Why you should be investing in index funds

August 30, 2009

Finance

Many people have misconceptions about the stock market.  In fact, I would venture to say that most  people have little to no idea what they are doing at all.  I would highly   recommend getting a copy of the book, The Intelligent Investor by Benjamin Graham.  As you can see on the cover, Warren Buffet still follows its principles to this day and calls it, “By far the best book on investing ever written.”  It is a very thorough and detailed book that hits on just about every topic you need to know.  Here are some of the main points it discusses.

1.  The difference between investors and speculators – There are two types of people who play the stock market — investors and speculators.  Your average person probably falls squarely in the category of speculator.  They chase hot stocks, buying up shares of a company when news of a big launch or product release hits, in the hopes that the stock will go up and they can sell at its high, thus obtaining a sweet profit.  Or they buy mutual funds that have  five star Morning Star rankings or because they have historically generated amazing returns.  If you do not know which category you fall into and you own stocks and/or mutual funds, try and answer some of the questions below.

Stocks

1.  Who is the CEO of the company?  What is his vision?  Do you agree with it?

2.  What is the company’s actual value in relation to its stock price?

3.  What are the company’s assets?  Liabilities?

4.  Have you had the opportunity to review at least a few years of the company’s financial statements?

Actively Managed Mutual Funds

1.  Who is the fund manager?  What is his track record?  Do you agree with his strategy?

2.  What funds comprise the majority of the holdings?  What is its asset allocation?

3.  What fees are charged by this mutual fund?  Is it high in relation to other funds in its category?

Answering these questions should be a given, but they only skim the surface.  The investor can not only answer these questions, but a whole lot more.  The investor doesn’t blindly follow the masses, but rather bases his decisions on thorough research in order to find companies that are currently undervalued.  He mainly purchases stock in companies with proven track records and solid fundamentals that, for one reason or another, has fallen out of favor with investors.  Once he has come up with a list of such companies, he purchases the stock and holds it.  Since he has done his research, he is confident in his choices and does not get sucked into the casino-like world of speculation and day trading.

So you don’t have time to do any of this stuff huh?  Guess what, neither do I.  I have better things to do with my time, like go hiking or hang out with friends.  Now if there was only something out there that charged ridiculously low fees, got me diversified in a broad range of stocks, and has historically beat out 80% of actively managed mutual funds.  That leads me to my next point.

Index funds

On the sexiness scale of the stock market, index funds are a 0.  They are boring.  They track broad indexes like the S&P 500, but for further diversification, you can buy index funds that track foreign markets as well.  You won’t ever do better than the market, but you won’t do worse than it either.  Because they don’t require much effort to maintain, fund managers charge extremely low fees.

This is the Vanguard Target Retirement 2045 fund.  It is invested 90% in a variety of index funds to include exposure to domestic and foreign markets.  It is also invested 10% in bonds.  As I get older and willing to accept less risk, it automatically adjusts my holdings closer to a 50/50 mix.  This shelters me against crashes in the market like the one we are currently experiencing while still allowing my assets to grow by still providing me adequate exposure to stocks.  Best of all it has fund fees of .18% versus .712% for actively managed mutual funds as of 2008.  Over time, this adds up.  This is the only fund you will ever need, or if you prefer, just buy each index fund individually and balance as you see fit.

Some people believe that this is the strategy for beginners and that they can, in fact, beat the stock market.  Let them believe that while you sip on margaritas on the beach in retirement.

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