Slow & Steady Wins the Race: All About Index Funds
By Marjorie L. Rand, CPA, CFP®, RICP®
We’re all familiar with the story of the tortoise and the hare: the fast, confident hare races ahead but takes a break, while the slow and steady tortoise keeps going at a steady pace—and wins. This timeless fable teaches the power of patience and consistency, and it’s a lesson that can be applied to investing as well.
In an era where “get rich quick” schemes are all around us, the steady, long-term approach of index funds most often outperforms actively managed funds that promise high returns. Passive investing offers lower risk and can deliver solid returns over time. If you’re considering adding index funds to your portfolio, here are some important things to consider.
What Are Index Funds?
Index funds are a type of passive investment in which a portfolio of assets is built to mimic the returns of a specific financial index. There are many different financial indices, including the Dow Jones Industrial Average (DJIA) and the S&P 500, and each one tracks a certain sector of the market.
When you invest in an index fund, you are essentially buying shares of all the stocks that make up that particular financial index with the expectation your return will match the market return for that segment of the economy.
Index funds make it easy to understand what you are investing in and which part of the market you are tracking, which aids in decision-making. With the complexity of some of the investment vehicles available today, many investors appreciate the simplicity and clarity of investing in index funds.
Risk Management Through Indexing
In single-stock investing, you pick a stock hoping it’s the next big thing. If the company you select makes a big advancement, the value of your stock may go up and you could possibly make a nice return on your investment. If the company turns out to be a dud, then the value of your stock could drop and your investment may turn into a loss. Because of this, single-stock investing is not for the faint of heart and it can carry significant risk.
Index funds, on the other hand, are designed to bet on all of the stocks in a particular market sector instead of just one, thereby giving you a return based on the overall winning and losing of the sector as a whole rather than a single stock alone.
Take the S&P 500, for instance. It is an index fund that invests in the top 500 largest companies in the U.S. If 100 of them have a negative return but 400 of them have a positive return, then you will more than likely have a positive net return on your investment.
This is called diversification. By putting your eggs in many baskets instead of just one, you avoid single-stock risk. Perhaps more importantly, you stand to gain all the advances of all of the companies in the index, which can amount to more consistent growth over time. The bottom line is that index funds greatly reduce the risk of loss through diversification.
The Time Factor
A common strategy used by active investment managers is timing the market. They attempt to “buy low and sell high” by analyzing current market trends for inefficiencies. But, as research has shown, most investment managers are unsuccessful. In fact, recent reports reveal that only 13.2% of active fund managers are outperforming the S&P index. That means that while some actively managed funds had higher returns than their comparable index, the vast majority did not.
Index funds are favorable because they do not try to beat the market. Rather, they rely on time in the market instead of timing the market. The longer you stay invested in a particular asset, the more likely you are to experience growth over the long term. Considering the S&P 500 Index has averaged around 10% for nearly a century, this strategy doesn’t seem all that bad. Indexing often results in much lower stress and a more secure investment experience for the average investor.
Lower Cost
Perhaps the greatest advantage of investing in index funds is their lower cost. With an index fund, no analyst is trying to figure out which stocks to buy. There are generally lower manager salaries to pay. Because of this, index fund fees are usually significantly lower than those of actively managed mutual funds.
Fund fees can have a big effect on returns over time. Even if an actively managed fund is able to beat the market, they have to do so by a wide enough margin to cover their higher costs and more. As such, even some funds that beat the market end up with lower returns once fees are taken into account.
Discover the Benefits of Indexing
If you’re seeking a smarter investment strategy, indexing might be the solution. With fewer management hassles, lower fees, and steady returns, index funds can be a valuable addition to your portfolio.
To explore your options and find out how Rand Financial Planning, LLC can support you, contact me today. Schedule a 20-minute introductory call or reach out to me at 908-895-2406 or marge@randfinancialplanning.com to see if I’m the right fit to help you on your financial journey.