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Financial Literacy 101: The upside of index funds

Fifth in a series for
Financial Literacy Month

At Sound Mind Investing, we're doing our part for National Financial Literacy Month by featuring a series of posts on basic principles of investing and personal finance.

Here's post five: a quick primer on investing in index funds.

A stock fund investor faces a fundamental decision when choosing an investment strategy: "Will I try to beat the market or just try to match the market?"

Attempting to beat the market requires using actively-managed funds — that is, funds that buy and sell stocks regularly in an attempt to hold only those stocks that are the best performers.

In contrast, matching the market can be done using passively managed "index" funds. These funds make no attempt to discern how specific stocks will perform, opting instead to simply buy the entire group of stocks included in a particular stock market index, such as the Standard & Poor's 500. (The S&P 500 measures the combined performance of 500 of the largest U.S. companies.) The indexer is willing to accept the "market rate of return" for that index.

Even though SMI's actively-managed strategy (Upgrading) has strongly outperformed our indexing strategy (Just-the-Basics) since the late 1990s, an indexing approach is still a good choice for some investors. Here's why:

Simplicity. Index funds are great for beginners because they are the epitome of "low maintenance." You don't have to know anything about picking funds or about diversification strategies. Just buy a fund such as Vanguard's Total Stock Market Index and — presto! — you own a share in virtually the entire U.S. market.

And you don't have to do any monitoring or fine-tuning until it's time for your annual "rebalancing" (to make sure the stock/bond mix in your whole portfolio is what you want it to be).

Predictability. You can buy index funds and hold them for years because their performance is predictable — you'll get what the market gives. You know you won't outperform the market, but you also know you won't lag the market.

That's more than most fund investors can say, since studies have consistently shown that a majority of actively-managed funds — as many as 80% over some time periods — fail to outperform the market over time. (Even the pros have trouble predicting winners!)

Availability. Usually, index funds are included as options in company retirement plans. So if you're stuck with only a handful of actively-managed fund choices in your 401(k), an index fund can be quite appealing — especially given the likelihood that most actively-managed funds will end up trailing the market. [MORE...]

SMI's Financial Literacy 101 series

• Creating your own personal financial plan
• Save by paying yourself first
• Where to put your savings
• How much should you save for emergencies?
• The upside of index funds
• A simple and steady investing strategy
• Inside-out investing
• Making the 'right' investing decisions
• Your most important investing decision

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