Why index funds are hot, hot, hot — and good for beginners

Using index mutual funds in a portfolio is a great tool for beginning investors. They provide diversification (explained in detail in this article) pretty cheaply. You may also have heard of indexing as “passive investing”.
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“By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.” — Warren Buffett
Basics
Index mutual funds are funds that replicate a certain index, which is normally mentioned in the name. For example, most mutual fund providers have an S&P 500 fund.
The fund might not buy companies the same way that the index itself does, instead using a statistical method to replicate it. Many S&P 500 funds use sampling techniques instead of buying shares outright in the 500 companies that make up the index.
“Passive” vs. “Active”
Studies show that very few active managers outperform their index. An active manager chooses the companies they want to invest in. An active small cap manager, for example, doesn’t simply buy the Russell 2000 index (a small-cap benchmark). They choose companies in that sector that they think will outperform.
Because these types of funds require analysts and more staff, their expenses are higher.
Net of fees, returns of active funds are often lower than the index net returns.
Managers who do outperform rarely do so for an extended period of time.
By contrast, no analysts are needed for the passive approach of mimicking an index, leading to lower expenses. Once these lower costs are factored in, their net returns are usually higher.
Benefits of indexing
- Even seasoned investors often like to invest with index funds. Choosing an active manager implies there’s some choice on your part. In other words, if your active manager is performing poorly, you might think that you chose poorly. You’ll want to make what looks like a better choice. So you start trading, which is expensive. These additional costs drag down your portfolio’s return.
Once manager choice is removed, you can pick index funds that fill out your asset allocation. When the index goes down in price, everyone expects their index fund to decrease as well. When the index is performing well, as most have for the past nine-plus years, the fund will gain as well (less the expense).
There are no unpleasant surprises, and no comparisons to make between a fund and its benchmark.
2. The fact that index funds cost much less than their active counterparts is also helpful for investors. Someone without much money can put together a reasonably diversified portfolio and allow it to grow, so in the future it becomes much more money! This is often harder to do with actively managed funds.
Indexing caveat
As noted above, we’ve had a bull market for nearly a decade now. Beginning and/or younger investors may never have gone through a prolonged stock market drop. Their appetite for risk might decrease substantially once portfolio values start to decrease. Index funds drop just slightly more than their indices during these times due to the fees.
However, there are active managers who practice defense in their portfolios. Investors may find these types of funds more comfortable in a bear market. Again, it’s difficult to tell which manager is going to outperform.
In addition, no one knows the timing of this drop.
It’s likely there will be one in the next few years. Investing in active managers is best before their prices rise because everyone is trying to buy them. But if you get defensive too soon (make your funds more conservative), you could end up missing out on a lot of gains. People have been forecasting the end of this bull market for years now. However, no one actually knows when it will happen.
Summary
Index mutual funds are excellent for all types of investors, including beginners. They help prevent investing behavior that would otherwise negatively affect the portfolio. These funds also allow those with little money to assemble a decent portfolio that they can live with through up and down markets.
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This article was originally published on Fab Fem Finance.

