Are you a DIY investor looking for the cheapest way to invest? If so, you might be a good candidate for investing in index funds. While there are many different investing strategies that you can follow, index investing is one of the most popular in the personal finance realm because it is simple and affordable.
What are Index Funds?
Index funds are “passive” mutual funds or ETFs that simply try to track the performance of the stock market. For example, a U.S. large-cap index fund that invests in the largest U.S. companies will try to match the performance of the S&P 500 index. If that index rises 5% in a year, the goal of the index is to match the 5% performance.
The opposite of an index fund is an “active” mutual fund because a human fund manager continually trades and picks stocks to beat the market. If the S&P 500 index is going to rise 5%, he wants his fund to return at least 5%.
Related: What is an ETF? Understanding The Difference Between a Mutual Fund
Active Funds Are More Expensive
Because active funds are constantly buying and selling stocks to try and outperform the market, these funds have higher expense ratios that make active funds more expense to own than passive funds.
Here’s some simple math, a passive fund has an expense ratio of 0.13% & an active fund has an annual expense ratio of 1%. Assuming you have $5,000 invested in each fund, you will pay $6.50 in fees each year with the passive fund and $50 with the active fund. That difference could be enough to buy another share or two each year to earn additional interest instead of paying the fund manager.
Active Funds Don’t Always Outperform
No human can constantly predict how the stock market will perform and it is hard for anybody to choose the best stocks to invest in each year. This includes active fund managers. In fact, most active mutual funds don’t beat the general market making it harder to justify the higher fees. Essentially you are paying more money for the same or worse results by not investing in the correct active fund.
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Index Funds Are Natural Diversification
If you have done any research, you have seen that there are many different options for actively managed ETFs and mutual funds that favor a particular industry like technology or finance. In good times or bad times, their investment strategy is to favor funds in these particular categories.
Because you are only trying to match the market with index funds & the low expense ratios that come with this passive investing style, index funds are a “set it and forget it” investing approach. While you should routinely rebalance your portfolio to avoid becoming too aggressive or too conservative, you know that your funds will perform like the entire market instead of relying on the performance of one or two investing sectors.
Index Funds Are Proven Performers
Ever heard of Vanguard? It probably has the most loyal customer base of all the investing firms largely because they invented the index fund. Yes, they do have active funds, but, they made DIY investing affordable through low-cost index funds. And, Warren Buffett, the richest investor alive, says that index funds are the best way for the average person to invest because of their low fees & simplicity.
It’s Okay to Invest Actively and Passively
Admittedly, passive investing is rather boring. You can legitimately buy a fund in your 20s and hold it until you retire 40 years later because of its passive investing style. It is okay to invest in active funds that do invest in a particular sector or currency to potentially outperform the market. You might just decide to keep most of your money invested in index funds because of their historical performance and low costs.
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