Warren Buffett is an investment genius, and his investment philosophy is simple: Have a diverse portfolio of securities, and hold onto them for a long time. In his letter to the shareholders of Berkshire Hathaway, the company he’s headed since 1965, he said that he was investing his wife’s inheritance in just two things: short-term government bonds and index funds.
If you want to invest but aren’t sure where to start, index funds make a simple and smart choice. Let’s take a look at what they are and why they’re good for beginning investors.
How Do Index Funds Work?
We measure the overall performance of stocks, bonds, and other types of securities by following specific indexes. The most familiar indexes are the Dow Jones Industrial Average, the S&P 500, and the NASDAQ. Other indexes include the Russell 2000, which tracks small-business stocks, and the Barclay’s Capital Aggregate Bond Index, which tracks high-performing U.S. bonds.
Index funds are a basket of investments in the companies that affect these indexes most closely. The performance of these investments mirrors the performance of the index they’re designed to track. Right now, investors have placed nearly $2 trillion in stock index funds and over $500 billion in bond index funds. Over the years, Warren Buffett’s favorite index fund, Vanguard’s S&P 500 Admiral fund (VFIAX), has gotten 60 percent higher returns than some of the world’s best hedge funds.
Why Are They So Great?
Getting a business management degree is a great way to advance your career, but even without one, you can still understand the benefits of looking towards index funds. The advantages include:
- Low costs. Brokerages operate most index funds at a very low cost. Low expenses mean that administrative costs and brokers’ commissions gobble up less of your investment return.
- Investment experts recommend that you hold a diverse investment portfolio. This means that you minimize risk by investing in many different companies as well as in several types of securities. Index funds, because they contain shares from a wide range of companies in different industries, provide instant diversification for novice investors.
- Good historical performance. The Vanguard 500 Index Fund (VFINX), another index fund that tracks the S&P 500, has outperformed 80 percent of actively managed U.S. stock funds.
What Are Your Options?
Most investment experts recommend choosing index funds as the core of your investment portfolio. You can choose between mutual funds and exchange-traded funds (ETFs). The biggest difference between mutual funds and ETFs, in addition to how gains are taxed, is that mutual funds are priced once, at the end of the day, and ETFs are priced moment-by-moment.
If you’re sticking with a buy-and-hold strategy, which you should be as a beginning investor, these differences won’t matter much. What matters more is that mutual funds usually have minimums for initial investments and reinvestments. These minimums keep the funds more stable, but you’ll have to save up before you can invest in them. With ETFs, even small investors can jump right in.
Here are some examples of index funds that you can buy, keeping in mind that you should research them thoroughly before making a final decision.
- Traditional Indexes
For people with little investment experience, a fund that tracks a big index, like the S&P 500, is the perfect starter investment. We’ve mentioned a couple of Vanguard Funds, but you can also track other indexes with the PowerShares QQQ (QQQ), which tracks the NASDAQ 100, or the iShares Core Total U.S. Bond Market (AGG), which tracks — you guessed it — U.S. bonds. You can also track overseas indexes with funds like Vanguard’s Total International Stock Index (VXUS).
- Other Indexes
Instead of tracking overall market performance, some indexes track commodities, government bonds, companies that pay dividends, or certain industries. As a beginner, stick with traditional indexes, but as you get more money, you can start branching out. Try the iShares Gold Trust (IAU), which tracks the gold market, or the Technology Sector SPDR (XLK), which tracks over technology industry performance.
Manage Your Risk
Buying and holding an S&P 500 index fund shouldn’t hurt you over the long term, but any plunge in the U.S. stock market will hurt your investments in the short term. As your assets grow, spread out your investments to include some bond, commodity, and international indexes.
