As I’ve mentioned previously, index funds that track the stock market are the recommended investment options, and a majority of your net worth should be invested in them. Let’s take a deeper look into index funds today.
What is an index fund, and why is it better than buying individual stocks or mutual funds?
An index fund is a type of mutual fund, but unlike most mutual funds that are actively managed and charge high fees to pay the salary of the people who manage them, an index fund automatically tracks the performance of an index, such as the S&P 500.
Index funds are recommended over actively-managed mutual funds because of their significantly lower fees. This makes a huge difference, because whatever you don’t pay in fees is re-invested in the market, and with the magic (or math) of compound interest, even a 1% difference in fees could mean hundreds of thousands of dollars over the long-term for an average investor. Mutual funds managed by professionals will not beat the market consistently enough to make them worthwhile. They are extremely profitable for the people who manage them, which is why they are marketed like crazy and unfortunately are still popular to uneducated investors today, but the evidence is overwhelming: investors who invest in low-cost index funds see much better results over time. So stay away from actively-managed mutual funds unless they are your only options, that is, if you are investing through your employer’s 401k or 403b plan and you have a limited choice of funds. In that case, still invest in whatever option you do have to maximize whatever employer match you can get, because that is basically free money which you should definitely take advantage of, and whenever you decide to leave that job, immediately roll them over to an IRA invested in index funds to let that money grow more efficiently.
As for individual stocks, buying them is fun but also not recommended for the sake of your future. If the professionals who manage mutual funds can’t even beat the market, what makes you think you can? However, trading stocks is far better than gambling away your money at the casino or through lotteries. At least the expected return is positive with stocks, unless you are trading so frequently to pay more in trading fees than the gain you should make through the market on average. So if you have an itch for gambling, by all means, be my guest and have fun trading stocks. Lotteries are stupid, because the more you play, the more you lose. If you do trade stocks for fun, just remember to only trade stocks with a small portion of your assets, and favor buying and holding for the long-term over trading frequently.
My grandmother actually trades stocks as a hobby, and I support her completely because this hobby is intellectually stimulating for her, and I think it is great for maintaining her sharp mental state even in her old age. I am also quite impressed to see her do it all without a computer. She watches a market-news program that shows the fluctuations of various domestic and foreign company stocks, keeps a mental state of the stocks she holds and their movements over time, and trades her shares through the phone by calling her broker. BUT!! As much as I love my grandmother and enthusiastically support this habit of hers, that is NOT my recommendation for you. My grandmother has invested wisely over her lifetime, has built up a fortune, and now she deserves to have this kind of fun even though her strategy may not be optimal. You, however, in order to optimize your investment, should avoid trading individual stocks, and simply invest in index funds instead. The problem with trading stocks is that because you are basically trying to time the market for each stock you buy or sell, you are often holding a portion of your assets in cash between the time you sell your shares and the time you decide on which company to invest in next. This gets pretty costly over time, because you are missing out on the growth of the market while your money is not invested in the market, not to even mention the fees charged for each trade you make. The overarching trend of the market is that it goes up over time. Even in the last two decades in which we’ve seen the dot-com crash of 2001 and the financial meltdown of 2008, the stock market has still gone up over time, on average. Trying to time the market is a loser’s game for that reason. You miss out on the growth that happens while you are not in the market. A far better alternative is to always be investing by keeping your assets in an index fund at all times.
Up next, we’ll take a look at the index fund that gives you the easiest, hands-off investment option: “target-date retirement fund.”