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Investing 101: What is an index fund?

This week we start a new series we’re calling Investing 101.  Over the next several months we’ll share some basics on investing to help you make wise decisions as you get out of debt and start investing for the future.  Look for a new blog on investing ever four to six weeks to guide you in your wealth building process.

As a general rule we suggest you never invest in something you don’t understand.  In fact, one of the key reasons many doctors have poor performing investment portfolios is because they invest in things they know little about.

We need to look no further than Medscape’s recent wealth study on physicians that showed only 50% of physicians have a net worth of greater than a million dollars.  There are many reasons for why this might be, and one big reason is doctors often times are seen as people who have a target on their back waiting to be enticed into investing in things they should be running away from.

There are many effective ways to invest such as single stocks, bonds, mutual funds, and real estate, just to name a few.  In this first blog we’re going to focus on one of our primary investment vehicles called an index fund.  So, exactly what is an index fund?

There are many “indexes” in the financial markets.  An index is just a group of stocks or bonds.  For example, one popular stock market index is the S&P 500.  You’ve probably heard of this index if you’ve done any reading on investing or watched any of the business channels on TV.  The S&P, which stands for Standards and Poor’s, is a collection of around 500 large companies traded on the New York Stock Exchange and Nasdaq Composite.  It’s designed to represent the overall composition of the economy.

For example, many of the companies in the S&P are those you’ve no doubt heard of and are even a customer of.  Top companies in the S&P 500 are Microsoft, Amazon, Google, Apple, and Johnson and Johnson, just to name a few.  There are currently 509 individual companies in the S&P 500, which leads to one of the key benefits to investing in an index fund-diversification.

Diversify to reduce investing risk.

You’ve probably heard the saying that diversification is key to any sound investment strategy.  The reason why being diversified, or owning stock in a bunch of different companies, is a good investment strategy is that when one industry sector goes down your losses could be minimized in comparison to not being diversified where you have a greater probability of taking on a greater loss.

Recent examples of what not being diversified could mean include Enron and General Electric.  You’ve probably heard the horror stories of employees who had their entire retirement invested in Enron who now have nothing left to retire on.  A similar situation has taken place with GE whose stock has gone from a high of $50 per share in 2000 to where it currently trades at around $10 per share.  In other words, the stock has decreased in value by 80% since 2000, so someone who had $1 million dollars in GE stock back in 2000 now has stock with a value of around $200,000.  This is a good lesson why being diversified can minimize your losses in down markets by not having all of your eggs in one basket.

Investing in an index fund such as the S&P 500 fund is the same as owning stock in 509 companies in a multitude of different sectors of the economy.  The S&P currently has stocks in the communications, energy, financial, healthcare, information technology, real estate, and utilities sectors just to name a few.  While it’s possible that all sectors could drop significantly at the same time it’s still a sound investment strategy to have your money spread across lots of sectors to minimize potential losses.

Index funds have lower tax implications. 

Every time a stock is bought and sold there is a potential tax liability to the stock owner.  For example, if you were fortunate to buy Apple stock back in the early 2000’s when it was about a dollar a share and sold it recently at around $200 per share you would be taxed on the $199 gain in value.  This is known as a capital gains tax.  You are paying tax on the increased value of the stock you purchased and sold.

Unfortunately, with mutual funds where someone else, an investment team, is managing the stocks in the fund, they decide when to buy and sell, and each time they sell at a gain you are liable for the taxes due.  If you’re using the fund as a tax deferred retirement account it’s not such a big deal since you only pay taxes when you take the money out at retirement, but if it’s in what is known as a taxable account, one that you can take money out of whenever you like, you’ll get a tax bill at the end of the year that will be due the following April.  This may not be a big deal for some people, but if you’re in debt and working your way out and are a bit cash poor you could be caught by surprise with a hefty tax bill you didn’t know was coming.

With an index fund very little selling of individual stocks is done because the companies in the index rarely change throughout the year.  Occasionally a company falls out of the index and is replaced with another, but overall index funds stay fairly consistent in their holding, which means lower tax liability to you the investor.

Costs are much lower with index funds.

A final reason, and perhaps the most convincing to the benefit of index funds, is their lower cost than other types of market investments.  Lately there’s been much written and broadcast about the cost of certain investments.  An argument can be made that the cost of owning a fund is money you can’t use for retirement or for personal use with a taxable fund. 

A typical mutual fund has a group of managers who actively manage the fund by buying and selling stocks and bonds to improve the performance of the fund.  They obviously don’t work for free, and a typical low cost mutual fund can have an annual management expense of over 1% that goes to the people managing it and not to you.  Now if they’re doing a great job that cost could be money well spent, but if you look at the research on mutual funds over the last several years, less than 5% of actively managed funds beat the performance of an index fund.  This number varies a little depending on how you compare the various sectors of the market, but there’s little doubt that on average an index fund will outperform those that are actively managed. 

This leads to making an argument for sticking with index funds to avoid the added cost of a managed fund.  Comparing one of the most popular index funds offered by Vanguard to a typical managed fund, Vanguard’s S&P fund (like most index funds) is over 20 times less expensive.

For example, if you invested $10,000 into the Vanguard 500 Index Fund Admiral Shares in ten years you would save over $2,000 in expenses.  This may not seem like a lot of money, but over decades and compounding with interest, fees paid to managers could get into the six-figures.

Some of this advice also comes down to just how greedy you are.  Everyone wants to beat the market, but very few do.  Our question is what’s wrong with simply making what the market has returned over its history, which is around 12% annually?  Why add all the complexity to your portfolio when if you invest regularly over the course of your career will quite likely lead to millions at retirement?

We’re not saying that as you gain experience with your investments you shouldn’t add some complexity, if that’s your thing, but for most, like us, we’d just prefer to keep it simple and live life without the worry and complexity that comes with an overly complicated portfolio.

Start simple.  Do some research.  Gain a greater understanding of how the market works.  You made it thought medical school and residency, which is far more complicated than investments, but don’t overcomplicate it.  For most of you, like us, simplicity is the right choice.

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