Your Guide to Index Fund Investing and Why They Are a Good Idea for Your Retirement

If index fund investing is good enough for the most famously successful American investor, then maybe it should be good enough for your retirement.
index fund investing
Warren Buffet, chairman of Berkshire Hathaway, one of the richest men and most successful investors in the world, recommends that people buy index funds.  He often touts index funds in his letters to shareholders as well as in interviews.  As he told CNBC, “Consistently buy an S&P 500 low-cost index fund. I think it’s the thing that makes the most sense practically all of the time. Keep buying it through thick and thin, and especially through thin.”

What Is an Index Fund?

An index fund is a type of mutual fund — an investment vehicle that pools money from a lot of investors to buy a diversified array of different stocks, bonds or other securities.

What makes an index fund special is that the diversification is based on an index — a collection of stocks representing a portion of the overall market.

What Are Examples of Index Funds?

There are two key components you need to consider when buying an index fund:

1) Who offers the fund:  Vanguard, Fidelity and Schwab are companies with good reputations who offer a variety of index funds.

2) What index you buy: You have a lot of choice when it comes to choosing an index fund. Most index funds are comprised of stocks, but you can also buy index funds for bonds and other investment types. 

Here are a few well known stock indexes that you can invest in:

The S&P500: Available from most companies selling mutual funds, the S&P500 is a fund comprised of 500 large companies that are traded on the New York Stock Exchange (NYSE) or NASDAQ.

World Stocks:  The specifics of this index will vary from company to company. However, the idea is to give investors access to nearly every publicly traded company in the world.

Dow Jones Industrial Average: This index was invented in 1896 by Charles Dow.  It tracks 30 significant stocks traded on the NYSE and NASDAQ.

Russell 3000: This index is comprised of the 3,000 largest U.S. traded companies.

Small Cap: This type of index tracks small-sized publicly traded companies.

Why Index Fund Investing is Good for Your Retirement:
Advantages of an Index Fund

There are quite a few advantages to index fund investing:

Diversification: John Bogle, founder of Vanguard and the person often credited with inventing the index fund has said, “Don’t look for the needle in the haystack. Just buy the haystack.”

What he is trying to say is that it is better to own a little bit of every stock rather than just trying to identify the stocks that will see the most appreciation.  If you buy stock in all of the companies, you are sure to buy the winners — the needles in the haystack. And it is better to own the winners and a few losers too rather than only owning one or two companies and hoping that they are the ones who will do well.

Low Cost: There is NOT a lot of research and analysis that needs to be done to manage an index fund — which makes them lower cost than other types of mutual funds.  Index funds are relatively simple — they just need to adhere to the rules defining the index.

Proven Performance: Index funds have consistently outperformed other types of mutual funds and even professionally managed hedge funds for the very wealthy.

Easy to Understand: You don’t have to worry too much about understanding your investments when you buy an index fund.  You know that the money is invested according to a certain formula and your money will rise and fall with the overall market.

What is the Downside of an Index Fund for Your Retirement?

Index fund investing still puts you at some degree of risk.  There are times when the overall market falls and, during these times, investors can experience huge (hopefully short term) losses.  And, if you need access to your money at a time when the overall market is down, you will have to sell your index fund at a loss.

So, if you are retired and you need access to your money for monthly expenses or at a specific time in the relatively near future, you may want to consider diversification beyond just index funds or at least beyond index funds based on stocks alone.

What Kind of Rate of Return Can You Expect from an Index Fund?

Benchmarking your own investment returns against an index fund is a good way to know whether you are doing well or not.

The average rate of return for the S&P 500 from 1928 (when it began) to now is approximately 10%.  However, according to Investopedia, if you adjust the rate of return for inflation, then it is more like a 7% average rate of return.

It is important to note that this 7% number can be a bit misleading — this is merely an average of the last 89 years.  There have been some wild swings.  For example, in 2008, the S&P 500 saw a NEGATIVE 37% return.

However, you can probably use 7% as a pretty good benchmark.  If you are not getting this kind of rate of return on investments, then you may want to re-evaluate your options.

Use the NewRetirement retirement planner to see exactly what kind of difference a higher or lower rate of return will have on your overall financial security. It is easy to run different scenarios for all of your accounts.




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