||Ask the Dollar Diva
Is an Index fund a good idea?
Dear Dollar Diva,
Is it a good idea for a 21-year-old to invest in an index fund in
her Roth IRA? I am inclined to stay away from the actively managed
mutual funds because I've read that only a small percentage of them
actually beat the market.
If investing in an index fund is a good idea, is it
better to invest in an S&P 500 index fund or some other index
that is centered on just small-cap or mid-cap stocks? I plan to
hold onto this fund until retirement.
Index funds are the perfect investment for the long-term
investor who wants to be in the market, but doesn't want to spend
time and energy on investment research. And investing in index funds
is a good idea for your Roth IRA.
An index fund invests in the same stocks that are
in a particular index. It's a passive kind of investing because
the index picks the stocks, not the fund manager. For example, an
index fund that buys the same stocks that are in the S&P 500
will have the same performance of the S&P 500, less the fund's
management fees. It doesn't try to beat the market; it just wants
to be a player. Management fees should be negligible because there's
no stock picking involved.
An actively managed fund has a manager who picks stocks
that he expects will perform better than the market. If it's a large-cap
fund, he expects his fund to outperform the S&P 500. Since he's
buying and selling stocks all the time, management fees will be
Common sense tells us that because of their loads,
fees and tax inefficiencies, it's not easy for an actively managed
fund to consistently beat the market. History tells us that managed
large-cap funds beat the S&P 500 sometimes, but very few of
them do so over the long haul.
The Diva gives a big thumb's up to starting with an
S&P 500 index fund. We don't have as much history on smaller-cap
and international funds, so the managed fund vs. index fund argument
continues for these categories.
However, when in doubt on an investment strategy,
it doesn't hurt to embrace the methodology of John Bogle, founder
of The Vanguard Group. His advice to investors: "To earn the highest
returns that are realistically possible, you should invest with
simplicity." Until you are ready to learn more about investing in
mutual funds, the simplest thing to do is stick with index funds.
When you're ready to learn more, start with the Diva's
a novice investor begin," and read some good books on mutual
fund investing, such as Alan and Steve Cohn's "The
Sage Guide to Mutual Funds"
Loads and Fees
When shopping for an index fund, look for the lowest
fees; and never, ever pay a load. To learn more about fees and loads,
read the Diva's "Mutual
Asset allocation is another word for diversification.
Someone your age, interested in index investing, might want to develop
an investment portfolio that looks like this:
|| S&P 500
|| 70 %
|| S&P Mid-Cap 400
|| 10 %
|| Russell 2000
|| 10 %
|| Morgan Stanley Capital
International's Europe, Australia and Far East (EAFE) Index
|| 10 %
Where to find them
Vanguard Group is the 800-pound gorilla of index funds, and
a good place to start your search. T.
Rowe Price and Fidelity
are also players, and your favorite search engine will help you
find more. For independent mutual fund information and analysis,
is the place to go. If you have two funds that you're considering,
the Morningstar Quicktake Reports can help you make your decision.
How your money will grow
If you start contributing $2,000 a year now, and can
get an annual return of 9 percent, your Roth account will grow to
$1,078,700 in 43 years. And because it's a Roth, none of your distributions
will be taxable. Not bad when you consider the following:
- Contributions to Roth IRA ($2,000 x 43) $
- Tax-free earnings 992,700
- Total Roth IRA account in 43 years $1,078,700
Make maximum 401(k) plan contributions, too, and you'll
be on your way to a very comfortable retirement.
-- Posted: Jan. 25, 2001