Everything I read told me to check out index funds, so I did.
Sure enough, theyre pretty awesome tool with a handful of advantages for new and seasoned investors.
What Is an Index Fund?
Youve probably heard the wordfundbefore in the context of investing.
They might be government bonds.
Either way, a fund is one big investment made up of smaller assets.
For example, youve probably heard of theS&P 500.
Its an index that measures 500 of the most economically powerful companies in the United States.
Or worse, research your own companies from scratch.
Who has time for that?
Index funds do all of that work for you, you just buy a single investment.
If the index does well, the index fund does well.
If the index drops, so then does the index fund.
And thats why everyone loves them: the research is done for you, and so is the picking.
There are a ton of different indices, andhere are some of the most common ones.
Firms likeVanguard,Fidelity, andCharles Schwabhave designed different index funds for all of these indices and more.
If the S&P plummets, so will VFINX.
The same goes for every index and its matching fund.
Historically, theS&P averages 10% (before inflation) every year.
So its no surprise thatVFINX has a similar return.
Diversification is hugely important when it comes to investing.
Youve probably heard the saying, dont put all your eggs in one basket.
For example, Google is a solid, steady investment.
However, you still dont want to investevery single dollaryou have into Google.
Youre at the mercy of anything that could go wrong with one company.
If they decide to use their every penny to revive Google+, youd get a little worried.
Long story short: if something goes wrong, you lose everything, and youre entirely screwed.
Thats diversification in a nutshell, and thats how index funds work.
Youre investing in hundreds or thousands of different assets, whether those are companystocks or government bonds.
In short: index funds have built-in diversification.
The banks and organizations that set the index specifically choose companies with diversification in mind.
Thats pretty good for long-term investing: namely, saving for your retirement.
Rothputs it over at Get Rich Slowly:
Do index funds always come out ahead in a given year?
In fact, theyre usually in the middle of the pack.
By definition, index funds produce an average market return no more, and no less.
However, over the long term ten years, or twenty, or thirty a remarkable thing happens.
Index funds float to the top.
It turns out that average performance in the short term is actually above average in the long term.
In short, index funds are meant to be steady and boring.
Low Fees
With other funds, an advisor or investor picks and chooses your individual investments.
They want to beat that average 6-7% return by actively managing your fund.
We call thisactive investing, and you pay for the work that goes into this.
With active investing, this ratio includes a higher management fee for the extra time and effort.
Again, if the index does well, your index fund does well.
If the index drops, your index fund drops.
We call this set and forget investing, orpassive investing.
Theres no maintenance involved, so the fees are much lower.
This study from Morningstarfound that, over time, index funds outperform actively managed funds.
Sometimes its worth it, but you know what youre getting with index funds: low fees.
Now the downside: Most index funds have a pretty high buy-in limit.
It can be between $3,000 and $10,000.
Its a lot, I know.
Consider that youre investing in thousands of different assets at once, thoughthat costs money.
Once you do, its time to think about picking and buying your fund.
A solid investment portfolio is well balanced in two basic asset categories: stocks and bonds.
A tool likePersonal Capitals portfolio checkup orBankrates Asset Allocation calculatorcan help you figure it out.
You just have to search for specific fund names that fall under the asset class you need.
Heres how this works.
First, look at the Asset Class category in the above example.
Lets focus on picking index funds for US Stocks.
I use Vanguard, and heres Vanguardslist of stock funds.
The more you learn about investing, the more precise your portfolio might be in each of these sub-categories.
But for now, you just need one or two basics to get started.
In my scenario, I picked the index fundsVTSAXandVFIAX.
Once I had these specific funds in mind, I researched a couple of important things.
For one, see to it your expense ratio is nice and low.
As you could see in the above example, only one of these hits 0.10%.
Vanguards expense ratios are notoriously low.
Also, double-check the fund actually tracks its index.
Compare the performance history of the fund with the index it tracks.
They should be pretty parallel.
Navigate to buy from your investment account, and enter the necessary information.
Index funds are the ideal solution to building your own easy investment portfolio.
Illustration by Fruzsina Kuhari.
