Dividend Journey 003

So I started putting my money into index funds. I opened up a Roth IRA, a taxable account and I put money into my 401(k).

Detractors of index funds say that you can never do better than the market average if you index (sometimes “index” is used as a verb to mean “invest in index funds”). Proponents say that is kind of the point. While some actively managed funds beat the index in a given year, few do so consistently. If a fund has done better than the overall market for X years, it will probably do worse than the market in year (X + 1). This probability will increase as X increases. You won’t beat the market with an index fund, but you probably won’t beat it outside of one either. In general, the markets tend to go higher over time.

Index funds have less turnover than active funds, so they have lower costs as well. Plus an index fund does not have to spend money on research. Granted, a fund tracking the S&P 500 has to buy 500 stocks. But I would imagine that they get some sort of discount not only since they buy in bulk, but because the composition of the order is predetermined. But I don’t run a fund so I am just guessing.

An interesting fact about an actively managed fund is that other investors in a fund could raise your tax burden. Funds pass on capital gains taxes and other taxes on to their investors. So if you are buying while a lot of other people are selling, you could foot part of their tax bill. That sounds like a raw deal. It could be a really bad deal if you buy into a fund in December, and you help pay the taxes for people who sold earlier in the year.

As I stated, there are investors who beat the market, sometimes over decades. People who argue against index funds will bring up their names: Peter Lynch, Bill Miller, Warren Buffett, George Soros, Steve Cohen. But there are a few caveats. First, the active proponents keep bringing up the same handful of names over and over again. Also, a lot of funds that beat the market are hedge funds, which are inaccessible to most people. (Some people think that is a good thing.) Some, like Lynch and Soros, have retired from managing money. You also need to get in at the beginning of a winning streak. If someone beats the market for 10 years, and you hear about it in year 5, then the big money has already been made. So how to find those funds that are just starting their streak? Good luck with that.

So in the 401(k), I put the money into 3 US stock index funds (large-cap, mid-cap and small-cap), and a bond fund and an international fund. The bond and international funds were not index funds, but I wanted to be diversified and had to take what was offered. In my IRA. I went into a large-cap fund (the S&P 500 fund), an index for US stocks not in the S&P 500 (I think they called it the “Extended Equity Index”), a US bond index fund and an international index fund. In my taxable account I put my money into an S&P 500 fund.

I mentioned that I had done some research, both via books and the web. (Keep in mind I am not offering any services or advice; this site has a disclaimer.)

The Motley Fool and CNN Money sites have been changed in the intervening years. They both had sections that guided you through the whole personal finance continuum: They started with how to get out of debt, how to pay off your credit cards, how to set a budget, how to look for a good savings account, how to invest, etc, etc, all the steps on one page. Now they seem to have things scattered. CNN Money has a retirement guide.

The Motley Fool seems to have split things as well. They have pages on general personal finance and another on how to start investing, with a page that mentions index funds.

I read a few books by Jack Bogle, The Great Mutual Fund Trap, and A Random Walk Down Wall Street. A Random Walk Down Wall Street gets updated almost every year. He never uses the term “index fund”. Instead he uses a phrase like “a diversified basket of stocks”. I probably read a few others, but I cannot remember them right now.

You can also find a few good posts about index funds at Skeptic Money: What Is An Index Fund?, Investing – Where Do I Start?, Financial Flimflam and How Does Turnover Ratio Affect My Mutual Fund Return?


Page created on 2013-01-13_23:22:15, last modified on 2013-01-13_23:22:15.

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