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Indexes are great tools for telling us what direction the market is taking and what trends are prevailing. So, how do we buy into these investment vehicles? Imagine the costs associated with buying the 6,500+ stocks that make up the Wilshire Total Market Index. Commission fees alone would run into the tens of thousands!
If you've been paying attention throughout this tutorial, you've probably noticed we mention index funds more than once. Index funds are simply mutual funds that based on an index and mirror its performance.
The thinking behind index funds has some academic substance to it. For years, many academics have been saying that it is impossible to consistently beat the market without raising your risk level - a theory known as Efficient Market Hypothesis (EMH). So in 1975, John Bogle took the stance that "if you can't beat 'em, join 'em" and created the first low-cost mutual fund that mirrored the S&P 500 index.
But, wait a minute. Isn't the whole purpose of mutual funds to coax us lowly investors into enlisting the help of professionals who can achieve superior returns? That's the idea the mutual fund industry has been trying to sell us for many years. The truth is that a majority of mutual funds fail to outperform the S&P 500. The exact stats vary depending on the year, but on average, anywhere from 50%-80% of funds get beat by the market. The main reason for this is the costs that mutual funds charge. A fund's return is the total return of the portfolio minus the fees an investor pays for management and fund expenses. If a fund charges 2%, then you have to outperform the market by that amount just to be even.
Here's where index funds enter the picture. Their main advantage is lower management fees than you would get from a regular mutual fund. An average non-index fund has an expense ratio of around 1.5%, whereas many index funds have an expense ratio of around 0.2%!
The reason the costs are lower is because an index fund is not actively managed. Fund managers only need to maintain the appropriate weightings to match the index performance - a technique known as passive management. The deceptive thing about the "passive" label is that most indexes are actively selected. Take the S&P 500, for example: when the index changes, it's almost like getting the S&P Index Committee's advice for free.
Investing in an index fund doesn't guarantee that you'll never lose money. You will go down in a bear market and up in a bull market. Historically, the return of the S&P 500 has been around 10-11%, which is pretty good. The key here is to hold on for the long term. If you get nervous during a downturn and sell, you'll probably miss the recovery.
Next: Index Investing: Conclusion »
Table of Contents
- Index Investing: Introduction
- Index Investing: What Is An Index?
- Index Investing: The Dow Jones Industrial Average
- Index Investing: The Standard & Poor's 500 Index
- Index Investing: The Nasdaq Composite Index
- Index Investing: The Wilshire 5000 Total Market Index
- Index Investing: The Russell 2000 Index
- Index Investing: Other Indexes
- Index Investing: Index Funds
- Index Investing: Conclusion
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