Investing Personal Finance

Index Funds: Set-It-and-Forget-It Investments

Written by Beth Trach

Index Funds: The Ultimate Set-It-and-Forget-It Investment

If you’ve been working hard to pay down your debt, improve your credit score and build up your savings account, you might be ready to think about the next step in your financial journey. If you have a job with even a little bit of extra income that allows you to invest, you should take advantage. When your money grows on its own, you reap all the benefits of compounding interest to build your savings exponentially faster than you would just by keeping it in a low- or no-interest checking account, so it makes sense to up your game when it comes to investing.

Nervous about investing in the stock market? That’s understandable, especially considering how volatile things have been so far this year. All those ups and downs can be terrifying if you’re following along, just watching your account balance go on a rollercoaster ride. After all, no one wants to lose their principal and walk away with less money than they started with — a real risk with stock investments that, unlike your bank’s savings account — aren’t FDIC-insured.

Enter the index fund. No, they don’t come with any kind of guarantee of success, but they do promise that you won’t do any worse than everyone else when it comes to your investment returns. For a low-key investment that doesn’t require you to track its performance, Index funds are the way to go. Here’s everything you need to know to decide if they’re right for you.

What Are Index Funds, Anyway?

An index fund is like a mutual fund, which is basically a big pile of stocks from individual companies that you buy into. When you buy a share of a mutual fund or index fun, you get a tiny piece of lots of different stocks, so your investment is automatically diversified and not toed to the fortunes of a single company.

Most mutual funds are made of up certain types of stocks, and they have a financial manager in charge. It’s this person’s job to research the market and make their best guesses about what’s going to happen next, buying and selling as needed to try to make the most money possible.

An index fund, on the other hand, is designed to perform the same way as an existing index — typically the S&P 500. All that means is that an index fund will have a broad balance of stocks and be passively managed to keep going up and down in the same pattern as the stock market at large. When the market does well, you benefit. It’s basically like buying one of every available stock so you have the whole market in your pocket.

The Index Fund Philosophy

The main thing that sets index funds apart from other mutual funds is that no one is trying to “beat the market.” With a mutual fund, the manager’s reputation — not to mention their annual bonuses — are on the line, so they work hard to make the right trades at the right time to sell when the market is up and buy when it’s down to keep shares of the mutual fund worth a lot.

An actively managed fund is great if the manager is making money, but most mutual funds don’t do better than the market. Certain funds might do well for a few years, but eventually the law of averages takes hold and, over time, the fund has diminishing returns.

This is why financial gurus like Warren Buffet recommend index funds for the average investor. If you’re not going to beat the market with a fancy mutual fund, why play that game? That’s an impossible task, because even the best fund managers are really just gambling and playing hunches after a while. No one can predict the future to know which companies are going to thrive, and when.

The Secret Advantage of Index Funds

In addition to giving you a nicely diversified slice of the entire stock market — and the promise not to do any worse than the stock market as a whole — index funds have one major advantage that makes them a secret weapon for savvy investors: low fees.

Because an index fund doesn’t have a hot-shot fund manager steering the ship, it costs a lot less to run. Those savings are passed directly to the investor in the form of low fees. Brokerages charge fees based on a percentage of your gains, so if the market goes up by 7 percent but your fees are 2 percent, you’ve only made 5 percent — and that can add up to thousands of dollars over the years.

Index funds, on the other hand, have very low fees — typically under half a percent, and sometimes less than a tenth of one percent. That means that you get to keep most of your earnings, and you’ll enjoy faster compounding of your interest and better growth if you stick it out for the long haul.

How to Get Started

If you already have an IRA or 401(k), you should be able to invest your money into index funds to reap the benefits of their lower costs. Not all index funds are created equal, so be sure to compare their expense ratios as you shop — you’re looking for the lowest number you can find.

If you don’t have a retirement account, start one! It’s the easiest way for most people to get involved in the stock market, and you’ll have a tax-advantaged investment vehicle to get you started, which is much better than diving into the market with a standard brokerage account — and the capital gains taxes that will come with it.

It’s also worth noting that index funds can be expensive to trade, with fees for buying and selling. You can avoid commissions by choosing your brokerage’s own index fund whenever possible, and you should invest in index funds for the log game: Day trading or frequent buying and selling will get pricey, and that defeats the purpose. Besides, the whole point is to embrace simplicity and accept the fact that you, a mere mortal, cannot beat the market, so buying and holding is your goal.

Have you given index funds a try? Let us know in the comments!

About the author

Beth Trach

Elizabeth Trach is a writer and editor living in Newburyport, MA. She also sings in a band, grows almost all her own food, and occasionally even cooks it. You can catch up on all her adventures in frugal living and extreme gardening at Port Potager.

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