What Is An Index Fund?
Posted by Phil Ferguson on January 31st, 2011 – 3 Comments – Posted in Money MondayNOTE: This post is part of an ongoing education series. This information is for educational purposes only. This information does not constitute investment advice. No rational person would make investment decisions based on a blog post. Please consult with your financial advisor before taking any action. If you think it is OK to make investment decisions based on a blog post, then for the love of the FSM – Stop reading this blog.
Money Monday
A nice place to learn about investment terms is Investopedia. Here is there definition of an Index Fund.
A type of mutual fund with a portfolio constructed to match or track the components of a market index, such as the Standard & Poor’s 500 Index (S&P 500). An index mutual fund is said to provide broad market exposure, low operating expenses and low portfolio turnover.
Good… but I’m not sure what they mean when they say, “… is said to provide…”. An Index fund actually does these things. Unless, you get a very specific type of index fund that focuses on a small market segment. Let’s look at an S&P 500 Index Fund.
Broad Market Exposure
This index fund invests in 500 stocks. 500 different US companies. This is very broad exposure. If one of those 500 stocks goes to $0.00 in just one day it will only bring down your portfolio 0.2%. The whole market can move more than that in a day. You will never even notice the loss. This also works on the upside, if one of those 500 stocks double it will only give you a 0.2% bump. This broad market exposure effectively reduces your volatility.
Low Operating Expenses
If you are in a 401(k) or a 403(b) you may see index funds with expense ratios as low as 0.5% to 0.8%. The average mutual fund has an expense ratio of around 1.6%. The extra 1% savings could make a big difference over time. If you go to Vanguard, you can get index funds with expense ratios lower than 0.2%.
Low Portfolio Turnover
If you are in a taxable account this can really pull down your performance. If a stock is held for more than a year than you will only pay capital gains of 15%. However, a stock sold in less than a year can be taxed as high as 35% – Ouch! An S&P index fund may change only 2-4 % of the funds in a given year. A managed fund can change 100% or more (sell twice) in one year. Even if your managed fund beats the market you may get killed on taxes.
One of my investment rules…. By Index Funds whenever you can!
Alright, so I know I shouldn’t make investment advice on the basis of a blog. But I don’t even know where to start! How do I get a financial advisor? How much do I have to pay her/him? How much money do I need to plan to invest to make it worth it? Can I talk to someone at my union? Etc.
I need to start saving for retirement (I’m in grad school) but I don’t really know how to even start or how to even go about *buying* any kind of stock, much less, kinds that make particular sense for me. Also, I have less than 10,000 I can invest right now, so it feels to me that paying a financial advisor would take out way to large a chunk of what I’d be making.
Annnyyyway. If you’re looking for suggestions of posts to make, possible one on “finding the right financial advisor” would probably be helpful
I particularly like these money posts though, since you’re the only one in the skeptic blog circle I follow who regularly deals with money matters and I think it’s important to approach this rationally as well as other parts of life.
@jemand,
Thank you for the kind words. I am glad to help.
A lot of good questions and comments. I will try to answer some of them in future posts.
If you wish you can contact me and I can point you in the right direction. One quick suggestion is to get a couple of “investment” magazines. Don’t follow any of their advice but you can learn about all of the terms used in financial news. For a deeper read, one of my favorite books is “Common Sense on Mutual Funds” by John C. Bogle. It has some math but it is really good.
Thanks for the info. I may send you additional questions via regular email.