Investing legends like Warren Buffett sing the praises of index funds all the time. And there's good reason. This special class of mutual funds, which tracks a market index, can help you grow your retirement savings even if you don't know much about investing at all. Here's a quick look at some of the key benefits of index funds and how you can add them to your retirement portfolio if you think they're right for you.
1. Instant diversification
Index funds are mutual funds -- bundles of stocks you purchase as a package. When you purchase one, you instantly own a small portion of hundreds of different companies. That kind of diversification is critical for reducing your risk of loss.
If your nest egg is only invested in one or two stocks, you need those stocks to perform well, or you could lose your whole life's savings. We can't count on the stock market doing what we want, so we have to hedge our bets by investing in a lot of different things. That way, when one of our stocks takes a hit, the other stocks we own can pick up the slack. Index funds make it easier and more affordable to become diversified than purchasing individual stocks.
2. Emotionless investing
Index funds are often marketed to beginning investors because you don't need to know a lot about how to pick stocks in order to succeed with them. Some people, if left to fend for themselves, try to bet on the next hot stock and panic if they start to lose money. This can lead to bad decisions, like buying stocks that are actually worthless and selling when you should just hold on a while longer.
Index funds eliminate the need for individual stock picking because they offer up a neat bundle of well-known, established companies that have weathered many financial ups and downs. Of course, that might not stop all emotional investing decisions, but if you're the type that just wants to put your money in something and not think about it very much, an index fund allows you to do that.
3. Low fees
Index funds are passively managed funds, which means the fund manager doesn't choose the stocks that are included. They mimic the market index they're based on, and that means there's less work for fund managers to do. While the stocks in the fund can change over time, index funds usually experience less turnover than actively managed mutual funds with stocks chosen by the fund managers themselves. Because there's less work involved in maintaining the fund, you don't have to pay as much to own it.
All mutual funds, including index funds, have expense ratios, or annual fees you pay for owning the fund. This is usually a percentage of your assets, so if you have $100 invested in the fund and it has a 1% expense ratio, you'll pay $1 that year. A 1% expense ratio may not sound that bad, but it can get costly, especially as you get more and more money invested in the fund.
Index funds often have expense ratios well under 1%, whereas some actively managed funds can have expense ratios of 2% or more. So even in a scenario where an index fund and an actively managed mutual fund see the same rate of return in a given year, the index fund wins because you're paying less to own it.
4. Strong performance
Index funds have their ups and downs just like any other investment, but often they outperform many actively managed mutual funds. In 2008, Warren Buffett made a $1 million bet that an S&P 500 index fund could outperform five of the hedge fund industry's best actively managed mutual funds over 10 years. He won. But he wasn't always leading the whole way.
With any investment, you have to be willing to accept some risk and trust that over the long haul, you're going to grow your wealth. While the past isn't an indicator of future performance, it can be reassuring, especially to new investors, to know that many of the market indexes the index funds are based on have trended upward over time.
How to start investing in index funds
If you think index funds would make a great addition to your retirement portfolio, you don't have to go too far to find them. Many brokers offer a variety of index funds for you to choose from.
First, you have to decide which index you want your fund to track. Then, you have to decide which index fund is best. This usually comes down to cost. Look at the funds' expense ratios, investment minimums, account minimums, and other details to decide which is right for you. Once you've found a fund and a broker you like, you just have to put some money in, sit back, and watch it grow.