known as the expense ratio—the percentage of the fund's assets that the managers take every year as payment.

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

For example, consider Vanguard's passive index fund that tracks the S&P (VOO). The annual 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%.

Another way that index funds save you money is how it reduces 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. That could mean dozens or hundreds of trades, which would require significant cash and would also introduce more opportunities for brokerage fees.

Combine Dollar-Cost Averaging With Index Funds

Index investing works well with a dollar-cost averaging strategy. This strategy involves consistent investments over the long-term—both in terms of dollar amounts and how often the investments are made. The goal is to reduce risks related to market timing by investing regardless of how stocks are performing. When stocks are up, you buy. When stocks are down, you buy.

This concept of spreading market timing risk is similar to 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 involves using passively managed funds to invest in major stock indices.
  • One benefit of index funds is that they do not require corporate analysis or an understanding of accounting, financial theory, or portfolio policy.
  • Another benefit is that these funds contain dozens or hundreds of companies. This diversification reduces company-specific risk.
  • A third benefit is that they have almost non-existent expense ratios, which provides a significant competitive edge over actively managed funds and improves long-term performance.