Many roads lead to financial security-some wind through dense forests and treacherous canyons, while others meander through pleasant meadows and over gentle hills. For many investors, buying into index funds is a simpler, albeit less exciting, means of planning for the future.
Index fund basics
Index funds are mutual funds that are designed to match the performance of a certain index. Since history indicates that the market goes up over the long term, index fund investing can be an easy way to make sure your investment earnings keep pace with the pack.
To understand index funds, you have to know just a bit about benchmark stock indices. No doubt you've heard of the Dow Jones Industrial Average and the S&P 500. You may also know of the Russell 1000 and the Dow Jones Wilshire 5000. Each index is based on a certain portfolio of stocks, and the numeric value of the index moves up or down as the individual stock prices in that index change. These indices help investors gauge the performance of either the entire stock market, or of a segment.
Pros and cons
Stockbrokers and professional fund managers generally try to outperform the stock market. This can be difficult to do, mainly because there are costs associated with actively managing a portfolio. These costs reduce your investment earnings. If you have a personal stockbroker, the costs are outlined on your statement as account management or trading fees. If you invest in mutual funds, the administrative costs are embedded in your rate of return. These costs go unnoticed by you until you compare the expense ratio of your mutual fund to the expense ratio of an index fund.
Index funds have very low administrative costs. Since the index fund simply duplicates the stock portfolio of the associated index, there's no need for a dedicated fund manager and research staff who will constantly buy and trade stocks. This leads to another advantage: Index funds have much lighter trade activity than other types of mutual funds. This means that you, the index fund investor, are less likely to incur taxable capital gains.
The disadvantage of index fund investing is that you don't have the opportunity to beat the market or avoid market downturns. If you have a whiz of a stockbroker or an investment strategy that consistently puts you ahead of the market, index fund investing isn't for you.
Opening an account
Once you decide that you like the low-maintenance, average-return model of index fund investing, do a little shopping around. Start by comparing expense ratios, minimum investment requirements, and historical fund returns. Keep in mind that some funds will waive or lower the minimum investment requirement if you set up an automatic deposit program-which is a great way to embark on the scenic country road to prosperity.