When Should You Invest in Index Funds?
There is no guaranteed way to predict which types of mutual funds will perform better than others. This is especially true during short periods such as one year or less. However, certain circumstances can make index funds a smarter choice.
During strong bull markets – when stock prices are rising across all sectors and types of mutual funds – actively managed funds may lose their edge. In a bull market, strategic buying and selling has an equal chance of underperforming against major market indices rather than matching or exceeding them.
For example, in 2006, when the market was in the last year of a rapid ascent, the Vanguard 500 Index Fund (VFINX) outperformed over 75% of large-cap blend funds. In 2010 and 2011, when stocks were in full recovery mode after the bear market of 2008, VFINX outperformed the majority of its peers.
Recessions typically lead people to buy bonds. However, the bond markets can be difficult to navigate. Active bond fund managers often learn the hard way: by underperforming index funds like the Vanguard Total Bond Market Index (VBMFX). For instance, when recovery faltered in 2011, and stock funds were fortunate to escape negative returns, VBMFX outperformed 85% of all long-term bond funds.
What is Dollar-Cost Averaging?
For those looking to mitigate market fluctuations, dollar-cost averaging is a good option. This strategy involves investing a fixed amount of money at regular intervals. For example, you might decide to invest 15% of your salary into your company’s 401(k) account. In this case, you would likely choose to deduct 15% from each paycheck.
Whether you contribute monthly, quarterly, or annually, dollar-cost averaging works. It ensures that you do not invest a large sum in a stock or fund when its price is high. Conversely, it positions you to take advantage of market downturns and buy at lower costs.
Suppose you bought 250 shares of ABC Company at $20 per share for a total of $5,000. If you used a dollar-cost averaging strategy and split that $5,000 into four purchases at prices of $10, $20, $25, and $30, you would end up with more than 279 shares. Over time, those extra shares can add value to your investment.
When Should You Choose Mutual Funds?
The most common time index funds lag behind actively managed funds is when markets turn volatile. In such an environment, a skilled (or lucky) active fund manager can sift through and find stocks or bonds that may outperform major market indices.
This type of market is often referred to as a “stock-picking market.” As with any market environment, some sectors can perform better than others. The main issue with mutual funds, however, is the fees. Some have expense ratios exceeding 1%, which can negatively impact significant returns.
Note: The difference between 0.5% and 1% in expense ratios may not seem large, but over the long term, it adds up.
Conclusion
There is no way to predict what the market will do in any specific timeframe, but the passive nature and low cost of index funds provide an advantage. Over the long run, this helps them outperform most actively managed funds. Lower costs often translate to better long-term returns, and you do not have to deal with the irrationality of human nature.
Funds
Index funds are smart tools for diversification. When paired with actively managed funds, they can help you build a strong long-term portfolio. Vanguard, Fidelity, and Charles Schwab are reputable companies offering a variety of low-cost index funds.
Frequently Asked Questions (FAQs)
How many index funds should I own?
To get a specific answer to this question, it’s best to consult a financial advisor. Generally, the more targeted the fund, the greater the need to build a balanced and diversified portfolio. With a total stock market fund or S&P 500, for example, you might only need one fund to build your equity exposure. If your index fund tracks a specific sector, on the other hand, you may want to balance that sector exposure with additional index funds that track other sectors.
How can I invest in index funds?
One of the easiest ways to invest in index funds is through a brokerage account or a retirement account like a Roth IRA. These accounts are opened in the same way as any other type of financial account. Once your account is set up and funded, you can place a “buy order” for the fund you wish to invest in.
What are the costs associated with investing in index funds?
The cost of investing in index funds depends on the specific fund in question and the broker you are using to invest in it. Index funds set minimum investment amounts, and it’s not difficult to find a fund with a minimum investment of $0. When a fund accepts any level of investment, it is up to the broker to set the minimum transaction values. Brokers that offer fractional share trading may allow you to place a buy order for as little as one dollar.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we verify facts and maintain the accuracy, reliability, and quality of our content.
Yahoo Finance. “Vanguard 500 Index Fund Investor Shares (VFINX).”
Yahoo Finance. “Vanguard Total Bond Market Index Fund Investor Shares (VBMFX).”
Investor.gov. “Index Funds.”
Source: https://www.thebalancemoney.com/best-time-to-invest-in-index-funds-2466412
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