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Why Index Funds Should Be Every Investor's Best Friend

Doug Whiteman
Why Index Funds Should Be Every Investor's Best Friend

Ready to start investing, but not sure where to put your money? An index fund can be a no-brainer.

The costs tend to be low, your risk is spread around, and it's easy to see how your investment is performing.

Do you watch the daily ups and downs of the major stock market averages? These days, it's almost impossible not to. Well, with an index fund, your savings go right along for the ride.

But just what are index funds?

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When you invest in an index fund, it's like investing directly in one of the major stock market averages.

An index funds is a collection of individual stocks mimicking a familiar stock index.

The best-known index funds contain stocks in the S&P 500 index or the Dow Jones Industrial Average and try to mirror how those big-name indexes perform.

Other index funds follow the Wilshire 5000 (an index of all U.S. stocks traded domestically), the Bloomberg Barclays U.S. Aggregate Bond Index (a major measure of the bond market) or the Russell 2000 (which tracks smaller companies).

How did we get index funds?

Index funds were the brainchild of University of Chicago graduate students Paul Feldstein and Edward Renshaw, who in 1960 proposed the idea of an "unmanaged investment company."

They said investment advisers rarely got better returns for their clients than the major stock averages, so investors might as well have a portfolio that automatically buys every stock in the Dow Industrials or some other index.

It took more than 10 years before the Qualidex Fund was launched, giving pensions a collection of Dow stocks. Then, in 1976, Vanguard Group offered an S&P 500 fund that's regarded as the first index fund for individual investors.

Why are index funds a good bet?

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Index funds might make you more money than a professional stock-picker.

It's estimated that index funds currently hold about one-fifth of all the money currently invested in the U.S. stock market.

Why? Mainly the reason Feldstein and Renshaw noticed almost 60 years ago: Index funds often do better than fancy portfolios managed by professional stock-pickers.

The legendary investor Warren Buffett made a bet in early 2008 that an S&P 500 index fund would beat a basket of actively managed hedge funds over 10 years.

By the end of 2017, it was clear Buffett had won the bet.

Index funds also tend to be cheap, because they're so simple. Standard mutual funds have much higher fees because they contain stocks hand-picked by managers who rely on research analysts. And those people need to be paid.

How do you buy index funds?

Eager to put some money into index funds? If you have an opportunity to open a 401(k) or other retirement plan where you work, do it — and make index funds the centerpiece of your portfolio.

You also might make index funds part of your portfolio if you open an account with one of today's automated investing services.

Or, you can buy into funds through any mutual fund company. Large fund firms may emphasize their own funds, so you might find a wider selection of index funds by turning to a smaller discount broker.

Happy investing!