Index and Mutual Funds
Index Funds
Index funds are the building blocks for every portfolio. Basically index funds are a collection of stocks. Index funds often track major indexes such at the Dow Jones Industrials, the S&P 500, or the Nasdaq 100. When you invest in an index fund you are buying all the stocks in that index. So, when you buy an S&P 500 index fund you are buying 500 different companies.
Talk to great investors such as Buffett, and they will all tell you that index funds are a great place for investors to begin. Index funds provide diversity and great returns over a long period of time without significant time commitments or large sums of money. Consider the S&P 500 index for example. This ubiquitously known index has returned approximately ten percent a year for the last twenty years. These gains are possible without minimal effort and relatively small sums of money. If feel you don’t have the time to research individual companies and decide to place your money solely in index you will be very satisfied with the results. Additionally, if you have an IRA or a 401K we believe that you should only invest in index funds to get great returns and minimize risk. If you decide you want test your wits and compete against the market we recommend that you invest in index funds for one year before buying any individual stocks. Our reasoning is as follows: (1) investing in index funds for just one year builds a strong base for you portfolio that you can build on in the future and (2) owning just index funds for a year helps you garner experience and know how to give you the best chance possible to beat the market with individual stock picks. During this year of just index funds you can still hone your stock picking skills with free services such as the Motley Fool’s Caps. The Motley Fool’s Caps allows you to make stock picks and then compares your performance against the S&P 500. You are then given a rating based on your performance and that of other players.
Now that you’re considering index funds, the question is how do you buy them and which one should you buy. First, how do you buy an index fund? Well, every index fund comes with a symbol just like a stock does. All you have to do is specify to your broker the number of shares you want to buy (the price of the shares are based on the value of the index) and poof! You own an index. It is really pretty easy. Different brokers have different ways of doing things; so if you have any questions you can contact your broker’s customer support center (you did remember to choose a broker with great customer service, right?) The second question you what to know is what index fund to buy. There are literally thousands of different index funds that you can buy. You can explore the world of exchange traded funds (ETF’s) at Yahoo’s ETF Center. If you want to get really in depth, you could spend as much time picking index funds as you would picking individual stocks, but the whole point of index funds is to give you solid returns with minimal effort. That’s why we recommend the S&P 500 index fund which will give you market average returns with minimal risk. Also, the S&P 500 index fund is one of the cheapest index funds to buy (the people who run these index funds charge a fee to make money, but since the S&P 500 index fund is so large the fees are very small which is another reason why we recommend it). You can find the S&P 500 index fund through the symbol SPY.
Mutual Funds
A Mutual Fund is like an index fund without the index. In a mutual fund, you give your money to the mutual fund company and they invest your money for you. However, unlike an index fund there is fund manager (an actual person) who makes all the decisions. Since an actual person runs a mutual fund, they are much more expensive than index funds. The fund manager’s goal is to outperform the index funds you learned about in the previous section which would justify the higher fees. However, three-quarters of funds under perform the S&P 500. This is the reason we do not recommend mutual funds. Also, we believe it is very difficult to invest in mutual since you have to invest in a person. Often times, it is very difficult to assess the fund manager’s ability. In all fairness, there are many great managers out there, but we believe they are difficult to identify especially for beginning investors. If you want to look into mutual funds further check out Yahoo’s Mutual Fund Center or look into the research materials your broker provides you, but we feel that you are best off just sticking to index funds. Note: there are many different types of mutual funds, most of which can be bought through your broker. Also, some funds can be bought from the actual mutual fund company. Carefully read all materials about a fund before investing and don’t be afraid to ask questions to your broker (remember the importance of customer support) or directly ask the mutual fund company.