Why Index Funds Are Ideal for Inexperienced Investor

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In our pursuit to make money work for us, rather than against us, we need to develop a plan to minimize debts and boost saving.  First, open a savings account to build up emergency savings that should be a minimum of one month’s earnings.  After that is accomplished, it is time  to create a portfolio of investments that will include a mixture of equities and bonds.  Equities are partial claims of ownership in a company, while bonds are certificates of indebtedness where companies pay interest and principal back to you over time.

If you are just beginning to invest, it is recommended that you purchase shares in a mutual fund, rather than individual stocks or bonds.  A mutual fund enables you to spread your risk in multiple holdings, rather than one.  This is an ideal way to achieve diversification where you can minimize the risk of losing returns without sacrificing risk.

There are a plethora of mutual funds in the marketplace, so be very careful in choosing the right investment that meets your rate of return goals and risk profiles.  Specifically, there are two types of mutual funds: index funds and professionally managed funds.  While many investors seek out professionally managed funds, index funds have historically outperformed managed funds and do it at a much lower cost.

Index funds are investment products where shares are bought and sold at a rate that would mimic the movements of a particular index.  For example, a Standard and Poor 500 (S&P 500) index fund would move in the same direction as the S&P 500 on a given day.  If the S&P 500 increases by 5%, then shares in the S&P 500 index fund would appreciate by 5%.  Conversely if the S&P 500 falls by 5%, then the index fund would decline by the same amount.  Its main advantage is that expenses are low because there is little management involved.

On the other hand, professionally managed funds are mutual funds that are operated by a director and staff.  They perform fundamental analysis where they sell stocks that are perceived to be overvalued and buy stocks that are undervalued.  If their insights pay off, then investors have the potential to earn returns above the market.  The downside is that their analysis could be wrong, in which case you can perform below the market.  However, this expertise is not free, so these type of funds have higher fees and expenses tied to them.

If you are an inexperienced investor, it is recommended that you opt for index funds.  However, be careful to choose funds that are operated from reputable firms.  There are a variety of indexes that offer different risks.  For instance, the S&P 500 tracks the largest 500 public companies on Wall Street.  Since they are large and well-established, growth opportunities are not as great as the NASDAQ 100 index, which tracks smaller companies.  Smaller companies carry more risk, but offer the potential for higher returns.  Nellie Huang of Kiplinger’s Personal Finance offered these best bets:

  • iShares Core Total U.S. Bond Market (AGG):  tracks Barclays Capital Aggregate Bond Index
  • Vanguard Total Stock Market Index (VTSMX): tracks a combination of New York Stock Exchange and NASDAQ
  • Vanguard Index 500 (VFINX): tracks the S&P 500
  • iShares MSCI Emerging Market Index (EEM):  tracks MSCI Emerging Market Index, which includes Asia, Latin America, and Africa
  • PowerShares QQQ (QQQ): tracks the Nasdaq-100 index
  • Vanguard Total International Stock Market ETF (VXUS):  tracks the MSCI All Country World ex US Investable Market Index

Age and risk profiles will determine the best match for you.  While index funds do carry less risk than managed funds, each of the above fund do carry risk.  Therefore, they may not be ideal options if you are near retirement and need those funds within the next couple of years or so.  However if you are young, then the PowerShares QQQ and Vanguard Total International Stock Market ETF might be an ideal option where both carry above average risk, but the prospect of higher returns.

Regardless, stop watching those fees drain your wealth and consider one of these low-cost index funds.


One thought on “Why Index Funds Are Ideal for Inexperienced Investor

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