Put Your Investment Portfolio on Autopilot With Index Funds

The debate about passive vs. active investing is constantly ongoing.  But, if you take to time to dig a little deeper, you’ll see some great reasons to go passive.

Let’s look at some of the reasons why…

Can portfolio managers beat the S&P 500?  Yes, in a given year, many often do.  The problem is that you can’t predict who is going to do it consistently.  Ever hear about fund managers of the year, or read a cover story about the hedge fund that made massive money in this or that trade?  The problem is what follows these events.  Massive amounts of capital inflows enter these funds as everyone wants a piece of the action.  The more money flows in, the harder it is to make out-sized returns.  Some mutual funds will close to new investors when something like this happens.

Many funds, however, welcome the influx of capital. Why? The simple answer is fees.

Here is where the beauty of index funds come right into play.  Index funds track an entire index of whatever security they are designed to follow.  So first off, they are highly diversified.  They also have very low turnover, which allows fees to stay extremely low.  Best of all, you don’t have to try to worry about who is going to beat the market in a given year.  You basically own the market, which over time has made some impressive returns.

Let’s take a look at one of the largest funds out there, Vanguard’s Total Stock Market Index Fund.  To begin, the expense ratio is 0.16%.  To give you an idea how cheap this is, compare that to the average fund with similar holdings.  Vanguard’s 0.16% trounces the average fund expense ratio of 1.09%.  All you really need to know is that  you get to keep more of your money, which can add up to huge amounts over long periods of time.  A ten-year comparison of fees (and this is straight off of Vanguard’s website).

$10,000 invested for 10 years:

Average fund: $2,457

Vanguard fund: $118

Another huge benefit with index funds are the ability to trade commission-free.  Vanguard, Fidelity, and Schwab all have a variety of options that you can trade at no cost.  This is another big cost savings, especially for someone just starting out, and for someone who likes to make small, consistent investments.

I will spend another post laying out how I specifically position my portfolio with these types of funds.  The key is to get diversified among a wide variety of asset classes.  Domestic and international stocks, large and small.  What percentage is allocated to each will depend on your age and risk tolerance.

I believe there is a place in one’s portfolio for individual stocks as well.  But the bottom line is this: with the bulk of your long-term investments (401k, IRA’s, and taxable investment accounts), your best bet is a diversified group of low-cost funds.  Reinvest your dividends, make additional contributions each year, and let time be your friend.  You’ll sleep better, not having to worry about daily market movements, or trying to “time the market.�  You’ll also take away the risk of a single stock destroying your portfolio.

The beauty is in the simplicity of it!  If you like the idea of keeping more of your money with a simpler, less-stressful portfolio, this is the way to go.

I’ll spend more posts going into depth on specific funds I like, and what percentage of my portfolio I allocate to each.

If there are any specific funds you prefer or have had success with, please feel free to share them here in the comments.