Every stock investor makes the fundamental decision, whether they realize it or not, to either attempt to beat the market or if they are content to merely match the market. To beat the market, you must use actively-managed funds – that is, funds that frequently trade stocks in an effort to hold only those that will do particularly well. But, for the average investor, attempting to select the right stocks at the right time can be quite a daunting task.
To merely match the market’s returns, passively managed “index” funds mirror the performance of a market index as their managers invest in the same securities used in calculating the index (such as the Standard and Poor’s 500 stock index). In doing so, the indexer is willing to accept the prevailing market rate of return, which has been 10-11% per year for stocks over the long haul. John Bogle, the Founder and Chairman of the Vanguard Group and often referred to as the father of indexing, created the first index mutual fund in 1976 based on the premise that “if you can’t beat ’em, join ’em”. Since 1976, index funds have gained popularity as more and more investors, even so-called “smart dollar” institutional investors, have poured money into an ever-growing number of index funds.
Can the popularity of index funds be attributed to their simplicity or simply the comfort of knowing that you can keep pace with the markets without taking the risk that you might make less (or lose more) than the markets?
Let’s take a look at a few benefits.
You can buy and hold index funds for years because their performance is predictable – you’ll get what the market gives. While you know you won’t outperform the market, you also know you won’t lag the market. That’s more than most fund investors can say, since studies have shown that as many as 80% of actively-managed funds fail to outperform the market over time. The main reason for this is the costs that mutual funds charge. A fund’s return is the total return of the portfolio minus the fees an investor pays for management and fund expenses.
An average non-index fund has an expense ratio of around 1.25%, plus any transaction costs associated with the buying and selling of securities inside the fund. Thus, the shareholders’ profits in the typical fund are reduced by about 2.0% per year due to operating and transaction costs. Index funds, on the other hand, typically have very low expenses, averaging only 0.20% annually. The reason the costs are lower is because fund managers only need to maintain the appropriate weightings to match the index performance, and transaction costs remain low because index funds require very little buying and selling within the portfolio. However, not all index funds are created equal. Be sure to check into the expenses, as some index funds charge much higher management fees to invest your money in the same stocks as other index funds.
Index funds, especially those based on the S&P 500, are increasingly being offered in 401(k)s and variable annuities. If you’re stuck with half a dozen mediocre mutual fund choices in your company 401(k) or other retirement plan, an index fund might be exactly what you are looking for to include your retirement assets in your overall allocation strategy.
Your investment strategy must be a well-thought-out plan that includes your investment objectives and risk tolerance. An index fund is just one option among many to implement your plan. It is always a good idea to seek the advice of a competent professional in this area to analyze your current investment strategy and to see if an index fund is right for you. You can search for a Qualified Kingdom Advisor who has committed to dispense financial advice and services consistent with biblical wisdom at www.KingdomAdvisors.org.
Finally, remember that we need to keep an eternal perspective on our money. If our attitude about money is to amass as much as possible in order to protect ourselves, we are trusting in money rather than God. God wants us to place our trust in Him rather than our investment portfolios. Proverbs 3:5 tells us to, “Trust in the Lord with all your heart, and do not lean on your own understanding. In all your ways acknowledge Him, and He will make your paths straight.” King David describes his trust in God by saying, “My soul finds rest in God alone; my salvation comes from Him. He alone is my rock and my salvation; He is my fortress, I will never be shaken” (Psalm 62:1-2). That, my friend, is real security.
Rob West is the Training and Communications Director for Kingdom Advisors, a non-profit Life that exists to equip and disciple Christian financial advisors to integrate their faith and profession. Please send questions and comments to Rob.West@KingdomAdvisors.org.
The information in this article is for information purposes only and does not constitute advice. You should not rely on any information in this article to make (or refrain from making) any decision or take (or refrain from taking) any action.