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|If you view your local newspaper's financial page as an imposing collection of numbers too confusing to make sense of, let alone to make use of, you are not alone. Many people decide that successful stock investing is beyond their grasp, so they decide to park their hard-earned investment dollars in less profitable investments such as bonds and certificates of deposits (CDs). But you do not need to understand the inner workings of the financial market to do well on Wall Street. Index investing is a very simple, yet profitable approach to stock investing that anyone can understand and use. |
It may surprise you that between 60% and 80% of the managed stock mutual funds underperform the stock market as a whole. This means that if you simply take the "buy the whole stock market" approach to investing, your return on investment will be better than most of the managed funds. With certain caveats, index investing is investing in the whole stock market.
HERE'S HOW IT WORKS
Here's how index investing works. Let's pretend that there are only 100 stocks in the entire US stock market and you can either invest in an actively managed fund or an index fund:
The index fund manager doesn't pick and choose from the 100, but rather buys a small portion of all 100.
The beauty of index investing is in its simplicity. You don't need math skills. You don't have to worry about who your fund manager is. You just buy into the whole market.
BUT WHICH MARKETS?
But how do you find the best index funds? Here are a couple of golden nuggets I have unearthed:
Golden nugget 1:
When investing, don't go for a win. Go for a tie instead. Index investing is an investment strategy that tries to mirror the performance of the stock market, or sector of the market, without any bias to whether a stock is undervalued or overvalued. It is made up of all the stocks within the group, or a sampling of enough stocks that will accurately reflect the group.
Index funds are tied to indexes that adhere to this unbiased view on stocks. Mutual fund manager Peter Lynch states in his book Beating The Street, "Over the last decade, up to 75% of the equity funds have been worse than mediocre, failing to outperform the random baskets of stocks that make up the market indexes, year in and year out."
Golden nugget 2:
If you're trying to get rich with bonds, you are wasting a lot of time. Let's suppose you have $100,000 to invest and your dream is to one day become a millionaire. If you invest your money in bonds, which have traditionally given its investors an annual return of 5%, you will reach your goal in 47 years. If, on the other hand, you buy stocks that traditionally yield an annual return of 11%, you will reach your goal in 22 years: in less than half the time.
The word you will often see trumpeted for a sound investment portfolio is "diversification." Diversifying in stocks is good; that's what index investing is all about. Diversifying with bonds is bad. It's "di-worse-ification." The more bonds you add to your portfolio mix, the worse your returns will be over time. A portfolio divided equally between stocks and bonds would be worth about $643,000 in 22 years, or $357,000 less than the portfolio that consists of only stocks. You can have a healthy, happy, and diversified investment strategy without any bonds. This is where index investing really shines.
When you buy into an index fund, such as one that tracks the Standard & Poor's 500, your investment is spread out over 500 companies in utilities, energy, financial, industrials, durables, staples, services, retail, health, and technology. This weighting over many companies in different market sectors creates its own ballast without hindering performance. It's the smart way to invest.
ADVANTAGES OF INDEX FUNDS
Index funds have several built-in advantages over managed funds. Here are some advantages you will enjoy when you invest in an index fund:
Should you invest over a course of years, your investment journey will be an experience of many different things. The world will change. The market will have its sunny side as well as its rainy one. But when the fog lifts, index investing will still be there. Index investing will stand the test of time because it is built upon timeless investment principles. If you are patient and stay the course, you will be richly rewarded.
— Eric Witkowski
REFERENCESLong-Term Government Bonds, 192699. SBBI Yearbook, 1999. Rate rounded to the nearest whole percentage.
Lynch, Peter . Beating The Street, Fireside Books/Simon & Schuster.
S&P 500 Index, 192699. SBBI Yearbook, 1999. Rate rounded to the nearest whole percentage.
A FEW INDEX FUNDS
Total Stock Market Index Fund
Vanguard Total Stock Market Index
Phone: 800 523-0790
Index tracked: Wilshire 5000
Trading symbol: VTSMX
Minimum initial investment: $3,000.
Minimum initial investment for an IRA: $1,000.
Large Cap Index Fund
Dreyfus S&P 500 Index Fund
Phone: 800 645-6561
Index tracked: S&P 500
Trading symbol: PEOPX
Minimum initial investment: $2,500
Minimum initial investment for an IRA: $750
Mid Cap Index Fund
T. Rowe Price Extended Equity Market Index Fund
Phone: 800 225-5132
Index tracked: Wilshire 4500
Trading symbol: PEXMX
Minimum initial investment: $2,500
Minimum initial investment for an IRA: $1,000
Small Cap Index Fund
Northern Small Cap Index Fund
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