What are index funds? Are they as glamorous as they sound? Can it be possible?
These 2 stylish dressers know something about glamour as anyone can clearly see
Yes, they're pretty much as glamorous as they sound. I've got my work cut out for me to make this interesting, but I will try. Index funds are a type of mutual fund that track an index, like say the S&P 500. But what does that mean, you may ask? And while we're at it, what exactly IS the Standard & Poor 500?
The S&P 500 is a group of 500 large stock companies that are tracked as a group. Together they are an indicator of how well the US economy is doing-- in terms of large business in all kinds of industries, that is. These companies were specifically selected to be in this special group because together they offer a decent representation of the US market. In fact they represent about three quarters of it! That's a pretty sizable chunk.
You have heard of many of these 500 companies: Apple, Bank of America, the Walt Disney Company, Under Armour, Starbucks, PayPal, Coca Cola, Mattel, and General Motors are just a handful in this group. As an investor in an S&P 500 index fund, you can own shares in all 500 companies without having to buy each individual stock. That would be a hefty amount of stock trades for one individual (or at least for me). Even at $7 a trade, the bill would be insane!
Not to mention that some stock prices start at hundreds of dollars per share, meaning you'd need a whole big stash of cash to do anything like that. People starting out usually just aren't overflowing with cash. For example, Chipotle Mexican Grill Inc closed today at $470.97 per share. So if you only have a small amount of money to invest, that's quite a bit of money. If that seems a bit steep for you, consider Berkshire Hathaway A. It closed at $215,450.00 a share today. Yes, you read that right. That's for 1 share. It's not part of the S&P 500, but Berkshire Hathaway B is. It's a LOT less pricey! It's closing price was $141.88 today.
Index funds offer a huge amount of diversification for you as an investor. The great thing about this is that if one stock is having a bad day, it is offset (hopefully) by those doing well. Historically the S&P 500 has had returns averaging 10% or more. Keep in mind that is of course over decades. Make no mistake-- that kind of return is not a sure thing in any given year. In 2015 the S&P 500 index had a -0.73% return. Yuck. That's not exactly awe-inspiring. But in 2013 it was nearly 30%!! Nice!
What are the total 500 companies that comprise this index? They can be viewed here:
So that's an example of one index that gets tracked. There are also mid-sized companies that get tracked as well as small companies, and so on. Accordingly, you can invest in mutual funds that will follow these. There are even total stock market index funds, which offer investors exposure to the entire US stock market.
There are multiple reasons index funds are of interest to investors. First, following an existing index like the S&P 500 makes an easy job for the manager of the fund. He/she just trades stocks within the index, and offers a pre-defined package of stocks for sale in one convenient package with no fuss or muss. By fuss or muss, I mean the research is done for the manager, as the fund is comprised of a set group of stocks that varies only under certain circumstances.
What are reasons the S&P 500 companies themselves could vary? From time to time each individual company may be going through some sort of change. For example, companies themselves may be bought or sold (often to one another), some may decrease in value, while others change their name, and so on. But for the most part it's pretty stable in terms of the 500 companies.
The manager of an index fund doesn't have to study each company and make selections based on personal research. This is why index funds are inexpensive-- they aren't labor intensive on the part of the manager. Their time & effort savings gets passed on to you.
There are no free rides with any mutual fund, but index funds will save you money!
Second, index funds often outperform many actively managed funds. The work, research and additional fees of experts hasn't historically always translated into more money for investors. So index funds are hard to beat in returns as well as fees.
Third, index funds are relatively tax efficient. The companies within them aren't sold like they might be in actively managed funds. This keeps turnover (mentioned in my previous blog post) low.
For you history buffs, index funds were created by Vanguard founder John Bogle in 1975. Bogle had 8 guidelines for mutual fund investors, which I will condense here:
Eight Simple Rules for Mutual Fund Investors
1. Consider the cost of advisors and decide if they're worth the expense.
2. Don't put too much faith in past fund performance...
3. ...but DO use that information to determine risk and consistency over time.
4. Don't get caught up believing that superstar fund managers can do the impossible.
5. Buy and hold (don't be a frequent trader).
6. Be careful when an actively managed fund gets too big (this is why many funds close to new investors at a certain point). The more people who buy into an actively managed fund, the more likely it can stray from its original goals AND become less cost-efficient.
7. Don't buy too many funds, however alluring that idea may be.
8. Buy index funds to keep fees low, diversify and stay tax efficient.