Best Index Funds
Thursday, August 13th, 2009
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.