4 things you might not know about index funds
Reprinted courtesy of MarketWatch.com.
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Most investors have heard of index funds, but not everybody understands how really good they are.
Here are four things about them you maybe haven’t considered.
1. If you have a spouse or partner who doesn’t want to put in the time and work to understand investing, index funds make it easy.
Actively managed funds are much more complex and challenging than index funds. There are at least 1,000 ways to build an actively managed portfolio, and it’s essentially impossible to prove in advance which ones are the most effective. Index funds are not like that at all.
When I was an investment advisor, I had many clients who struggled to educate their spouses about investing. Here’s the best solution I found: Get the spouse to spend an hour or two with “The Little Book of Common Sense Investing” by John Bogle.
2. Index funds don’t have to keep a lot of cash on hand. Why should you care about that? Mainly because, as anybody who invests in money-marker funds knows only too well, cash is a low-return investment
Typically, an actively managed fund keeps more than two percentage points more cash than an index fund. That alone robs shareholders of probably one-tenth of a percent of return. That doesn’t matter much in a single year, but over an investment lifetime, that tiny difference can cost an investor (and his or her heirs) $150,000.
3. Investors in index funds tend to be patient investors. That means these funds don’t usually experience heavy outflows of cash in bad times or heavy inflows in good times.
When an actively managed fund has stellar performance, it attracts lots of new money. A manager will most likely have to use that new money to “chase” a relatively small group of stocks. This buying pressure can drive up stock prices, forcing the fund manager to pay higher prices than would otherwise be the case. This affects all shareholders by reducing the fund’s future gains.
And when a fund goes from the top of the heap to the bottom, the reverse happens: Shareholders want their money; stocks have to be sold at unfavorable prices; trading costs go up, and the patient shareholders who stay the course see the value of their shares decline.
4. Once you commit your investment strategy to index funds, you will never again need the help of a securities salesperson. That means you eliminate a source of advice that’s potentially so bad it could easily cost you hundreds of thousands of dollars.
Investors conveniently forget the unprofitable moves they made, often the result of advice that seemed sensible at the time. Let’s say you lost $2,000 in your 20s on a bum investment trade that was suggested by a broker. If instead you had invested that $2,000 in an S&P 500 index fund, in 50 years that money could have been worth nearly $250,000.
I have a friend who wanted to remind himself of this. So he set up a special $25,000 account to invest only in the “best ideas” he got from brokers. But the “best ideas” turned out to be mostly dogs. When the account value had dwindled to less than $2,500, he closed it and gave up on the idea of “having fun” as an investor.
Fortunately, there’s a much better way.
Index funds are easy and boring. If you want your investments to be a hobby that’s engaging, exciting, intriguing, challenging, and a source of bragging rights, you probably won’t like index funds.
But if your priority is achieving above-average returns with little or no work, index funds should be just your cup of tea. Consider these points:
Index funds automatically make you an above-average investor. The reason is ironic: Index-fund managers don’t try to beat the market. Their job is to be the market, and it’s easy for them to succeed.
This leads to above-average results, because the majority of investors fail to even match the market. Ironically, this is because most investors try to beat the market. For more on this, here’s an interesting article.
With a portfolio of index funds, you don’t have to spend time and energy “staying on top” of your investments and who’s managing them.
Index-fund managers are smart people, but their success doesn’t depend on brainpower, intuition or great ideas. Their success comes mostly from sticking to a simple formula and keeping their costs down.
I think I know more about investing than most people, and I spend what some people probably think is too much time following the financial news. But because almost all my portfolio is in index funds, I don’t have to actually do anything about whatever is going on in the markets. My index funds do it for me automatically.
What’s not to like about that?
Most investors can’t tell you much about how their investments are performing, or why. This is information they should know in order to make good decisions. But if your investments are in index funds, it’s quick and easy to find out how each index is doing.
Many investors seem to think investing is complex and difficult. But index funds are easy to understand. I have talked to hundreds of high school students who have no trouble understanding them.
Because these funds make no promise except to represent a particular asset class, the investor’s only challenge is to determine the best asset classes (high school students can easily handle this one, too) and find funds that track those asset classes with low expenses.
As I have stated before, index funds are the sleep-easy investment. They are highly regulated, they cost very little to buy and own, and they provide massive diversification that’s easy to understand and control. They’re very liquid and require little emotional involvement.
In addition, index funds are recommended by Warren Buffett. What’s not to like about that?
I believe most investors can get what they need from index funds. The ones I have recommended for more than 15 years all have respectable returns and are likely to continue doing so.
For more, check out my podcast on index funds.
Richard Buck contributed to this article.