Indexing may be one of the most overlooked investment choices. Many investors shell out hundreds and thousands of dollars a year in commissions and other various fees. You look at day trading companies such as E trade, which take a cut of all transactions. Transaction commissions are cutting hard earned dollars set aside for investment. Why would anyone want to pay a broker to purchase your stocks when you can personally buy mutual fund index shares with no commission cost. Every dollar you put into an index fund goes towards buying shares in that particular index.
Index funds are unique because they are not actively managed. There are no fund managers playing the guessing game as to which stocks will rise or fall. The index is simply designed to follow the particular benchmark it has been assigned with. For example, if you index with an S&P 500 benchmark, your index fund will buy shares invested in the 500 largest companies in the United States. Because the fund buys into so many companies, the gains and losses are going to offset each other. As some companies are falling, other companies are rising in stock price. The slow gains are what turn people away from index funds. Short-term day traders want to see immediate profits within hours, but the reality is any profits they made will most likely be lost to commissions anyways.
“If you can’t beat the market, be the market: That’s the logic behind index funds.” John Bogle, founder of the Vanguard Group, is a pioneer for index funds. When others claimed they could beat the market through personal stock selection, he found that by indexing and reducing expense ratios, he could consistently outperform more than 85% of the other mutual funds. His key to index selection is choose the index fund with the lowest expense ratio. That is right, more expensive does not necessarily mean better. The higher the expense ratio, the more it will cut into the investments. A few hundred dollars in extra expenses may not seem like a lot, but that money invested over time translates into thousands of dollars lost due to extra expenses.
Bogle was asked what is the highest expense ratio that an investor should accept? He stated, “three-quarters of 1 percent maybe.” Compare that to actively managed funds, which can run anywhere from 1.5 to 3% and you can see that index funds allow for the lowest expense ratios. It is no coincidence that Vanguard offers the lowest expense ratios of any investment firm. The Vanguard 500 Index Shares fund has an expense ratio of .15%. For people who do not have an initial $3,000 to invest they can set up an account with TIAA-CREF, which accepts investors willing to make smaller monthly investments. TIAA-CREF has slightly higher expense ratios around .50% plus, but still fall well below Bogle’s maximum .75% expense ratio. The key to indexing is keeping the expenses as low as possible in order to maximize investment gains.