We've introduced many topics in this tutorial:
- Investing is about making your money work for you.
- Reinvesting your earnings allows you to take advantage of compounding.
- Each investor is different in his or her objectives and risk tolerance.
- There isn't just one strategy that can be used to invest successfully.
- Each investment vehicle has its own unique characteristics.
- Diversifying investments in a portfolio helps to manage risk.
For our example, let's look at a fictional investor named Melanie. Melanie is a twenty-something who is relatively new to investing. Melanie knows that she wants to invest, but isn't sure just how to do it. Her knowledge of finances is good, but she has no desire to spend her free time poring over financial statements (or losing sleep because of her investments).
After checking out this tutorial and reading more about stocks and mutual funds, Melanie learns that there are two basic styles of portfolio management: passive and active. Each of these styles results from a different approach to the market. The goal of active management is to select securities that will perform better than the overall market. For example, when a mutual fund manager analyzes a company's financial statements to determine if the stock is suitable for the fund, he or she is actively managing the portfolio.
A passive investor on the other hand has no desire to try to beat the market. Instead, relying on the stock market's history of increasing over the long term, the passive investor, perhaps believing that trying to beat the market is too much work or even futile, will simply purchase a security such as an index fund, which mirrors a benchmark used to track the performance of a market.
Melanie decides that passive investing is more her style, so her investment vehicle of choice is the S&P 500 index fund. This is a mutual fund that is indexed to the S&P 500, which is composed of the 500 largest companies in the U.S.
Why an index fund?
- Buying an index fund is passive investing, so Melanie is still free to have a life and doesn't have to worry about picking stocks.
- Melanie gets instant diversification (because the fund owns many different kinds of stocks) without having to invest huge sums of money. Most index funds can be set up with an investment of $1,000 or less.
- Most importantly, the fees are far less than the cost of the average mutual fund. These lower fees are another advantage of passive investing. Because the fund does not have to pay some hotshot (and expensive) MBA fund manager to pick stocks, an index fund is often cheaper than any other mutual fund. (For more on this, see the Index Investing tutorial.)
Putting the Concepts to Work
And that's about all there is to it. It's pretty simple stuff, actually. And despite the ease of setting up a strategy like this, it allows Melanie to follow all the principles we've been discussing:
- Her money is definitely being put to work, and she is becoming part owner of the 500 biggest companies in the U.S.
- With no additional work on her end, she can reinvest all the money that gets paid out in dividends, which allows her to see the benefits of compounding over time, even more so if she sets this fund up in a retirement plan that allows her investment to grow without being taxed immediately
- It's easy! This fits Melanie's preference to avoid the work of picking stocks. Those who do want to develop an eye for stocks, however, can get started with an index fund and then eventually work their way into more active strategies over time. (For further reading, see Guide to Stock Picking Strategies.)
- A strategy like this can be molded to meet an investor's objectives and asset allocation. In Melanie's case, she has a time horizon of more than 20 years, so she is comfortable being completely in equities. If an investor is not comfortable with being just in stocks, it's easy enough to buy a bond index fund. It would still offer the low costs of indexing, and allow you to customize your asset allocation. (For more on this, see Being Lazy With A Couch Potato Portfolio.)
Perhaps most importantly, indexing in the long term doesn't do any damage. There are plenty of ways to lose money, whether in speculative investments or through excessive fees in mutual funds. On the other hand, it's possible to be too risk averse. If you put your savings under a mattress, we guarantee it's not going to increase in value.
There are many other alternatives out there. We strongly encourage you to explore them and see what works for you. But, for the average investor, the smart route includes saving regularly, keeping investment expenses down and being in the market for the long term. Whatever you do, keep the principles we've discussed in mind, and never stop trying to learn more.
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