Investing is about more than money – it’s about your future. This makes investments both particularly important, but also stressful. There are so many options to choose from, but knowing which will truly help your portfolio meet benchmarks to make a return isn’t always clear.
How you invest your money depends on a lot of factors, many of which are personal. In that sense, no one investment is “right” for everyone. However, index funds (a type of mutual fund made to mirror certain market indexes) provide numerous advantages that shouldn’t be overlooked.
What are the top 5 reasons to choose index funds for your portfolio?
1. Index funds don’t need to be actively managed
Actively managed accounts are risky to some degree. The goal is to “beat the market.” Managers make predictions about the market and essentially invest based on their research and judgment.
Choosing an organization to manage your investments requires a lot of research and trust, to some degree.
In some ways, index funds are easier and less risky since they rely on hard data rather than human decisions. Your stocks or bonds and investments reflect what’s actually happening in the market.
This can be especially appealing for someone just starting out who doesn’t know much about stocks or investments.
2. Index funds have fewer costs and are less expensive
One major advantage to investors is the low costs and fees associated with index funds.
Actively managed funds require just that – constant management by a real human. You trust that person to make financial decisions, but you also need to pay them to do so. This means more operational costs and fees, according to CountWise.
However, index funds are managed by the stock market and a computer that tracks it. Since you don’t need to pay a person to do research or make any changes or decisions, there are fewer operational costs and lower fees.
To put that into perspective, the average equity mutual fund charges fees from 1.3 to 1.5 percent, but the fees for an index fund can be as low as .2 percent.
The average expense ratio of indexes compared to actively managed funds is also telling.
According to the Wall Street Journal, the average index bond and equity funds charged just over $1.00 a year on a $1,000 investment in 2013. Actively managed bond funds on the other hand cost around $6.50 while actively managed equity funds cost around $9.00 a year on a $1,000 investment.
3. Index funds bring more returns than actively managed funds
New studies show that a lower cost also means greater rewards. Morningstar published a report in 2015 comparing active to passive managers. Perhaps surprisingly, the report showed that in the long run, passive funds tend to make more money than active ones.
And, even more enlightening, Morningstar found a correlation between low fees and high performances and high fees and … well … a flop. This led them to make the bold statement that fees “are one of the only reliable predictors of success.”
A report from S&P Dow Jones Indices confirms this trend – in 2014, over 80 percent of large-cap equity managers underperformed their benchmark, and over a 10-year period 82.07 percent were still underperforming.
One reason for this, according to Vanguard, has to do with high-interest rates on actively managed accounts. A fund that charges 1.3 percent annually will take out a much larger chunk of your earnings than .2 percent.
Although it might sound small initially, after 10 years, 1.3 percent might cost you hundreds of thousands of dollars compared to a lower interest rate.
4. Index funds have a lower portfolio turnover
Index funds help investors save in other ways as well. Actively managed funds tend to turn over portfolios more quickly than passive funds. In fact, Market Watch reports that most managers turn over a portfolio in less than a year.
Why does this matter?
Turning over a portfolio means selling one of your investments before placing it in a new stock or bond. When you sell something, you have to pay taxes on capital gains. This might hurt your earnings in the long run, especially when you could have held your funds in one account for a longer period of time.
5. Index funds have more diversification
To reduce risk, many investors try to diversify their portfolios. Combining some risky investments with more stable ones evens out the portfolio, making it more stable.
Index funds in and of themselves help you diversify by investing in shares from an entire index.
Actively managed funds rely on picking and choosing, but indexes are more standardized. For example, Standard & Poor’s 500 stock index covers about 75 percent of the equity market in the U.S. You can invest in large indexes like this or diversify further by investing in multiple indexes, big and small.
Index funds are certainly a popular, and wise choice for many people. However, it’s important to keep in mind investments aren’t always black and white. Before making any decisions about your future, consult an accountant or financial planner about what type of funds are right for you and your family.
Author Bio: Troy Martin
Troy has been married for 27 years to his wife Shauna. They have six active children and they love to participate in many extracurricular activities including: boating, flying, mountain biking, hunting, fishing, horseback riding, and adventure motorcycling (pretty much whatever will get them outside).
Troy has a vast amount of experience in the following business sectors: medical, dental, manufacturing, retail, restaurants, construction, farming and ranching.
He is a shareholder in Cook Martin Poulson a Utah Accounting Firm.