INDEX FUNDS ARE LIKE the overbearing producer on the set of a motion picture. You know the guy. The one who always wants to cut scenes to lower costs. The one pounding the drum for cheaper costume changes and sets. Maybe worst of all, the one who prefers recycling old standards for the soundtrack instead of creating new music. It makes the results predictable. The cost of making sure that you avoid failure is that you also never create magic.
That’s the life of an index fund.
It may sound like index funds are the enemy of creative individuals, but think for a moment how your money differs from your art. With money, there should be little creativity. By keeping it simple, you’ll understand your investment approach. If a fund can find a way to eek out a steady profit by the time you need money, isn’t that the goal? For many, it’s a comfort to know that the base of their money is invested in a collection of solid investments. Index funds aren’t usually geared for you to take big chances. For many investors, this is exactly the investment they’re looking for.
In essence, when you buy an index fund, you’re choosing the overbearing producer to manage your money. He’s much better standing next to your cash than interfering with your art.
Index funds are largely defined by three criteria: low costs, attention to discipline, and low taxes. Let’s talk about how they work, then how to buy them for your portfolio.
An index fund follows something called an index. If you’ve ever heard people on the radio talking about the New York Stock Exchange, NASDAQ, or Dow Jones Industrial Average, you’ve heard of indexes. An index is a collection of stocks that people track to get a feel for how the market is acting. The Dow Jones Industrial Average tracks the performance of 30 industrial companies across a spectrum of industries. When people say the Dow Jones Industrial Average fell, it means that these 30 stocks decreased in value. Because they’re big companies, you can quickly surmise how the broader stock market and the U.S. economy performed that day.
Indexes track a variety of investments. The NASDAQ index tracks mid-sized, technology-oriented companies. The S&P 500 tracks the performance of the largest 500 companies in America. The EAFE International Index tracks the largest stocks outside the United States.
Sometimes they’re quirky. The NASCAR Index tracks companies that advertise during auto races. The Austrian Index tracks the largest Austrian companies in the world. The Commodities Index tracks the prices of precious metals, timber and other resources.
These are low cost investments because there is no need for a manager. Instead, the fund mimics the action of the target index. These funds produce low taxes because they aren’t trading unless a stock is replaced in the index.
Index funds make a fantastic centerpiece for your portfolio, because they allow you to diversify at a low cost. Here are some tips to get you started investing in index funds:
- Only invest in stock index funds if you have a long time frame until you need the money. Stocks are wonderful for goals at least ten years away. They’re rotten choices for your new car next year or a home improvement fund.
- Start with large companies. Choose an index fund that tracks a large number of big companies in the United States. An S&P 500 fund is a good starting point for a new investor.
- Dollar-cost-average into the fund. Make purchases regularly rather than buying into the fund on one day. If you invest all of your money in one swoop and the index drops in value, you’ve lost money. If you place a little in while it’s high and more when it lowers, you’ll gain a profit more quickly when it rises again. Most investors sign up to make regular investments into their account.
- Use online resources to find a good fund. Become familiar with Morningstar.com. This website offers third-party analysis of every available fund. One tool on the site is called the “Fund Screener.” Screen for available index funds. Compare the price tag of the funds. Invest in one of the lowest cost funds available.
- Once you’ve established a large company index fund, diversify your portfolio with an international fund and small-sized company fund. If you use them at all, save investments in quirky funds like the Austrian or NASCAR indexes for your most aggressive dollars, because these are as much “bets” as they are investments.
Although nobody likes the penny-pinching producer in the artistic world, he’s a hero in financial circles. Like the index fund, he worries about costs, taxes and consistent productivity. Although you probably won’t invite him to your next party, he’s a great guy to have around when it comes to managing your portfolio. Follow these steps above and you’ll have a portfolio which meets your long term investment goals.