Building a Legacy Wealth Portfolio: Index Funds

There is a lot of hype, misinformation, and confusion going around when it comes to investing in the stock market.  There are so many different stock options that for many it is overwhelming and hinders their ability to move forward with their legacy wealth building plan. Fortunately, there are alternatives.  You do not have to try to pick the winners in the stock market to achieve steady long-term growth.  A proven strategy is to invest in the market itself.  An index fund is a bundle of securities that collectively track the performance of stock market indices like the S&P 500, Dow Jones Industrial Average, or the NASDAQ.  An index fund contains the same investments in approximately the same proportion as the market indices that the fund tracks. The index itself is usually focused on a specific sector, geography, or stock exchange.  While many of the biggest index funds track the stock market, some funds track indexes in other markets like bonds, commodities, or real estate. Index funds enable passive investing, broad diversification, low costs, and provide attractive returns. Historically, index funds outperform other types of funds that are actively managed by top investment firms.

1. Passive investing. While professional investors make a living by trying to out-perform the market, that strategy is difficult to consistently execute over a long period of time. Even billionaire investor Warren Buffett, whose stock picks are closely followed, has repeated recommended index funds. Last May, at Berkshire Hathaway’s virtual annual meeting, chairman and CEO Buffett said: “In my view, for most people, the best thing to do is to own the S&P 500 index fund.”
2. Broad diversification. The most obvious benefit of investing in index funds is that your portfolio becomes instantly diversified, minimizing risk/the likelihood of loosing some or all of your money. While the performance of companies can fluctuate wildly over time, investing in a fund that holds all of the companies in a particular index allows your portfolio to match the performance of the index itself.
3. Low costs. Index funds have relatively low costs associated with it. The major costs associated with investing in other types of funds such as mutual funds and Exchange Traded Funds (EFT) are taxes and management fees, which offsets how much you make from investing in those funds.  Index funds pool money from a group of investors and then buy the individual stocks or other securities that make up a particular index. This passive investing model helps to reduce the associated costs that fund managers charge, compared to those funds where someone is actively strategizing which investments to include. Among equity funds, the average expense ratio for index funds was 0.08%, compared to .76% for actively managed funds. That works out to $0.70 for every $1,000 invested versus $7.60.  Additionally, index funds hold investments until the index itself changes (which doesn’t happen often), therefore they have lower transaction costs and generate less taxable income.
4. Attractive Returns. Index funds often perform better than the majority of non-index funds that strive to beat the market. For instance, U.S. News & World Reprt oted in 2011 that index funds tied to the Standard & Poor’s 500 index generated better returns over the previous three years than almost two-thirds of large-cap actively managed mutual funds.

There are many different index funds. They are typically named after the sector or index they are replicating such as:

• General Equity Market Index Fund
• Large Cap Index Fund
• Small Cap Index Fund
• Dividend Index Fund
• Bond Index Fund
• International Equity Index Fund

To own thousands of companies and get invested in the market all that is required is to open up a brokerage account, do your due diligence and figure out which index fund is appropriate for your risk tolerance and financial situation. Many people (including myself) like Vanguard index funds. The key is to do your research, get started, stay consistent with your investing, and continue to educate yourself about finance and saving.   

This blog is part of a Building a Legacy Wealth Portfolio series:

Legacy Wealth Portfolio: Commercial Real Estate

If you want more information on commercial real estate investing or need help with creating a legacy wealth budget for your household, please do not hesitate to contact me for help.

Charleese Hasan, PhD, The Budget Dr. OH Charlie LLC: ohcharlie2llc@gmail.com