Investing In Index Funds

An index fund is a mutual fund designed to track a particular group of stocks known as an index (the S&P 500 is an example of an index). The overall trend of the stock market is up over the past 50 years and the general belief is that it will continue to go up over the long term (despite sharp setbacks like 2008). In the past, the market has gained significantly faster than the rate of inflation, making it a great way not only to build nominal wealth but real wealth as well.  Why is this important?  Because inflation plays a pivotal role in eating at the returns of fixed-income financial instruments like certificates of deposit. For instance, if your certificate of deposit only earned 1.7% in a year but inflation was 2.1%, did you earn any money? The short answer is no:  you actually lost money in real purchasing-power terms. Now, let us look at mutual funds in general.

There are quite a few well known mutual funds that have a sparkling reputation. Some of these are Janus, Fidelity and Oppenheimer funds. These names are familiar even to non-investors. These funds are simply famous. That fame was gained by earning 10% – 20% per year for many years. These funds are led by famous managers with highly reputed investment techniques. Investing in index funds is quite the opposite. Index funds are filled with every (or substantially all) stocks in a particular index.  If you were to buy an index fund (or index ETF) in the S&P 500 like SPY, then you would expect gains on the same magnitude as the S&P 500 average every year. If the S&P 500 gained 4% next year, then you should expect your index fund to also gain about 4% (actually just slightly less, because of expenses). If there is too large a difference between the fund and the average some questions should be raised.

Index funds are actually one of the simplest financial instruments on Wall Street, which also makes them one of the best.  You see, when it comes to investing simpler is almost always better. Most tools are much more complex and require plenty of specialized research, making it very unlikely most individual investors like you or I could ever really understand how they work. On the other hand, you can actually intelligently pick an index fund yourself.

All investments carry risk.  As we all learned recently, some years the Dow doesn’t do as well as others, but the long-term trend has always been up. Please consider these factors whenever you invest in index funds. Some index funds are relatively safe but all investments carry risks. Index investing is no different in that respect. When in doubt, consult a competent, low-cost financial planner.