10 Ways Index Funds Can Save Your Retirement
Reprinted courtesy of MarketWatch.com
Published: Dec. 19, 2012
To read the original article click here
It’s no secret: Millions of Americans are behind — some very far behind — in their plans to retire. Some of this stems from neglect and poor choices; many people are in trouble because of circumstances beyond their control.
But whatever the cause, an effective and inexpensive tool is readily available to help: index funds.
Almost every week, when I describe my busy life as a retiree, somebody tells me some version of “I sure hope I will be able to do that someday.”
One thing they can do, usually quite easily, is move their investments out of individual stocks and actively managed funds and into index funds. This simple step can help you retire earlier, with more money in the bank and more money to spend.
Index funds are understandably boring, and Wall Street doesn’t push them much because they aren’t very profitable. But Wall Street’s pain can be your gain.
Index funds can do two very important things for you: They can add money to your retirement savings and help you avoid making dumb decisions that may derail your dreams.
Add money to your savings? Yes indeed. Index funds’ low expenses (sometimes only one-tenth those of comparable actively managed funds) leave precious money in your account instead of taking it out for Wall Street. They do this for you silently, in the background, day after day, month after month, year after year, without any action required of you.
Avoid dumb decisions? I certainly don’t mean to imply that you personally would make a dumb decision. But I can guarantee you this: Some people you know repeatedly let fear, greed and hubris lead them to make poor investment choices.
The headlines may tell you a particular stock is hot or cold; a broker may urge you to buy it or sell it. But you’ll never see a headline about a red-hot index fund. Here’s why that’s good: Low excitement means few transactions, making you a true buy-and-hold investor and more likely to succeed.
Here are 10 ways index funds can help:
One: Index funds can add one to two percentage points to your annual return, without increasing risk, simply by reducing the drip-drip-drip of those all-but-invisible expenses that remove money from your accounts.
Two: Index funds rarely replace the stocks and bonds in their portfolios. This cuts down turnover, and that saves you money. In some actively managed funds, turnover can cost shareholders as much as 1% a year.
Three: Index funds offer something you’ll never get in an actively managed fund: a guarantee to give you the return of an asset class, less only relatively low expenses. This protects you from active managers who pick bad stocks.
Bill Miller achieved celebrity status as the manager of Legg Mason Capital Management Value Fund LMVTX, +0.32%, beating the market 15 years in a row. Shareholders willingly paid high expenses. But inevitably, Miller stumbled. He’s gone now, leaving new managers to pick up the pieces. Over the past five years, this fund has trailed the Standard & Poor’s 500 Index SPX, 0.39% by seven percentage points annually.
Four: Unlike Bill Miller, unlike many individual stocks, and unlike many actively managed funds, index funds have survived all the ups and downs of the market. If you’re in for the long haul, you want these survivors on your side.
Five: Because of their low portfolio turnover, index funds save taxes for their shareholders. Most people have at least some of their savings in taxable accounts, and index funds help them hang onto their money.
Six: Index funds give investors total control of the variable that experts say is the most important divide between success and failure: asset allocation. If you want 20 percent of your equity assets invested in U.S. small-cap stocks, you can have it – exactly. You won’t have an active manager leading you astray into some other asset class.
Seven: Index funds are recommended by many of the best brains in academia and Wall Street: Warren Buffett and Charles Schwab come to mind, along with Daniel Kahneman, a psychologist who won the Nobel Prize in Economic Sciences. That should give you the confidence to make a good plan and stick with it, knowing you have done the right thing.
Eight: Index funds reduce risk through very high diversification. Some index funds own 10 times as many stocks as the average actively managed funds in their asset classes. This doesn’t guarantee higher performance, but it guarantees lower risk.
Nine: Index funds get your mind going in the right direction by letting you stop trying to find dynamite managers. Instead, you can look for great asset classes like REITs, small-cap value stocks and emerging markets stocks. I have seen investors benefit from this time and again.
Ten: Because they are mechanical and boring, index funds take much of the emotion out of investing. That alone can make you more likely to succeed.
There are many ways to invest with index funds; here are my recommendations.
Also see: Beating the market is easy
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