Advantages to Investing in Indexed Mutual Funds

The average investor is likely to benefit most from investing in indexed mutual funds when compared to other mutual funds or individual stocks. This is due to the notion that the average investor is looking to save for retirement and is therefore unwilling to take on large amounts of investment risk. As long as the investor is savings for at least five years, indexed mutual funds represent the safest investment with the highest yield. This strategy is riskier for those retiring in the next few years. As we saw in 2008 and 2009 the market is prone to bad years and retirees may not have sufficient time to recover their losses in a bad market.

Costs of Actively Managed Funds

Actively managed funds face relatively high expense ratios. This is a measure of the amount of the fund’s money that goes toward paying the fund manager and other costs. It stems from the time and expertise required to manage a mutual fund, including making decisions regarding what to buy and how much to hold. However, not all mutual fund managers are able to pick stocks that all outperform the market. In fact, a mutual fund holding a sufficiently high number of different stocks is likely to see returns that are almost identical to a market index. This is due to diversification, which means that the risk of investing in individual companies’ stock is reduced, or eliminated,  when many uncorrelated stocks are held in a portfolio. The risk that is left is called market risk and it represents the inherent risk of investing in stocks at all.

So if a large number of funds are made up of a lot of stocks that are in the market index, then those funds can expect to make returns that are reasonably similar to market returns. This tends to be the case, but the fund’s expense ratio still must be paid. The fund is usually paid close to 2 percent. Another issue is that mutual fund managers generally keep cash reserves in the portfolio as a precaution. This cash is tied to risk-free securities like Treasury bills, so it does not earn the same returns as the rest of the market. This will also work to reduce the fund’s returns when compared to the market.

Composition of Indexed Funds

Indexed funds do not face the challenges that actively managed funds because the investment decisions are clearly predefined. A mutual fund that is tied to the S&P 500 will invest in the stocks listed in the index at weights for each stock as close as possible to the weights in the index. While it is possible to invest in individual stocks and yield higher returns than the market in any given year, there is also a much higher risk of losing money than by investing in the market. The S&P 500 and other market indexes have historically outperformed virtually all mutual funds over long time periods, making them wise investment choices for those investors looking to live off of their investments during retirement.

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