Buy 500 Companies for $1,000
With a Low Cost Stock Index Mutual Fund
Guaranteed Average Returns
Index funds allow average people to participate intelligently in the stock market, by offering diversification and low fees. On the other hand, actively managed mutual funds often do no better than index funds but charge higher fees. Individual investors are flocking to index funds to meet their investment goals.
 What is a Stock Index?
A stock index is a list of names and numbers of shares selected according to some established criteria. For example, the well-known S&P500 Index is a list of 500 selected companies that make up 79% of the stock market in terms of market capitalization.
All stock indexes are managed lists. The list is revised when companies merge, when company performance declines or when other conditions dictate. Companies that are added to the list are often selected for their growth potential.
Some common indices include the S&P 500, the Russell 1000 and the Wilshire 5000. The Russell 1000 Index uses the largest 1000 companies that make up 89% of the market. The Wilshire 5000 Index has more than 5000 companies and includes 99.9% of the market
What is an index fund?
An index fund is a mutual fund that buys the stocks of companies in the index, and holds them in its portfolio. The fund is set up to mirror the performance of the stock index, by holding all the stocks in the index, in the same proportions as the index. The investment goal of index funds is to achieve average results. An index fund turns in an average performance, rather than trying to hit the ball out of the park.
The best-known index fund is the Vanguard 500 from The Vanguard Group, which began in 1975 to track the S&P 500
Like all mutual funds, index funds are a diversified investment, because they hold a large basket of stocks. If one of the stocks in the basket doesn’t perform, the performance of the other stocks probably will offset its loss. Diversifying your investments lowers your risk.
Advantages of owning shares in an index fund
According to the theory of market efficiency, you'll be automatically benefiting from whatever logic the market uses to value each stock. If you don't believe in market efficiency, that's okay, too, since the index is still a diversified basket of stocks.
Other funds charge annual management fees for analysis of stocks. Index funds are passive funds and charge no management fees.
When a U.S. mutual fund sells stocks at a gain, it is required to distribute the capital gains to its shareholders. Funds usually distribute their capital gains once a year. You receive no cash, but your number of fund shares is increased to reflect the distribution. The shareholder must report and pay income taxes on the capital gain, even if the unsold shares show a loss. Because index funds are not active traders, there are often no distributed capital gains. Your tax savings can remain fully invested and continue to improve your investment performance.
Like all mutual funds, index funds are extremely liquid. You can buy shares at your convenience and redeem your shares whenever you need the money. The minimum investment is usually $1,000 or less. There are also ETFs, Exchange Traded Index Funds, which are bought and sold like shares of stock.
Disadvantages of an index mutual fund
Because most indexes are market value weighted, the largest companies in the index influence the index much more than small companies do.
We invest in index mutual funds because we believe that stock markets are efficient and stock-pickers on average will not outperform the market. There is a paradox in this way of thinking, called the Grossman and Stiglitz paradox. If everyone believes that markets are efficient and, therefore, does no stock picking, in the long run markets will not be efficient.
Notwithstanding this paradox, an index mutual fund is an excellent way for the investor to participate in stock markets and realize long-term investment goals.
How much does a share of an index fund cost?
The price of a share in any mutual fund, including index funds, is its Net Asset Value, NAV. At the end of each day, the value of the stocks owned by the fund is recomputed, plus cash held, minus unpaid expenses. The result is Total Net Assets. The total is divided by the number of shares of the fund owned by investors like you. The result is the NAV, the price you pay to buy one share of the index fund. The daily NAV of all funds is published in the financial section of many newspapers, as well as on the Internet.
What am I charged to buy an index fund?
If you purchase your shares from the fund managers, there are generally no other charges, no sales commission, no front-end load fee, and no rear-end load. All of your invested money is put right to work for your benefit.
All mutual funds have operating expenses. Because an index fund is not actively managed, its expenses are significantly less than other mutual funds. The annual expense is often less than .5% of its assets under management. Once a year, the fund collects this fee from your account by reducing the number of fund shares you own by .5%.
How do I buy shares of an index fund?
It’s easiest to buy the shares directly from the mutual fund company that manages the fund. Once you’ve chosen a fund, the website will have details to open an account and send your money. You can also hold index fund shares in your 401K or IRA account.
Many funds offer automatic investments, when you allow the fund to debit your checking account for regular monthly purchases.
Another convenient and cost-effective way to trade the S&P index is to purchase the S&P SPDRs, (symbol SPY). This exchange-traded fund (ETF), which is commonly referred to as "spyders" or "spiders," tracks the performance of the S&P 500, sports an extremely low 0.12% expense ratio and can easily be bought or sold on the open market just like a regular common stock.
How do I sell shares of an index fund?
Selling your shares is called “redeeming” them. You can request a full or partial redemption of your shares by telephone, by letter or on the fund website. It usually takes about five business days to receive the money.
How much money will I make?
The average return of the S&P500 over the past 3 years is 10% per year. Over 5 years, 6% per year. Over 10 years, 8% per year. Of course, past results cannot predict future performance.
Investors should remember that, after all expenses and fees are subtracted, their rate of return will not exactly match the market return of the index. However, it should be very close.
Because of the annual expense fee, and because of the “tracking error” of all index funds, your shares could earn slightly less than the change in the S&P Index.
It is impossible for your fund to mirror the index exactly, because the fund must keep some cash on hand for redemptions, and the fund cannot buy all its stocks the minute an investor sends cash. The small difference between the index performance and the fund performance is known as the “tracking error.” Tracking error can be positive or negative. A well-run S&P 500 index fund should have a tracking error of no more than 5 basis points, which is .05%
Occasionally, when the index adds or drops companies, the index fund has to redistribute its portfolio and may suffer a loss in the action. All in all, however, these losses are small, compared to the fees of managed mutual funds.
To meet your long-term investment goals, to minimize risk and to save the time and expense of researching stocks for yourself, an index mutual fund is the ideal investment vehicle.
I hope this advice brings you much success. I wish you a very happy day.
----- Surfer Sam
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