Wednesday, August 1, 2012

The Value of Index Funds: Part 2

Historical S&P 500 performance (thanks to Google Finance)
...and now for our dramatic conclusion of this series!

Previously, we left off on the cliffhanger on what should one invest in when it comes to their 401k or IRA?  Well, before I get into that, let me explain something else to you...I know, the suspense.  Whenever you look at different mutual funds, stock funds, or other types of investments in your 401k selection, I want you to draw your eye to a little section called "expense ratio".  This little expense is the management fee for your particular investment.  If it says something like 1%, then each year, the operators of this fund you have selected will take out 1% of your average assets for that year.  This can definitely lower your returns if you have a high expense ratio.  So what is the best investment you can select, while still keeping the expense ratio low?


An index fund is a collection of stocks that tries to mimic a particular index like the S&P 500 or Dow Jones Industrial Average.  This investment you should select is essentially the market growth rate.  If you remember my post on beta, than you'll know that beating the market rate of return without taking on more risk is almost impossible in the long run.  Look in your company's investment choices and see if there is anything close to an index fund.  On top of the best returns you can expect, these type of funds are usually very hands off to run, and therefore are very cheap to you.  Whereas the typical mutual fund can have an expense ratio up to 2.5%, the expense ratio in an index fund is usually around 0.04%!  These cheaper fees go directly into your pocket.

Here are some other options for index funds that usually perform 1-2% better in the long run than a traditional index fund.  Company 401k programs usually don't include these, so you are more likely to use them in an IRA.  A simple search on any of these topics will bring up a series of funds to invest.

Equally Weighted Index Funds - Instead of being weighted by market cap (or size of the stock), these funds hold all companies in say the S&P equally as a portion of total fund's balance.  The benefit here is that it allows small cap companies to have much more influence over the fund

Fundamentally Weighted Index Funds - These take the same set of S&P stocks and weights them by economic size which includes factors such as 5 year averages of book value, cash flow, dividends, and sales.     The result is something similar to a market cap weighted index fund, but brings in a more true look at each company's economic strength.  This allows you to invest more in the better companies.

Value Weighted Index Funds - These funds weight the stocks by their relative value based on their stock price relative to their earnings.  The goal here is to own more of the stocks measured to be undervalued, thereby maximizing returns.

Any one of these investments will take care of you throughout your life, but just remember, these funds move with the craziness of the market.  In the short term (less than 5 years), you're bound to see dramatic ups and downs if your fund's value.  Just know that you are in it for the long haul and it will pay off.

Wonderful Moment of the Day: Eating a homemade chocolate covered marshmallow!

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