Greetings! On the plate for this post are index funds and why they’re my personal preference over mutual funds any day of the week. I will explain what an index fund is, why I prefer them over mutual funds, and show where mutual funds lack.
If you ever had a financial person or place of employment push mutual funds on you as an investment for your retirement plan, then I wrote this post for you because we’re going to talk about something better, and why they’re better.
Please note that I’m not a financial advisor, and when it does come to index funds vs. mutual funds, a Certified Financial Planner who knows your situation precisely will have a more perfect answer for you and your investment objectives.
What is an index fund
First off, what’s an index fund? According to Investopedia, an index fund is a type of mutual fund or exchange-traded fund (ETF) with a portfolio constructed to match or track the components of a financial market index.
In plain English, an index fund contains stocks that are part of an index, such as the S&P 500, so that if you own the index fund, you own every single stock of that index.
Investors can buy index funds as a way to limit their risk over picking individual stocks. While individual stocks can shift rapidly up or down, index funds move with the entire market. Therefore, they generally have less gain and less loss over short periods of time or less volatility.
Brokerage firms list index funds that you can buy, should you be interested. I use Charles Schwab Bank for my brokerage account, and if you use my Charles Schwab Bank link to sign up, you could get up to a free $500 added to your account based on how much you deposit on your first deposit.
Why invest in index funds
We don’t hear much about index funds in commonplace. We often hear about mutual funds, which I’ll get into shortly. Index funds are superior to the vast majority of mutual funds for three primary reasons:
- They are low cost: Index funds don’t come with high management fees like mutual funds. Many index funds take less than 0.1% per year in fees.
- Steady: Index funds follow the general trend of the index they follow. For example, the S&P 500 generally trends upwards at 9.8% per year when you take the average over several decades. An S&P 500 Index fund would do similar.
- They’re Reliable: Despite Morningstar Ratings and money managers touting mutual funds, the vast majority of mutual funds do not consistently beat the market, but with an index fund, you are meeting the market, which is an efficient way to invest.
Mutual funds vs. Index funds
Let's go over some key differences of index and mutual funds. Mutual funds are actively managed, meaning a portfolio manager actively trades shares to attempt to bring in the most money. Index funds are passively managed and follow one of the many stock indexes, such as the S&P 500 or the Dow Jones industrial average.
If you have a 401(k) at work, you’ve probably heard of mutual funds, and they’ve probably been sold to you hard. If you have a financial advisor, you may also have been sold mutual funds. Why? What’s the big deal with mutual funds?
According to Tony Robbins, author of the incredible book Money Master the Game: 7 Simple Steps to Financial Freedom, mutual funds are all about marketing. When mutual funds gain money, the managers and companies make money.
With index funds, the investor is banking almost everything, so why should the firms talk about them? What gives them motivation when there’s no money in it for them?
Why else don’t I like mutual funds. Another fun fact from Tony Robbins from his book is that 96% of all mutual funds FAIL to beat the S&P 500 over the long term. So why invest your money in them?
Here’s another way of looking at it. If I asked you to give me your money, and I would invest it how I see fit, and if I messed up, you would lose your money, and I would lose nothing at all, how would you feel about that? That’s essentially what a mutual fund is.
The fund manager takes no financial risk if they lose your money, and you still pay fees in the form of expense ratios and more, to be a part of the professionally managed fund.
Why index funds are a better solution
Index funds are a better solution. As said earlier, they are low-cost, and they follow specific indexes, allowing your money to grow with an entire segment of the market.
Let’s look at a graph of the S&P 500 over 40 years and see how much your money could potentially grow in an S&P 500 index fund over the course of your adult life.
On May 23rd, 1980, the S&P 500 was valued at $110.62. Today it’s valued at $2,970.70. Assume if you will that there’s an index fund that followed the S&P 500 precisely for 40 years. You would have over 25 times your money 40 years later. That’s crazy!
Growth over time
Let’s assume you can invest $500 per month into an S&P 500 index fund for 5 years, 10 years, 20 years, and 30 years. How much would you have? Let’s check that out just below. Assume an average growth of 9% per year, which follows an average historical progression.
I chose $500 per month for a reason. You can currently invest $6,000 per year ($500 per month if you average) into a Roth IRA. Roth IRAs use after-tax dollars, and you do not pay taxes on your earnings if you withdraw your money after you are 59 ½ or if you meet other qualifying conditions.
That means your $6,000 annual investment at a potential 9% growth per year, averaged, could definitely give you a nest egg for retirement.
Wrapping it up
I have always been a big proponent for index funds. They’re simply better in almost every way you look at them. If you’re in the market to invest in mutual funds and ETFs, consider looking into index funds. Your financial advisor or brokerage firm can answer any questions you may have.