The other day I talked a little bit about investing in my Intro to Investing post. In that post I talked a little bit about what investing in the stock market is and some basic things you should know before you start. One of the things that I mentioned was index funds. These are a great way to get started in investing. They offer a great way to protect your money and still see growth in the long term. Today I’ll go over what they are and how to use them as well as why you would want to.
First, index funds are a special type of mutual fund. A mutual fund is an investment that just combines the money from a lot of investors, then uses that money to buy a bunch of different investments. Mutual funds usually have a theme. For example, there are mutual funds that invest in tech stocks. Those funds collect all the money from people that want to buy in. Then they use that money to buy stocks in companies like Google, Facebook, Apple, and other technology companies. There are also mutual funds that invest in healthcare companies, banks, utilities and just about any other type of investment you can think of.
Mutual funds are run by professional money managers. They evaluate the different investment options and buy and sell to meet the fund’s goals. Typically this means that the fund managers evaluate the profitability of different companies in the fund’s theme to find the best way to allocate the fund’s money to both maximize the potential profit and minimize the risks.
Mutual funds have several advantages. The two greatest are security and expertise. Mutual funds typically invest in a large number of companies at once. In many cases hundreds or thousands of companies. This is very difficult to do when you are just starting out and don’t have millions of dollars to invest. This type of diversification can protect you in the case where one company goes out of business. If you can only buy three stocks if one company goes out of business then you could lose a third of your money. However, if you have a mutual fund that owns stock in hundreds of companies then the loss of one company won’t be noticed as much since the growth of the others will typically offset the loss. The mutual fund managers are typically experts in their field. They know a lot about the industry that they are investing in. They also know a lot about the companies they are investing in. They stay current on industry trends and read the financial reports published by the companies. This makes them uniquely qualified to pick appropriate investments in their industry. This can help because they will have a better understanding of how a company is making their money as well as the future prospects that company has. This means that they can more wisely pick how they will invest the mutual fund’s money.
There are a few disadvantages to mutual funds. They can offer a false sense diversification, and they can grow less than other investments. While mutual funds invest in a lot of different companies and offer security against one company failing, mutual funds don’t offer protection against the group failing. For example, if you owned a mutual fund invested in oil stocks and the gas price drops then the price of the mutual fund will drop as well. So the fund protects you from the failure of one company, but not the drop in an entire sector. You can protect yourself from this by investing in more than one type of mutual fund. And it may be a good idea to sell the fund entirely if an industry is going away. The other major disadvantage is that they may grow slower. This is because not only do all the high performing companies make up for the low performing companies, but the low performing companies do drag down the high performing ones. So, by investing in a mutual fund you will have a lower return than if you invested completely in the high performing companies. The problem with this is that it is nearly impossible to predict who the high performing companies are 100% of the time. It’s also impossible to know when to sell and move on to the next company. Most people will accept slightly lower returns for the protection of diversification.
Index funds are a special kind of mutual fund. Like mutual funds they invest in a lot of different companies. The thing with index funds is that they tie themselves to a particular index. For example, there are S&P 500 index funds. These funds simply buy each of the companies in the S&P 500 using the same weighted average that the index uses. This means that the fund will go up and down pretty much matching the index. And since the S&P 500 has historically gone up and average of 9-10% a year, your investments will too.
There are several advantages to using index funds. In addition to the advantages of using mutual funds the biggest advantage of using an index fund is cost savings. Since index funds track an existing index the fund managers don’t need to do extensive research on companies, or spend as much time on managing the investments. They simply buy the stocks based on the index. Since most of the time-consuming work is done for them the fees for index funds are typically very low. The reduced fees result in greater profits. Most actively managed mutual funds have fees that are many times the amount of the index funds. The returns on index funds are also more reliable. Since many indexes have been around for a long time it is easy to see how the indexes have grown on average. This is a good indication of how the index fund will grow.
Index funds do have some disadvantages. The main disadvantage is that index funds track very large trends. This means that they rarely see big growth. So while growth will be more predictable than most other funds the growth won’t be as high as some funds. Index funds are also tied to what is in the index. Even if a fund manager knows that a company is doing poorly they can’t sell the stock as long as it remains in the index. For example, during the dot-com boom and bust the Nasdaq was heavily technology companies. So a Nasdaq index would have been heavily invested in technology stocks. As the bust happened any Nasdaq index fund would have held onto the stocks of those failing companies until they were removed from the index. An actively managed fund could have sold those stocks earlier.
When it comes down to it mutual funds in general and index funds in particular are great investments for first time investors. This is where I wish I had started years ago when I first started investing. Instead, I bought several random stocks I thought looked good. Most lost money. If I had invested in an index fund like the S&P 500 then it would have gone up and down over the years, but in the end would have grown 9-10% per year.
Index funds allow you to invest in a lot of companies which protects you from any one company failing. It also lets you see more predictable growth with your money. You don’t have to worry about trying to read a company’s financial statements. You don’t have to worry about picking the right company among the thousands of companies selling stocks. You just have to pick an index that historically grows. One example is the S&P 500. These are the 500 biggest companies in the US. Companies like Apple, Coca-Cola, and 3M. There are several index funds that track this index. Another is the Russel 2000. This index tracks small companies. They tend to have higher growth, but they are also more volatile. So you’ll see lots of dips and lots of spikes. For new investors and people who don’t want to spend their time studying financial reports this is definitely the way to go.
Do you invest in index funds? What do you think about it?