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!