Wanna own shares of some of the best-known companies in America and beat the pants off of most mutual funds? It’s shockingly easy with index investing. In the next 60 seconds, we’ll show you how to do it.
0:60 What is an index?
The Dow, the S&P 500, the Nasdaq 100, the Wilshire 5000, the finger next to your thumb — they’re all indexes. Each is a group of stocks chosen to represent portions of the stock market (except for your index finger, of course). Most index investments are based on the Standard &Poor’s 500 (the stocks of 500 leading companies in leading industries) and the Wilshire 5000 (all the publicly traded companies in America). Heard of General Electric, Tupperware, and Microsoft? If you invest in the S&P 500 or the Wilshire 5000, you are a part owner of these companies.
0:50 Why invest in an index?
A broad-market index matches as closely as possible the return of the overall stock market. What’s so great about that? Most mutual funds find it hard to do. In fact, less than 20% of actively managed diversified large-cap mutual funds (in plain English: big funds managed by guys and gals in fancy suits) have outperformed the S&P 500 over the last 10 years. Pretty dismal.
0:40 Save money!
One of the reasons index investing kicks butt is because it’s so cost-efficient. Index funds just invest in whatever companies are in the index. No MBA-toting analysts needed! This significantly reduces the operating fees the fund must charge shareholders, leaving more of your money to grow, grow, grow.
0:30 Buy the fund or the stock
There are two main ways to invest in indexes: through mutual funds and through “exchange-traded funds” (ETFs), which trade like regular stocks on the American Stock Exchange. ETFs that track the S&P 500 include Spiders (AMEX: SPY) and iShares (AMEX: IVV). The Wilshire 5000 can be tracked by investing in Vipers (AMEX: VTI).
Which are better, mutual funds or ETFs? Performance-wise, it doesn’t really matter; the returns are almost identical. But there are a few things about each type of investment that may sway you one way or the other:
Index funds: There are a whole bunch of them, as you can see from this comparison table (and that just scratches the surface). Funds can have high minimum investments, but those are often waved if you enroll in an automatic investment program (which regularly transfers money from your checking account to your fund each month). You can invest in a mutual fund directly through the mutual fund family or through your brokerage account.
Exchange-Traded Funds (ETFs): Since they are bought and sold just like stocks, you must have a brokerage account. (If you don’t — or you want to see how yours stacks up — visit our Discount Broker Center). This means you’ll pay a commission each time you buy or sell.
0:10 Keep those fees in check!
Index funds and ETFs charge investors annually for the costs of running the fund. This is known as the expense ratio, and it’s calculated as a percentage of the amount you have invested. There’s no need to invest in an index fund or ETF with an expense ratio greater than 0.40 (four-tenths of a percent).
Note: Make sure that you invest in a no-load fund, i.e., a fund that does not charge a commission.