Late last month, famed investment guru Warren Buffett, the 86-year-old billionaire chairman of Berkshire Hathaway, offered the following advice in his annual shareholder letter: “Both large and small investors should stick with low-cost index funds.”
Naturally, think pieces came out soon after, either calling Buffett brilliant or bonkers. In any case, if you’re part of the estimated half of the country that doesn’t invest, according to numerous surveys, you may well be wondering how risky index investing is, and if you should get in on it.
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Of course, if you don’t invest, you may well be wondering what an index fund is. In a nutshell, it’s a type of mutual fund. But whereas traditional mutual funds are managed by an investment company’s portfolio manager, with an index fund or an exchange-traded fund, aka ETF, a subset of an index fund, you aren’t actively managing it. You’re investing in a collection of stocks that represent parts of the stock market, such as the popular Standard & Poor’s 500 index, and hoping that your investment grows over the years.
Is it worth investing in? That’s up to you and perhaps a financial advisor to decide, but here’s what you won’t be risking if you invest in indexes — and what you will risk.
There’s little risk of paying a lot of high fees. This is why many investors and wealth advisors are enthusiastic about index investing. It’s a generally less expensive way to invest over hiring a manager to oversee a mutual fund. As Buffett said in this year’s annual shareholder’s letter, “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.”
How low are the fees? It varies, naturally, and actually, instead of “fees,” expense ratio is the lingo used to define how much you’re paying to invest in index funds.
“The average [expense ratio of an] equity index mutual fund or ETF could be in the .08 percent to .12 percent range,” says Dan Yu, managing principal of EisnerAmper Wealth Advisors in New York City. For an equity mutual fund, Yu says that you might end up paying more in the range of .8 percent to 1 percent.
“The fees will range based on the type of ETF or active mutual manager, but the point to take away is there is a significant fee difference,” Yu says.
For instance, if your expense ratio is 1 percent, and you’ve invested $10,000 into a mutual fund during the year, $100 of that went to fees. If you invested $10,000 in an index fund with a .08 percent expense ratio, you spent $8.
Of course, if you believe you made more on the mutual fund than you would have with the index fund, the higher fee may not bother you.
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You won’t risk making emotional, bad decisions (probably). Anyone can mess up a good thing, but index investing is best for someone who plans on planting his or her money and being willing to let it grow without constantly thinking about it, according to Jeremy Sakulenzki, an investment advisor and owner of South Texas Wealth in San Antonio.
“Index investing in specifically either the Dow Jones or the S&P 500 can be an attractive investment for younger investors and even people in their early 50s,” Sakulenzki says.
Sakulenzki doesn’t, however, recommend it if you’re close to retirement. Index funds, he says, are “great investments for long-term growth, but being so heavily invested in stock, 100 percent, it can also at times be quite volatile. When people start to get closer to retirement, they should start steering away from indexed investments and toward more conservative investments because they no longer have the time it takes to recover from a possible correction.”
So, yes, you can make an emotional, bad decision to invest in index funds, especially if you panic easily and sell at a loss. But if you can invest and then forget about it, the way most people tend to do with index investing, you’ll probably be ahead of the game, according to Robert Johnson, president and CEO of The American College of Financial Services in Bryn Mawr, Pennsylvania.
“Investors tend to make two critical mistakes,” Johnson says. “First, they often try to time the market. That is, when markets are rising they tend to become confident in the markets and make investments. After the market has corrected they get nervous and sell out, only to get back in after markets have risen. In essence, people tend to buy high and sell low, in direct contradiction to the old Wall Street adage. People should realize that time in the market is more important than timing the market.”
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You will risk your money. Low-risk investing is not no-risk investing, and plunking down a minimum payment to invest in an index fund can be costly. There are some exceptions, however. For instance, to invest in index funds at Charles Schwab Corporation, you only need a minimum investment of $100. But more often than not, you’ll be asked to pony up, at a minimum, $3,000 to invest in index funds. That’s surely too steep of an admission fee for many consumers. And even if you set up your bank account so you’re investing in index funds every month, and you don’t panic during the inevitable downturns in the stock market, and you wait for years until you’re ready to sell and reap your rewards — there’s no guarantee you’ll be rolling in the money. With few exceptions, most investments involve some risk.
Then again, you could never invest in anything, and that might be considered risky, too.
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How Risky Is Index Investing? originally appeared on usnews.com
