I don’t think you can beat index funds — I don’t mean this necessarily in terms of performance. While index funds are hard to beat even when it comes to rates of return, they’re even harder to beat in their simplicity and affordability. Index funds are a pretty low cost way of investing in the stock market and staying in it for the long term. If you want to grow your money without having to do much work as an active investor, then index investing is a good way to go. You can check out our discussion on this in the post: passive investing vs active investing.
Most people have heard of index funds and are quite familiar with them. If you’ve got a 401K with your employer, then it’s pretty likely that you’ve come across these funds as an option for your retirement money. Index funds may be a better option for you if your mutual funds aren’t beating the market.
Can You Beat Index Funds?
I want to give you a challenge. Are you ready? It’s a simple question. I want you to give me one thing in your life that can work only 20% of the time and still be considered successful. I’ve been thinking about it for a while now and can’t think of anything. If you do happen to think of something, what if you were paying somebody to provide it? Would a 20% success rate be worth paying for? This kind of track record won’t really measure up, would it?
Now to clarify, I’m going to define success as being able to beat the stock market. And in fact, statistics show that only 20% of all mutual funds actually beat the market. To make an overly general statement, this means that only 20% of the mutual funds in existence are performing at an average level, where the “average” describes the general market’s performance. I’m a school teacher and that means that 20% of mutual funds have better than a “C” on their report card.
That’s not very good is it? Especially if you’re paying extra for better results. For those expecting great returns, you may want to ask yourselves: what if your car only worked 20% of the time? You’d probably be upset with your mechanic. What if your doctor correctly diagnosed you only 20% of the time? You’d switch doctors right away. If you’re paying somebody to outperform certain benchmarks, you expect superior results.
There’s a silver lining here though. Even if your fund managers aren’t beating the market, they are probably (hopefully) getting you a better return than what you’d get from a high yield savings account or a certificate of deposit. I don’t mean to say that you aren’t making money (with these fund managers), but you’re probably not making enough.
Investing In Index Funds
If you have a choice of where your money goes, look at index funds. Index funds are similar to mutual funds but they track a stock index. An index is a collection of stocks that represent the market. The most well known index is the Dow Jones Industrial Average. This is the number that you see on the news all of the time. This index is made up of 30 stocks representing large companies like GE, 3M, and McDonald’s. This collection of stocks is what represents “the market” in this particular index. Other indexes are the S&P 500 which has 500 stocks in it and the NASDAQ Composite which is made up of technology oriented stocks.
An index fund allows you to invest in all of these stocks at the same time. They are diversified and they match the returns of the markets they are tracking. They typically charge lower management fees and can be some of the cheaper investments you can buy. You make money when the index goes up and you lose money if it tanks. You will never worry about beating or not beating “the market” because with index funds, you are already invested in the market rather than in just a single stock. Index investing is a relatively conservative way to invest in the stock market.
There’s been long standing debates here between those who believe that you can beat the market vs those who think it’s pretty unlikely that you will. I believe that if you play the market consistently, it’ll be harder for you to consistently beat the market, although it’s not impossible to be able to beat it on occasion. The more time you spend understanding and learning about investment markets, the better an investor you can expect to become. Those who want to go the easiest route will typically buy index funds.
How Do You Start Investing?
ETFs or exchange traded funds are very similar to index funds. You will need a top investment brokerage or mutual fund account to buy into these funds, and they trade exactly like stocks.
This is only a brief introduction to index funds, so go out and do some more research on your own and consider these as attractive investment vehicles. Just remember this: you shouldn’t pay somebody to beat the market only 20% of the time as this wouldn’t seem like very good value.
Contributing Writer: Tim Parker
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