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Slow and steady wins the race, and Index Funds are indeed a slow and steady way to make money in the stock market. If you want a get rich quick scheme, read no further. Warren Buffett, the most successful investor in history, has said it over and over again: “The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time”. There are three key phrases here: “index fund”, “low-cost” and “buying regularly over time”.

What’s an Index Fund?

Before we dive into Index Funds, let’s discuss their counterpart: the Managed Fund. These are the original Mutual Funds. Typically you are paying a manager or managers to pick stocks for you. They do research, make phone calls and visit companies they want to invest in. This amount of work can cost you some bucks. Most managed funds charge at least 1% for this service, with some moving closer to 3%. So, for every $100 you invest you pay $1-$3 dollars, for every $1000 it would be $10-$30. This is not a small amount, and will add up over years of investing. It would be worth it if the returns were great, but usually they are not.

Index Funds are like regular mutual funds, except they follow a specific index. The most popular index is the S&P 500, which is an index of the 500 largest American stocks. As you probably guessed, there really isn’t a lot of work involved in determining this list. It’s pretty automated. The result is that you pay a reduced fee. S&P 500 Index funds typically charge less than .5%. The most popular of the group is Vanguard Funds which charges a fee of .15%; that’s only 15 cents for every $100 you invest!

A common mistake is that if you’re paying more, you must be getting more. Managed funds must perform better than index funds. The truth is that over 90% of managed funds UNDER perform their target benchmark over the long haul. And their target benchmark is usually an Index Fund.

Vanguard Funds founder, John C. Bogle, was really the guy to bring index funds to the masses. For his undergraduate thesis at Princeton, Bogle found that three out of four fund managers could not outperform a passively held basket of the 500 largest US stocks. They may end up picking specific stocks that do as well, but paying high expenses associated with their research and taxes incurred during active trading, just resulted in their funds under performing the S&P 500. Bogle is the king of index funds. He built the well respected Vanguard Funds on that philosophy and even wrote a great book about common sense investing which highlighted index funds.

Low-Cost is the key

The secret to successful index fund investing is low expense. Why pay more for a list of companies that require no research? Get the prospectus or visit Google Finance or Yahoo Finance for the fund you want to invest in and check the expense ratio. You should aim for .5% or less. Other things to look out for are the minimum investment and account service fee. For example, to get Vanguard’s low expense ratio of .15%, you need to make a minimum investment of $3,000 in the fund. An annual $20 fee is tacked on to your account if it’s less than $10,000, unless you sign up for e-delivery of statements and some other bells and whistles. So research the fund expenses before you send them any money.

Buy regularly over time, because you can’t time the market

Nobody can time the stock market. Warren Buffett has never called a market high or a market low, so seriously, what chance do you have? By buying regularly over time, you adhere to the old standby of dollar cost averaging, which works very well.

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So, you still aren’t convinced that index funds are a great choice for you? Well, maybe this will convince you. Warren Buffet is so sure that the S&P 500 will outperform an actively managed fund over the long term that he bet over $300,000 that they would: “Over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S & P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.” If I can’t convince you, hopefully Buffet can.

The truth is: the stock market goes up and down in cycles.  These cycles usually last 5-10 years.   Take a look at the chart below.

This is the 10 year chart for the Vanguard S&P 500 Index Fund (VFINX), which represents the 500 largest companies in the United States.  As you can see, the price in Oct 1998 is similar to the price in Oct 2008.

So, if you invested $1000 in Oct 1998, you saw your money grow substantially in 2000, then you saw it drop again in 2002, rise again in 2007, and then drop again in 2008.  What a roller coaster!

If you invested one time in Oct 1998 and just sat on the money for 10 years, you pretty much broke even over this span.  Not a very good return on your money.

But, if you have been investing in your retirement plan regularly, then you’ve been dollar cost averaging.  You bought shares at the lows in 1998 and 2002, and at the highs in 2000 and 2007, and everything in between. Depending on your timing, you may have even made some money.

Here’s the scoop:

1. If you’re nearing retirement you need to remember that you probably won’t need all your retirement money when you retire.  The best strategy is to slowly withdraw the money every month or quarter over your many years of retirement.  By that time the stock market should recover, because it usually fluctuates in 5-10 year cycles.
2. You may want to consider increasing your contributions to your 401k plan.  That’s right– increase!  The stock market is on sale, so why not take advantage?

Either way, just remember, you don’t lose your money until you sell.

I am interested to know what you’re doing with your retirement account.  Please leave a comment below.