I made my very first stock-market purchase in 1998, in the midst of the dot-com madness. But instead of buying shares of a company that used a sock puppet to peddle pet food, I bought an index fund.
An index fund owns shares of companies that are tracked by a stock market index like the Standard & Poor's 500 or the Wilshire 5000. Unlike a mutual fund manager, who hopes his stock picks will beat the market, an index fund just wants to match it.
While index funds are dull, they are a good bet, especially in a bull market when many stocks are doing well. In 2006, nearly two-thirds of mutual fund managers failed to beat their benchmark index, according to Morningstar. Yet even in a down period, like when the tech stock bubble burst in 2000, only 50 percent of funds beat their index.
When it comes to fees, index funds have actively managed mutual funds soundly beat. You can buy some index funds for as little as a tenth of a percent of what you invest; many mutual funds charge 1 percent or more.
"In investing, the only thing you can be guaranteed is the lower your cost, the lower your cost," said Charles Buck, a certified financial planner in Woodbury, Minn., who also teaches retirement planning at Minnesota State University, Mankato. Fees matter because they come right out of your returns. It doesn't matter if your mutual fund beats up my index fund if your fees eat up the difference.
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That said, there is a place for actively managed mutual funds in a portfolio. I own both flavors in mine.
To decide when to put your returns in the hands of the market or a manager, ask the following questions:
Q: What market sector are you buying?
A: Looking to buy big well-known U.S. companies? Consider an index. "It's hard to add value against [the large-company stock] indexes without taking a lot of risk," said Patrick Egan, manager of asset management marketing at Thrivent Financial for Lutherans, a Minneapolis-based company that sellsboth index funds and actively managed funds.
When it comes to stocks of small companies and international companies, having a fund manager there to kick a company's tires "adds real value," said Nate Wenner, a certified financial planner with Wipfli Hewins Investment Advisors.
Q: What type of an investor are you?
A: Are you going to pay attention to your funds' fees and returns, research your funds' managers, or use a financial adviser to pay attention for you? You could find superior funds that tend to beat the market.
If you want to set it and forget it, consider an index.
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Q: What's your investment philosophy?
A: Some investors take comfort in knowing they'll do no better or worse than the market, whereas others want to invest to win. To be happy with an index, you must be "pragmatic by nature," Egan said.
An index-minded investor is also less likely to jump out of it in order to chase a high-flying or well-advertised fund. Research has shown that the S&P 500 beats the typical fund-jumping individual investor by about 3-to-1.
Q: Are you a big cheese or a small fry?
A: Buck likes index funds for investors with a small amount to save because you can "get a diversified portfolio without a lot of money, without a lot of funds." A cheap, easy-to-understand and well-diversified portfolio can be created using three funds: a total-market index fund that invests in domestic companies of all shapes and sizes, an international index fund and a broad-based bond market index fund.
Q: Where are you investing?
A: If the answer is a workplace retirement plan such as a 401(k), you may be out of luck. Not all plans offer index funds.
If the answer is outside your plan, index funds are appealing because their infrequent buying and selling makes them tax-efficient.
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Kara McGuire writes about personal finance for McClatchy Newspapers. Write to her at kara@startribune.com .
