Investing In The Stock Market

Photo credit: BAD RABBIT INC.

While some investors are comfortable with going for more exotic investing options such as penny stocks, most people are better of with more traditional investing styles.  One of the best ways for a regular investor to start investing in the market without having to spend every waking hour obsessing over their trading account is to invest with index funds.

To recap the idea behind index mutual funds, they are basically a fund that simulates an entire sector of the stock market, or in some cases, entire markets.  For example, there are several very popular index funds that follow the S&P 500 index.  This means that however well the S&P 500 performs, that’s how well the index fund does.  Index funds provide the ultimate in diversification, since they hold a very broad range of stocks.

Now, if you’re new to index funds, you might wonder why you would buy a fund that can only do exactly as well as the market.  After all, isn’t the idea to beat the market?  As it turns out, beating the market is much harder than most people think it is.  You might think you can beat the market buy reading the financial news everyday and making a few trades, but the truth is that you probably can’t.  Even most professional money managers have problems beating the market, and most under perform.  Index funds will never under perform, and they couldn’t be any easier to invest in.  Think of it as a tortoise and the hare type situation.

So, assuming you’re sold on investing with index funds, what are the best index funds to invest in?  The answer to this question has two parts.  First, we will talk about what implementations of a given fund you should be choosing.  For example, of the many S&P 500 funds, which one should you choose?  Secondly, we will talk a bit about asset allocation, which tells you what general type of index fund is best for you.  That is, should be be invested in the US small caps, or foreign growth stocks?  Not an easy question, but we’ll take a look at it.

So, let’s talk about fund implementations.  Every mutual fund, including index funds, has something called an expense ratio.  Expense ratio represent the cost associated with running the fund.  In the case of managed funds, this helps pay the fund manager and pay the trading commissions.  In the case of index funds, there is no manager, and trading is automatic.  Thus, the expense ratios are very, very low, allowing you to keep more of your own money.  This is a good thing, I think we can all agree on that!  In light of this, you should choose an index fund with the lowest expense ratio possible.  This information should be readily available in the fund’s prospectus.  Vanguard index funds are known to be some of the lowest in cost out there, but check into the expenses for any fund you buy and compare, just to make sure.  This will save you surprising amounts of money over the long run.

Now, let’s talk about buying the best index funds from an asset allocation perspective.  This is a huge topic that I can’t possibly cover fully here, but let me try to sum it up in a word: diversify.

Yep, that’s right.  Don’t buy into a biotech sector index fund because you think they will do well.  Don’t buy all emerging market funds since you think the rest of the world has a lot to grow.  Don’t even buy the US stock market, since we all know that can down.  Instead, build a balanced portfolio across as many non-correlated asset classes as possible.  While parts of your portfolio are down, other may be up, reducing your volatile and increasing your potential returns.  With the diversity afforded by index funds with a diversity of asset classes, you should be able to weather many market storms.

I highly encourage you to keep researching asset allocation.  Finding a good plan and sticking to it is the easiest way for most people to invest with index funds.  In short, there is no “best index fund.”  Rather, there are simply low expenses and solid asset allocation plans.  Stick with these principles, and you will surely do well.

With the inherent instability involved with investing in the stock market, many question the wisdom of even trying at all.  What’s the use of investing in a company if it might go bankrupt the next year?  There are many who claim that you can time the market, and buy the right stocks at the right time in order to make a good profit while suffering few losses, but in reality, statistics show that even professional money managers have difficulty evaluating these sorts of complex financial markets.

In fact, if we look at the statistics, we see that most professional money managers ever outperform the S&P 500 index over the long run.  If professional fund managers, with all their education and experience, can’t beat a pre-set average of the top 500 stocks, why should the individual investor feel like he or she could even start making the right decisions?  How can investor hope to outperform a market the professionals often underperform?

The answer:  they really can’t outperform the market.  It’s just too complex and unpredictable.  However, they can do the next best thing, something that the professionals often fail to do:  match the performance of the overall market exactly using an index fund.

An index fund is simple a financial product that basically lets you buy the whole market (or a specific sub-set of the market) in bite sized pieces.  You can buy a part of the S&P 500 for a small amount of money.  The best part about this approach is that you are %100 guaranteed to match the performance of the overall market, since you own the overall market.  With one simple purchase, you are matching a market that most professional money managers fail to match.  Pretty nice, eh?

There is much more to learn about investing with index funds, and I’ll be covering this in other articles.  For now, though, understand that buying index funds is a great way to get started in investing without having to learn a bunch of complex financial lingo.  Just buy the market, and hang in there for the long term.  There will ups and downs along the way, but over time, you’ll very likely make money.