7 Reasons Why Most of Your Money Should be in Index Funds

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why you should invest in index funds
It sometimes seems that nearly everyone is looking for some foolproof method to beat the market and earn a lot more return on their investments. This can include investing in actively managed funds, buying individual stocks, taking a shot on penny stocks, or loading up in select investment sectors. But while any of those strategies…

It sometimes seems that nearly everyone is looking for some foolproof method to beat the market and earn a lot more return on their investments. This can include investing in actively managed funds, buying individual stocks, taking a shot on penny stocks, or loading up in select investment sectors. But while any of those strategies could payoff handsomely, there is at least an equal chance that you can take a serious beating. This is why most of your money should be in index funds.

There are at least seven major reasons for making index funds your primary investment hold.

Reasons Your Investments Should Be in Index Funds

Taking Advantage of Professional Management

A big advantage that you have any time you invest your money in funds is that you don’t have to concern yourself with managing your portfolio. The fund is a portfolio all by itself. And it is managed by people for whom investment management is a full-time occupation. Because of this, they also have access to more tools and information than you will as an individual investor.

When you are investing in index funds, you won’t be taking a chance on the investment manager “getting it wrong”. Index funds are determined by the underlying index of stocks, so there’s virtually no chance of fund management overloading the portfolio with bad investments.

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Few Investors Beat the Market Consistently

Despite all the hype swirling around this and that magical investment program, very few people are able to beat the market. Those who do might do it in a given year – or even over a two or three-year time frame – but the majority don’t. In fact, studies have indicated that even the majority of active mutual fund managers under-perform the market over the long run.

You can do all that you can to beat the market yourself, and still come up short. And it can end up being a lot of work with no real benefit.

Index funds will always at least track the market, because they are the market. That makes performance and returns a lot more reliable than the alternatives.

Index Funds are Tax-Advantaged Investments

why you should invest in index fundsThis is a factor that becomes more important as your investment wealth grows. Investment portfolios generate income, which means that they also create tax liabilities. Those tax liabilities have the net effect of reducing your return on investment.

But index funds are often referred to as being tax-advantaged investments. That’s not the same as being tax-free, or even tax-deferred, but it is a significant benefit.

Because index funds are tied to the underlying index, they only trade securities when necessary to remain consistent with that index. That means that they don’t trade nearly as often as actively managed funds. Where an actively managed fund may have an annual turnover ratio of greater than 100%, an index funds may be in the 20% to 30% range.

The lower level of trading reduces the amount of capital gains income that you’ll receive. This is especially important in regard to short-term capital gains, since they are taxed as ordinary income, and don’t have the tax benefits that long-term capital gains do.

In an index fund, individual securities are held for many years. This allows them to continue growing without creating capital gains. This is why index funds are said to be tax-advantaged. Growth, with fewer capital gains taxes.

Lower Transaction Fees

Yet another advantage of the low turnover rates in index funds is lower transaction fees. Since the funds trade far less than actively managed funds, they also incur far lower transaction fees. This means that less of your investment returns will be eaten up by these fees. A small difference in transaction fees, each year over several decades, can make a difference of tens of thousands of dollars.

Built in Diversification

When you invest in index funds you don’t need to concern yourself with diversification, at least not as far as the stock portion of your portfolio is concerned. By investing in a broad index fund, such as one based on the S&P 500, you’ll be investing in hundreds of stocks, in dozens of sectors. You will even have a fair amount of money invested in commodities and real estate through the fund, even though you may have be aware of it.

Your only real responsibility on the diversification side will be to make sure that you have an adequate allocation in cash and fixed income investments. But as far as the stock portion is concerned, you’ll be totally covered by the index fund.

The Track Record of the Market Speaks for Itself

It’s hard to resist the lure of even the potential to double your money in two or three years. However, most that potential is never realized. By contrast, the overall market has a long track record that can’t be denied.

The historic rate of return on stocks based on the S&P 500 is something approaching 10% if you go all the way back to 1928. While that may not represent overnight riches, it’s practically a guaranteed route to prosperity if you can stay invested for many years. If your money earns an average of 10% per year, you will roughly double your portfolio every seven years.

Do the math on that one and see where it leads. Then ask yourself if you would rather go for the route to known prosperity, or take a chance on something that’s much less certain?

You’ve Got Better Things to Do With Your Time

Most of us have a life that has nothing to do with investing. The less time that we need to spend managing and tracking our investments, the more time that we’ll have for everything else.

This is one of the biggest advantages of investing in index funds. You can make a choice of a single investment vehicle, and your only concern is to make sure that you continue to fund it on a regular basis. Then you don’t need to worry about choosing securities, creating allocations, and contemplating when to sell to take profits or cut losses.

You can go on with your life – with a clear head – secure in the knowledge that your investment life is under control by virtue of your participation in index funds.

I’m sure that there are people out there who prefer to choose their own investments for the pure fun of it. But for most of us it’s likely that the only reason for investing is to grow our money to create a more prosperous future. Index funds will accomplish exactly that for us.

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About Kevin Mercadante

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

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