Investing in Index Funds

by Staff - Original publish date: January 18, 2012

Who has the time, interest, or confidence to pick and track individual stocks (unless, of course, it's what you do for a living)? For those of us who don't, there are index funds. Every self-help guide on investing champions index funds as the safest gateway into the stock market. As portfolios of securities, indices are designed to match the performance of the market as a whole. They are essentially mutual funds that track the market, allowing even the least savvy investor to benefit from an expanding economy in a hands-off, lower-risk way.

Most people have heard of the more famous indices such as the S&P 500 or the NASDAQ 100. The S&P 500 is an index of the 500 largest and most profitable companies in the United States. It has increased an average of 13.6 percent annually for the last 50 years. If your grandfather had invested $10,000 in your name in 1951, you would be able sell that position today for $5.78 million (before taxes). Lucky you.

There are other, less familiar index funds, like the Russell Indices (three indices - the Russell 3000, the Russell 2000 and the Russell 1000 - used to rate the activities of stocks based on their market capitalization); the Wilshire 5000 Equity Index, which covers the entire stock market; or the Dow Jones Industrial Average, which is made up of 30 utility, industrial, and transportation stocks.

Index funds are unquestionably the lowest-cost, lowest-maintenance form of market investing. Unlike managed mutual funds, which charge average annual fees of 1.5 percent of the total assets invested (i.e., not just earnings), indices are free from punitive management fees. Much of these mutual fund fees goes toward management salaries and high marketing budgets.

Not all index funds are created equal - especially as far as maintenance costs go. The Vanguard 500 Index Fund, for example, posts low annual costs of roughly 0.18 percent. Full-price brokerage Morgan Stanley, however, runs an S&P index (buying exactly the same stocks as Vanguard) that has annual costs of 1.5 percent. That's nearly eight times the cost for the same product.

If you can't beat 'em, join 'em
"Some investors think index funds are tame and unexciting," said Erik Rosdahl, a private investor from Malibu, California. "You don't get to pick and track the stocks and it doesn't seem like you're playing the market at all. But the only reason to move beyond a low-cost index fund is if you believe you can beat its performance, after costs. If you can't beat the index, you're better off joining it. Some of us learned that the hard way."

Certain indices allow you to establish a regular account for an initial investment as low as $500, as long as you set up an automatic investment plan adding $50 each month thereafter. If you start with less than that, look into a Direct Reinvestment Plan, or DRIP, account. "If you have money to invest for five years or longer and it underperforms the market for that period," said Perry Nagle, a lawyer and do-it-yourself investor from New York, "then you or someone else has made a big mistake, because you can get an average market return out of an index fund without doing any homework whatsoever and without taking on significant risk."