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-- Posted: Jan. 25, 2001

Dorothy Rosen -- The Dollar Diva 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.

Junvi


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.

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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 higher.

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 "Where does 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 fund fees."

Asset Allocation

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:

Index Funds Index Percentage of Portfolio
Large-Cap S&P 500 70 %
Mid-Cap S&P Mid-Cap 400 10 %
Small-Cap Russell 2000 10 %
International Morgan Stanley Capital International's Europe, Australia and Far East (EAFE) Index 10 %

Where to find them

The 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, Morningstar 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) $ 86,000
  • 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.

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