How Index Funds Make Investing Easier
Index funds are a time-tested way to invest without becoming a full-time stock trader or spending a fortune.
Investing is a little like flossing in the world of personal finance - you've heard it's good for you, and you might even know how to do it. But when it comes to actually committing to an investment strategy, it's easy to get sidetracked, and eventually abandon the plan.
That's because smart investing, like flossing, doesn't provide many quick benefits. Just like you won't instantly cure a cavity with a little flossing, investing isn't a get-rich-quick scheme. When done correctly, it's not unlike any other savings plan: Slow and steady wins the race, although the end of the "race" might still be several decades down the line when you retire with much more extra cash than you began with.
"Index funds are a great fit for long-term savings."
This can be made possible with index funds, a time-tested way to invest without becoming a full-time stock trader or spending a fortune. When most people think of investing, it's assumed that individual companies are selected based on their past performance. This is one way to do it, but there are downsides to putting all your eggs in one basket. That's why professional investment managers will distribute money among a blend of many different stocks, effectively spreading out the risk and allowing for a better return. But figuring out which stocks to pick would be either too time-consuming or expensive for the average person.
Index funds solve this problem by investing in just one type of stock. Although you'll still have to give the money to a company to do so, their fees are often much lower than for managers who cherry-pick funds. And over time, they can actually perform better than most individual companies. For example, the Vanguard 500 index fund has consistently provided returns equal to the average of all stocks in the S&P 500. An investor who put $10,000 into this fund in 2006 would see it increase to more than $20,000 in value today.
All of the sudden, investing doesn't seem so bad. But before you can begin with index funds, it's important to get everything in order first. That includes establishing an emergency fund. According to the Financial Industry Regulatory Authority, it's important to set aside at least three months of bare-minimum expenses in a liquid savings account before undertaking any investment strategy. Keep these funds in your local bank as a "rainy day fund" in the event you lose your job, get hit with high medical bills or another unexpected expense.
Most importantly, don't begin investing in anything until this emergency fund is comfortably stocked.
Picking your fund
Although index funds are supposed to be a little easier than doing things the old-fashioned way, you still have many options to choose from. As Consumer Reports explained, there are at least 50 different funds that all track the S&P 500. To make things a little more confusing, these all can provide different net returns based on fees, taxes and other considerations.
- Where to begin? Consumer Reports suggested prioritizing low fees, especially if a passive, hands-off approach is what you're after. Some of the least-expensive funds will only charge about $1 for every $1,000 invested, whereas others may charge 10 times that amount or more.
- Tracking error vs. expense ratio: While these funds track the same index, they can deviate from the average due to fees. Look for the fund with a tracking error about equal to the expense ratio, which is determined by fee per dollar invested.
- Who's in control: The reason behind the variance in fees for investing in the same fund comes down to which company is managing it. Some are publicly traded, and thus aim for maximum returns. However, bigger companies may be more willing to offer investment advice and strategies in exchange for higher fees.
Once you've made your choice, feel free to make the minimum investment. Now, simply keep it parked for as long as possible. As interest builds up over time, you'll see your investment grow for practically no work. Stay current on your expenses and keep your emergency fund full, and you're well on your way to a comfortable financial future.