Twenty Something Sense

Today’s guest blogger is a friend from Virginia Tech (go Hokies!). Nate was in the business school and was extremely active with the campus newspaper and various other groups. These days he keeps himself as an aspiring entrepreneur and oh yea - a day job.

Index Investing
by Nate Jones

I love investing but I go about it in a very calculated manner. I’m young so I’m willing to take on a fair amount of risk but fundamentals are important to my strategy. One of those fundamentals, I don’t like seeing money left on the table - no sense in overpaying for your investments! My general approach…index funds! That doesn’t mean I don’t invest in some actively managed funds. It just means I monitor them very closely and only do so when it makes absolute sense.

An index fund is an investment vehicle that invests in a statistically significant sample of equities in a particular market. It’s unrealistic to track every single stock which is why index funds choose a smaller sampling of equities that is representative of the whole. In English, an index fund essentially allows you to own a little bit of everything without actually owning everything. Index funds are typically based on computer models with little human intervention and there’s an index funds to track just about anything you can imagine from short term bonds to Total World Domination…well domination is a bit much, but you catch my drift.

Actively managed funds, on the other hand, retain a fund manager whose sole goal is to manage
investments in a manner that allows the fund to outperform industry benchmarks whether it be the Dow, S&P 500, NASDAQ, etc. They employ a range of strategies and throw money in a number of investment vehicles to accomplish this goal. Their strategies and types of investments are typically driven by the type of fund it is.

Advantages
Quite possibly the greatest thing about index funds are that they are cheap…dirt cheap…and
easy. You can pick up a phenomenal index fund for around .2% of the account value and be up
and investing in no time. Compare that .2% with a typical 1%+ fee for actively managed funds
and that fancy fund manager of yours better beat the benchmark to make up the difference.

Another great feature of index funds is the inherent diversification and risk mitigation. They won’t make you completely diversified, and definitely don’t confuse it with asset allocation, but again, you own a little bit of everything which means some of the funds share values will go up while others go down. This levels your volatility but you rely on the overall market trending upwards to create your gains. Given the last year and likely this year, that trend can be difficult but consider this the perfect time to buy…LOW.

Because index funds are generally computer run, they also remove the emotion in investing. Let’s be honest, even the best fund managers can get emotional at some level which can lead to bad decisions. By allowing a computer to do all the work you systematically mitigate the risk involved with emotions.

Disadvantages
As much as I’m evangelizing index funds, even I must admit they aren’t perfect for every situation and they definitely don’t suit every investors palate. Some of the things that make index funds great are the same reason they don’t always fit.

While computers have the ability to crunch more data than any human being, they don’t get emotional. While I consider it an advantage, there are times purely qualitative data can be a driving force in making sound investments. While they are more risky, higher risks present the possibility of higher returns. But, keep in mind, it also presents the possibility of a greater loss.

On a similar note, the fact that you own a little bit of everything with index funds is both a blessing and a curse. You own a sample that represents the whole which means you may not own that hot, new stock and if you do, it may not be enough to get you that magical return. However, it is likely enough to outweigh the losses of another asset [in the fund] and hopefully push your fund trend in the proper direction…up!

In closing, index funds aren’t for everyone but they are something everyone should consider. They don’t offer the most glamorous returns but they’re consistent and they go along ways in helping investors mitigate risk and keep a larger portion of their returns (or more of their initial account value if they have a bad year). Some people love the rush of knowing they picked the right stock or that their fund outperformed another, and that’s ok. Index funds are for those of us that are willing to shoulder a calculated amount of risk and looking for consistent performance. I mean…it doesn’t make sense to pay for someone else’s (a fund manager, perhaps) retirement.