Index funds: Passive investor’s paradise

Fernando J. Saballos, Contributor

Instead of trying to beat the market (actively looking every day at businesses’ stocks and predicting individually how they will do), investors should employ an investment strategy known as ‘indexing” via the index fund.

An index fund is a mutual fund that seeks to replicate the performance of certain market indeces. Indexing is a passive form of fund management that has been historically successful, consistently outperforming most actively managed mutual funds in terms of returns and risk. While the most popular index funds track the S&P 500, a number of other indeces, including the Russell 2000 (small companies), the DJ Wilshire 5000 (total stock market), the MSCI EAFE (foreign) and the Barclays Capital Aggregate Bond Index (total bond market) are widely used for index funds.

The passive minded investor can reap great reward from opting to go the index route. Warren Buffett, the second wealthiest man in America and arguably the most well regarded investor of our time, is a major activist for passive investing. He admires and supports this strategy as it lends equal opportunity for investors of any income level. Buffett tresses the importance of the four E’s. He has said, “The greatest Enemies of the Equity investor are Expenses and Emotions.”

The returns may not be astronomical, but the risk pales in comparison to individual stocks or bonds. Compared to actively managed mutual funds, the fees are significantly lower. With passive investing, there is significantly less activity. The reduction of trading and management oversight reduces the fees charged. The average expense ratio for an S&P 500 index fund is below 1 percent compared to active funds that can get upwards of 2 – 3 percent that could also charge higher commissions and other fees at the discretion of the fund manager. While the spread appears small, remember the index fund is encouraged for a long-term investment. Over 30 years that spread will increase and significantly cut into gains.

So, how do you invest in an index fund? Brokers such as Charles Schwab Inc., Fidelity Investments, and The Vanguard Group notably offer their own variations for the several major market indices mentioned above. Typically, there is a minimum investment amount, but subsequent investments can be less. There are rarely commissions, making it even more cost-effective to invest at your own convenience. In addition, many index funds might be available for investment via your job’s 401k plan, in which a portion of your paycheck goes towards ownership in shares.

If you are interested in learning further as to why index funds are a great investment product for people of all ages, risk levels, and wealth, I recommend you read The Little Book of Common Sense Investing by John Bogle.