When I first started learning about investing and retirement accounts, I struggled to determine where I should invest my money. Thankfully, several great personal finance web sites (including Motley Fool and Bogleheads) agreed that investing in index funds led to the most benefit for most people. Index funds are mutual funds that track what is called a market index, like the Standard and Poor’s 500, and maintain small slices of companies in proportion to the companies’ share of the index. For example, if Apple currently makes up 2% of the S&P 500, an S&P 500 index fund would place 2% of its holdings in Apple.
Why is indexing preferred over investing in actively managed funds, where fund managers buy and sell stocks on a frequent basis? The frequent buying and selling of stocks generates commissions for the fund managers and their companies (this is your money going to pay the fund managers). Additionally, there are often fees associated with the initial purchase of actively managed funds. At the end of the day, actively managed funds must increase in value not only to match the gains of index funds, but also to cover actively managed funds’ much higher expenses.
Study after study indicates that index funds outperform actively managed funds:
I recommend Vanguard Funds (www.vanguard.com) for index funds, as Vanguard’s funds have the lowest expense ratios. One fund that is highly recommended by many proponents of indexing is Vanguard’s Total Stock Market Index Fund (VTSAX), which has an extremely low expense ratio of 0.05%. In comparison, many actively managed funds have expense ratios of over 1.00%. While this extra percentage point may not seem like a lot, when compounded over time, this extra 1.00% may result in you paying fund managers tens of thousands, if not hundreds of thousands, of dollars that could have been used to grow your retirement nest egg.