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In This Article
Here’s an untold secret of the stock market: the top companies in the US (on average) return more money to their stockholders than 84% of people who claim to make money investing for you (active fund managers). Sounds crazy right? It’s true. So if you’re looking to save for retirement in the stock market—consider the option with low fees, and consistent returns. Consider stock index funds . .
You know investing is a great way to grow your net worth and prepare for your retirement years. Listening to all the talk about the stock market can be baffling and intimidating though.
One month there’s growth across the board and the next, all you hear about are predictions of an impending bear market. Enter, the magic of stock index funds.
Stock index funds provide a way to invest in the stock market leaving behind all the confusion and most of the work. By consistently investing in small pieces of some of the wealthiest companies and accepting average market returns, stock index funds succeed in beating many active fund managers over time.
It might be hard to believe—but there’s no real magic in stock index funds. It just feels like it.
What is a Stock Index Fund?
If you haven’t already, you should learn the fundamentals of stock investing.
You’ve probably heard of the Dow Jones Industrial Average (Dow) and Standard & Poor’s 500 (S&P 500). These are examples of stock market indices, and their job is to measure a particular section of the stock market.
The Dow is a stock market index for the thirty major stocks most heavily traded on the Nasdaq and New York Stock Exchange. Companies like American Express, Coca-Cola, Disney, and Nike are included in the Dow. The strength of the U.S. economy has historically been measured by this index.
The S&P 500 is a stock market index of the 500 largest U.S. companies trading publicly. Companies in the S&P 500 include Amazon, Berkshire Hathaway, Facebook, and Starbucks. Because of the large number of companies it tracks, the S&P 500 is also a very reliable gauge of the broader stock market.
A stock index fund is a type of mutual fund with a portfolio built to match a particular stock index. Index funds are passively rebalanced by computers, rather than actively managed. This lowers the management expense ratio on the index fund.
When you buy an index fund matching the S&P 500, you’re buying a fund following preset rules for purchasing only the stocks in the S&P 500 index in the same ratio as they exist in the market. The performance of any index funds tracking the S&P 500 will typically be very similar to the performance of the S&P 500.
Stock Index Fund Magic
There are many benefits to investing in index funds. These funds are low-fee, low-risk investments with a history of solid performance. And you don’t need to know very much to be a successful investor. Just a willingness to put your money to work for you over the long-term.
Performance Over Time
Stock index funds have consistently outperformed the vast majority of investment vehicles. In fact, according to Spiva’s Statistics and Reports, over 84% of actively managed funds underperformed the S&P 500 over the last five years.
And if you lengthen the investing horizon to fifteen years, over 90% of mutual fund managers failed to outperform their benchmark index.
That doesn’t mean fund managers can’t outperform an index benchmark in the short term though. And some professional active fund managers routinely beat the market. The question is, “Do you have access to those managers?” And if you do, what will you pay them to manage your investments?
The Effect of Fees on Returns
Since stock index funds don’t incur all the trading costs, taxes, and other expenses going into many of the more actively managed investment strategies, you keep more of your money.
At Vanguard, you can find expense ratios under .1% for some stock index funds, and Fidelity recently came out with zero expense ratio index mutual funds with no minimum investment.
The fees you pay on investments take away money that can grow and compound over time, dramatically reducing the amount of money you have at retirement.
According to the Securities and Exchange Commission (SEC), a 1% annual fee will cost almost $28,000 on a $100,000 initial investment growing 4% annually over 20 years. And if the $28,000 of expenses were invested over those 20 years, an additional $12,000 could have been earned.
Fees can cost an investor hundreds of thousands of dollars over their lifetime. Luckily calculators are available to help you analyze the costs associated with buying shares in a mutual fund.
Remember, individual stocks and mutual funds cost more to manage as there are fees and commissions paid to fund managers, along with transactional expenses to the brokerage.
Lower fees in stock index funds equal more money for you. It’s not magic—the math really matters!
Knowing What You Don’t Know
Unless you plan on becoming an expert investor—and realize that even if you do you may not beat the market—investing in stock index funds makes sense. If professional fund managers struggle to continually pick winners and outperform benchmark indices over time, you likely will too.
Many people choose stock index funds because they’re easy. If you lead a busy life with work and a family, you can save time and energy knowing you can succeed in the market over time without much effort.
Keeping Your Emotions in Check
What’s your investing style?
Does “water cooler talk” or news headlines about market dives make you rush to buy or sell investments?
Stock index fund investing eliminates this sporadic trading activity by removing most emotional decision-making.
There is no more “winning or losing” because you don’t need to look at market performance every day; which can be a huge benefit to people who become addicted to tracking every market move. Your hope is all companies in the index will do well over time and if a company is losing—a winner will make up for those losses.
You’ve likely heard the saying about “knowing enough to be dangerous,” well in terms of investing, your emotions and a little bit of knowledge can be a costly combination for your portfolio.
The magic of stock index fund investing is it allows you to tune out the noise and enjoy a growing nest egg through passive investing.
Building Wealth Over the Long Term
Just keep in mind this isn’t going to happen overnight, and for some people, it will take willpower not to get back into the (investing) game. But consistent investing in—easy to manage, low-fee, tax-efficient, stock index funds—will help you come out ahead in the long run.
Whether you are 25 or 45, retirement may be decades away, and it may be hard to believe letting your funds sit in passive accounts to grow is the right move. When in doubt, come back and read about how stock market index funds return over time.
This should help you refocus on why you chose them and let you get back to enjoying life!
Getting Started with Stock Index Funds
If you’ve decided stock index funds are right for you, take more time to learn about the different index fund options available, including domestic and international market funds. You might also be interested in learning about bond index funds.
Is one fund right for you or would diversifying and choosing a mixture of funds be your best move?
Research specific index funds from a variety of brokerage firms. Make sure you consider all fees involved and minimum investment requirements.
Lifecycle or target-date index funds may be another option to consider if you’d rather not pick funds yourself or rebalance them over time.
These funds shift asset ratios with your retirement timeline. They may have slightly higher fees, but those fees are still much less than fees in actively managed funds.
Being Content with Average
There isn’t anything sexy or exciting about investing in stock index funds. You can mostly ignore them, and they’ll grow over time.
You won’t have huge wins on a given day, week, or year and you’ll have little need to follow the market.
You give up more control, but stock index funds are a smart investment and one of the best ways to grow your wealth.
If you can learn not to chase returns and be content with average growth, low-cost, low-risk index fund investing is for you. By avoiding putting all of your “eggs in one basket” and by choosing investments banking on growth in hundreds of companies rather than just a few, your chance of being a successful investor over time grows.
Park your money in a stock index fund, invest consistently, and let the magic happen.