What are the pros and cons of mutual funds and index funds?
I remember when I first learned about mutual funds I thought, “Whoa, this is cool but also confusing! Expense ratio what?” Once I fully understood mutual funds and especially index funds, I felt like I had a super power: the knowledge that this was the best way for me to build wealth in general and to save for retirement specifically.
So, let’s talk about mutual funds and a type of mutual fund called an index fund. I’ve tried to keep this very simple. Please email me if something here is confusing or if you have more questions. Full disclosure: I used to invest in many mutual funds but I now invest only in index funds.
What is a mutual fund?
A mutual fund is an investment product that lets you invest in a whole bunch of companies’ stocks, bonds or other products all at once. In this post I’ll focus on stock mutual funds.
Think of a mutual fund as a basket filled with the stocks of several or even hundreds of companies, from Apple to Chipotle to Kodak. When you invest your money in a mutual fund, you buy a share of the basket. This means you’re now invested in a diverse set of companies.
Investing in a mutual fund means you have less risk than if you invest in individual stocks. If you put your money in a mutual fund with Apple stock in it and Apple goes out of business, you might lose a little bit of money. If you own the Apple shares outright and the company goes under, you will likely lose a lot of money.
Hundreds and even thousands of people can invest in one mutual fund. And there are hundreds and even thousands of different kinds of mutual funds in which you can invest. There are technology funds that invest only in tech companies. There are socially-responsible funds that invest only in companies that do good. And there are funds that invest in emerging markets around the world. The Morningstar website is a good source of information about all mutual funds available for Americans to invest in.
Mutual funds charge fees to cover the cost of managing and operating the funds. The expense ratio — the official term for the most common of these fees — is basically a managing fee. It’s always expressed as a percentage. An expense ratio of 0.2% means that if you invest $10,000, then 0.2% or $20 will be taken out as a managing fee. An expense ratio of 2% means that if you invest $10,000, then $200 will be taken out as a managing fee. There are other fees besides the expense ratio; this article from The Balance does a good job explaining all mutual fund fees.
The bottom line on mutual funds
• Fund managers may not work in your best interest
• Potential for high management fees
• Majority of funds don’t outperform the stock market
• Diverse and flexible investment
• Less risky than owning individual stocks
• Potential for high returns
What is an index fund?
An index fund is a mutual fund that tracks a specific financial market index. An index fund is a basket of stocks — like a regular mutual fund — but all the stocks in the basket match the companies that are in a financial market index.
What companies are in a stock index?
You can see the DJIA components here, the S&P 500 components here and the NASDAQ components here. Other countries have their stock indices, too. If you’re nerdy like me, you can scroll through this list of their cool names, like the Hang Seng in Hong Kong and the DAX in Germany.
Let’s take a baby step back and define a financial market index. You’ve probably heard people talking about the stock market going up or down, right? In the United States, what they’re really saying is that the Dow Jones Industrial Average (DJIA), the S&P 500 or the NASDAQ went up or down; those are the three most-followed U.S. stock indices. An index fund is filled with the stocks of companies that make up those indices. Most importantly, an index fund tries to match the stocks it owns in the same proportion as they are in the index. What that means for you, the investor, is that if the stock index goes up 5% in one year then your index fund should go up 5%, too.
What makes an index fund attractive to many investors is how simple it makes investing. Many investors also like its low cost. Whereas many mutual funds have a human person at the helm actively deciding which and how many stocks to put in the basket, index funds have a human person at the helm who just has to make sure the stocks in the basket track the index. That’s a lot less work. This translates to a lower cost for you vs investing in a non-index mutual fund.
If you’re planning to save your money for a long time before taking any out, then an index fund is also attractive because history shows you will likely make money. All U.S. stock indices have moved up over the long-term. For example, the S&P 500’s average annual rate of return is just under 10%. That’s low compared to some non-index mutual funds but higher than others. It’s all about how much risk you’re willing to take.
The bottom line on index funds
• No flexibility in investments
• Rarely outperforms the index
• Easy way to invest
• Low operating expenses
• Dependable return on your investment