What an index fund is
An index is a list of securities built by a rule, such as the 500 largest American companies or every publicly traded stock in the country. An index fund simply buys everything on the list in proportion. It employs no team of analysts, which is why it is cheap, and one share of a total market fund makes you a part owner of several thousand companies. Over fifteen-year stretches, a large majority of actively managed stock funds have trailed the index they tried to beat. Their costs are simply higher than their edge.
Expense ratios
The expense ratio is the annual fee, expressed as a percentage of your balance and deducted quietly from returns. Broad index funds charge roughly 0.03 to 0.10 percent, and active funds often charge 0.5 to 1 percent or more. On $10,000 that is $3 to $10 a year against $50 to $100. The gap compounds. At a 7 percent gross return, a 1 percent annual fee leaves you with roughly 30 percent less money after forty years.
Mutual fund or ETF
The two are different wrappers around the same portfolio. An index mutual fund is priced once a day after the market closes, accepts any dollar amount, and is easy to feed with automatic monthly purchases, though some funds require an initial minimum of $1,000 to $3,000. An exchange-traded fund trades all day like a stock through any brokerage, and its minimum is the price of one share, or less where the broker sells fractional shares. ETFs are slightly more tax-efficient in a taxable account because they rarely distribute capital gains. Inside a 401(k) or an IRA that difference vanishes.
Building with them
Three funds cover nearly everything: a total United States stock fund, a total international stock fund and a total bond fund. A target-date fund packages all three and shifts toward bonds as its year approaches, for a slightly higher fee. The common mistakes are specific.
- Owning a large-company fund, a total market fund and a growth fund is not diversification, because all three hold the same stocks.
- Thematic, leveraged and inverse ETFs borrow the vocabulary of indexing, but they are narrow bets with high fees.
- The word index on a label does not guarantee a low cost, so check the expense ratio every time.
- Selling during a decline converts a temporary loss into a permanent one.
Tip Turn on automatic dividend reinvestment the day you buy. Reinvested dividends account for a large share of the market's long-run return, and the setting takes ten seconds.
