Advantages of Index Funds

An index fund is a special type of fund that invests money in financial vehicles that make up an index. For example, a stock index fund that wants to replicate the stock market may buy all 500 shares that make up a stock index like the S&P 500 index. The value of this "copycat" index fund will change more or less in the same way as the S&P 500 index

A stock index fund will always move up and down close to the same amount as the stock market. You will never be disappointed that your fund performed much worse than the stock market. Index funds work to ratchet up or down in proportion to the market as a whole. When you read in the papers that the stock market went up 15% in any given year, your index fund will also be up about 15% if you had held that index fund throughout the entire year. This does not mean that an index fund will never go down in value. It only means it will go down in value at about the same rate as the stock market should the stock market decline. The benefit of index funds is that they are expected to perform as well as the market as a whole. Since over the long run the stock market is expected to go up, index funds are largely considered a good bet for investing.

Index funds have an additional benefit. As a rule, you pay a lot less in management fees for an index fund than you pay for a so-called "actively managed fund." Please click here to see how low fees impact you in the long run.

Vanguard, the largest fund manager of index funds, also charges the lowest fees. Other companies such as Schwab and T. Rowe Price offer index funds, but they usually charge higher fees that simply diminish your annual return.

If you are interested in index funds, I suggest that you discuss index funds with an advisor at Vanguard or another company. Take care to only discuss index funds and not "managed accounts". Fund management companies would like to get you into "managed accounts", because they can charge you fees for "managing" your savings on top of the management fees you pay for managing the fund itself. Once you have decided on a savings strategy, you do not really need your savings to be "managed". It is best to let such savings run on autopilot and to check on the performance and suitability of the savings strategy about once a year. The only time you may want to consider setting up a "managed account" is if you would like to get help with managing your savings. In this case, an account manager will help you allocate your savings, monitor its performance with you, as well as suggest and make any agreed-upon adjustments to the allocations.

Whenever you choose an index fund, you don't have to bother to choose a mix of individual stocks or mutual funds to perform for you. Using index funds will make investing in "the stock market" fairly simple. In addition, index funds tend to do better on average than mutual funds; so it makes your stock choice easier if you go with an index fund.

When you invest in stocks, I would first invest only in the US stock market and suggest only buying shares in an S&P500 index fund. Once you accumulate some savings, you may want to sell some of your US stock holdings, say 10 – 25% and put these proceeds into an international index fund. For a start, simplicity is a good recipe in this case.

The S&P500 index is a broad index of US stocks that has a great track record in the long run delivering fairly steady returns to investors. On the other hand, international markets are riskier, which is why it is better for inexperienced investors to hold off investing in international markets for a little while. However, mixing international index funds with an S&P500 index fund will likely make your returns steadier, since you will have your eggs in more than one basket. When the US stock market or the S&P500 index does not perform well, it is possible that international stocks perform better. This could still give you a decent return on your investment or cushion the decline in the US stock market a bit.

Index fund companies such as Vanguard also offer bond index funds and money market index funds. Investing in these other index funds allows you to get exposure to three of the most important ways to to save your money, and you can do it all with just one investment management company.